Although stocks are still up for the trailing three month period, broad benchmarks have come well off their highs. The S&P 500 has fallen by about 4% in the past month, as talk of tapering bond purchases and weak data from global markets have led to sluggish trading conditions.
There is also some concern that this trend might take a little longer to play out as there is still uncertainty over the Fed’s bond buying program and when tapering will actually begin. Furthermore, some believe that China is just in the beginning stages of a crisis of its own, while other markets—both developed and emerging—are on shaky footing to say the least as well.
Still, the U.S. economy has seen plenty of strong data points lately suggesting that if you can get past the Fed-inspired issues, there are at least a few reasons to be bullish. Consumer confidence has been quite strong while home prices and durable goods orders both came in above expectations, signaling that many aspects of the U.S. economy are doing quite well.
How to Play
Given this situation, investors may want to stay allocated to U.S. markets, but apply a hedge to their portfolios in case more volatility returns. While adding on a short ETF or looking to uncorrelated assets may be a way to go, investors may also want to consider taking a closer look at either Barclays ETN+ S&P VEQTOR ETN (VQT - ETF report) or the PowerShares S&P 500 Downside Hedged Portfolio instead.
These two products both look to track the S&P 500 Dynamic VEQTOR Index. This benchmark seeks to give investors broad equity exposure, along with a volatility-related hedge, possibly making either an ideal play in this environment (see Which Volatility Hedged ETF Should You Consider?).
This looks to be done by dynamically allocating exposure across three separate types of assets; the S&P 500, the S&P 500 VIX Short-Term Futures Index, and cash. The portfolio stays mostly in equities, but it always has at least 2.5% in its ‘target volatility allocation’.
This allocation to volatility increases when realized volatility levels are elevated, or are on the rise, potentially rising to make up 40% of the portfolio in extreme situations. This approach helps to save performance during turbulent market times, and can actually assist in outperforming broad stocks during rocky situations when stocks are sliding across the board.
This has definitely been the way to go lately, as both VQT and PHDG have easily outperformed the markets in the trailing three month period. Both are now beating out the S&P 500 by about 170 basis points in the short time frame, more than making up for the extra cost associated with the duo (also see As Yen Weakens, Currency Hedged ETFs Soar).
However, it is worth noting that much of the outperformance for VQT and PHDG stems from their ability to hold up well during market turbulence. SPY has outperformed during the rising market environment, while its hedged counterparts—thanks to their volatility focus—have avoided the worst of the sell-off in recent trading, and have earned their keep in this time frame.
VQT vs. PHDG
While both VQT and PHDG do target the same benchmark, investors should be aware of a few key differences between the two. First off, VQT is an exchange-traded note and the older of the two, having launched in 2010 compared to PHDG’s 2011 debut.
Additionally, VQT is far more popular than its counterpart, having amassed close to half a billion in assets, compared to just $30 million for the PowerShares product. This has also helped VQT to beat out its competitor on the volume front, as it does about 20,000 shares a day in trading, compared to a rough average of 15,000 for PHDG (read The Truth about Low Volume ETFs).
While it might sound bad for PHDG at this point, investors should note that it is far cheaper than its counterpart, charging investors just 39 basis points in fees, compared to 95 basis points for VQT. This is obviously a huge differential, and it could sway new investors towards the PowerShares ETF for low cost exposure.
No matter how you come down on the VQT vs. PHDG debate, there is no denying that both have proven themselves to be solid picks in sluggish market environments. Their focus on volatility, and the move towards bigger volatility allocations as this reading rises and markets become choppier, can clearly lead to some outperformance during rough trading periods.
Still, you need to remember that during normal market conditions—and especially bull markets—this hedged ETF strategy will likely underperform broad equities. The allocation to volatility will usually lead to underperformance during this type of situation, while the extra fees will not help either (see the full list of Top Ranked ETFs).
So if you think that today’s strange combination of market uncertainty and decent U.S. fundamentals may continue, either VQT or PHDG may be worth considering. But if you believe that the worst of the selling pressure is over, it may be best to avoid these hedged ETFs, as some underperformance could be ahead for this group which earns its keep during rocky market conditions.
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