Thursday, October 14, 2010

The Case for VQT

Many investors, present company included, are sitting on sizeable gains from long positions going back as far as March 2009. With the S&P 500 up 16% from its recent July 1st low of 1010 and looking like it may take another run at 1200 sometime soon, longs are torn between the desire to lock in some profits on the one hand and have the potential to benefit from further upside on the other hand.

While there are a number of ways to approach this problem, a new off-the-shelf strategy became available with the launch of Barclays ETN+ S&P VEQTOR ETN (VQT) on September 1st.

To briefly recap, VQT is essentially a portfolio with two components: a long SPY component and a long VXX component. At the end of each day, the ETN evaluates volatility risk and based upon rules which incorporate realized volatility and implied volatility, determines how much the SPY positions should be hedged with VXX. The result is a dynamically hedged long position that is hedged with volatility. The SPY component of VQT is set to vary in a range of 60-97.5%, with the VXX component comprising the balance of the VQT at anywhere from 2.5-40%.  VQT also has another intriguing portfolio allocation feature that none of the other volatility ETNs have:  a stop loss provision which overrides all other allocations.  This stop loss provision is triggered whenever VQTs 5-day return falls below -2%, at which point the ETN's portfolio automatically switches to 100% cash and remains at 100% cash until the 5-day return rises above -2%.

The chart below shows that VQT is structured not only to limit losses in an environment of increased volatility, but also profit in some high volatility scenarios.

Since VQT is perhaps the most complex actively managed ETN that is traded, I highly recommend that readers study the pricing supplement for VQT, the highlights of which I sketched out in Barclays VEQTOR ETN (VQT) Begins Trading.

Finally, I feel obliged to mention that to date VQT has only managed to trade about 5,000 shares per day, on average. While market depth is not great, the spread is consistently in the area of about 0.06 – which is not bad considering that VQT is trading over 105 as I type this. As is the case with any exotic ETN, there is no guarantee VQT will attract sufficient interest to become a permanent fixture on the investing landscape, which would be a shame, because I believe this ETN has considerable potential.

For those who think they might have an interest in this product further on down the line, I have one thought: use it or lose it!

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[source: Barclays]
Disclosure(s): long VQT and short VXX at time of writing

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