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Is Virtu The Perfect Hedge?

Feb. 11, 2019 4:56 PM ETVirtu Financial, Inc. (VIRT)ITG, SPY, TLT15 Comments

Summary

  • Virtu benefits from volatility in the stock market. The correlation between Virtu and the S&P 500 is -0.04.
  • Adding Virtu to a portfolio tracking the S&P 500 can reduce the volatility by 5% and increase the return by 1%.
  • Virtu has a dividend yield of about 3.5% and is a capital light growing business. The acquisition of ITG should close in H1 2019 and should enable future growth.
  • Virtu seems undervalued with a Price/Earnings ratio of 13 based on 2018 earnings.
  • The TLT is a more effective hedge against market risk than Virtu and can reduce the volatility of the SPY by 45%, but at the expense of lower returns.

Introduction

The main business of Virtu Financial (NASDAQ:VIRT) is market making in the cash, futures and options markets in North America, Europe and Asia. As a market maker, Virtu commits capital on a principal basis by offering to buy securities from, or sell securities to, broker dealers, banks and institutions. The Execution Services business of Virtu offers execution services on behalf of institutions, banks and broker dealers. This execution services business will grow further after the planned acquisition of Investment Technology Group (ITG). Virtu is listed on the Nasdaq. The IPO of Virtu was on April 16th, 2015.

The market making business benefits from volatile markets, because during market turmoil, bid/ask spreads widen and the amount of transactions increase. The correlation between Virtu and the SPDR S&P 500 ETF (SPY) is -0.04. This is very interesting, because stocks with a negative correlation with the SPY are rare. The picture below shows this slight negative correlation.

ChartData by YCharts

Is Virtu a good hedge for the SPY?

In theory, the negative correlation of Virtu can be used to hedge market risk. I did a back-test using daily closing prices of Virtu and the SPY since the Virtu IPO. The back-test showed that the volatility of a portfolio consisting of 17% Virtu and 83% SPY had an annual volatility of 12.3%. This is 6% less than the annual volatility of the SPY, which was 13.1%. This VIRT/SPY portfolio did not only reduce the volatility, but it also increased the annual returns by more than 1% due to the rebalancing of uncorrelated stocks. I explained in my article, Volatility Alpha: Capturing Additional Returns From The Volatility Of Uncorrelated Assets, that the rebalancing of uncorrelated assets increases returns.

Is Virtu a better hedge than the iShares 20+ Year Treasury Bond ETF (TLT)? The

This article was written by

I am a value and quant investor specialized in special situations.

Analyst’s Disclosure: I am/we are long VIRT, TLT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

I am short SPY

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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