Saturday, June 7, 2014

ETFs are likely to be at the center of the next crash; Exhibit 1

A Strategy With Literally Fantastic Returns
By Samuel Lee | 05-16-14 | 06:00 AM | Email Article

A version of this article was published in the February 2014 issue of Morningstar ETFInvestor. Download a complimentary copy here.

The S&P 500 Dynamic VEQTOR Index is a shining example of financial innovation gone wrong. Start with the name: If an investment sounds like it came out of a science fiction novel, it's likely too creative for its own good. Products with futuristic names are targeted at people impressed by the veneer of sophistication. They are rarely good investments.

Why am I picking on this index? Because at least $850 million tracks it through the  Barclays S&P 500 Dynamic VEQTOR ETN (VQT) and PowerShares S&P 500 Downside Hedged (PHDG) despite the index's short history. I fear that the product is sold on the basis of a literally fantastic back-test that seems to offer the Holy Grail of asset allocation: high returns and negative correlation to the market during downdrafts. Had this strategy been implemented prior to the financial crisis, it would have skyrocketed more than 50% when everything else was collapsing.

Before I get into why the back-tested returns are fantastic, I need to devote a fair amount of space on the nature of the strategy and its underlying exposures (yet another bad sign).

The index allocates among the S&P 500, the S&P 500 VIX Short-Term Futures Index, and cash. The critical piece is the VIX allocation. VIX is the options market's estimate of the S&P 500's future 30-day volatility. The measure is derived from the implied volatilities used to set call and put options on the S&P 500. When the market declines, expected volatility almost always spikes. When very bad news comes out, VIX can shoot the lights out. Owning VIX is like taking out an insurance policy on market fear. If you could directly own VIX, you'd have to be crazy not to. Even though VIX is highly mean-reverting and generates little to no long-run return, its insurancelike properties could dramatically improve a diversified portfolio's risk-adjusted returns. Alas, VIX is not directly investable. One can only invest in VIX-linked futures. The gap between the two is big enough to drive a truck through.

VEQTOR aims to ramp up its VIX exposure at times when volatility is more likely to surge. The VEQTOR Index can be thought of as a highly leveraged market-timing strategy that effectively shorts the market at certain times by greatly increasing its exposure to VIX futures.

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