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Top Yielding ETFs

Although economic data seems to be improving as of late, the market is still having trouble breaking to the upside thanks to continued European worries. Threats of a default in some of the smaller PIIGS nations, as well as rising borrowing costs in many core members of the common currency bloc, are casting a shadow over what have been surprisingly good payroll reports and relatively solid manufacturing data releases over the past few weeks.  

Thanks to this uncertainty over the European situation, volatility could spike in the coming weeks especially if more nations in the region have trouble servicing, or finding buyers for, their debt. However, if the region remains stable, the slowly rising strength in the American economy could help push stocks higher in spite of these concerns. As a result, it may be ideal for some prudent investors to stay on their toes and keep a close eye on their positions in this uncertain time. For those unable to do this, a closer look at an ETN from Barclays could offer quality exposure that can dynamically allocate between three separate asset classes; equities, implied volatility, and cash, which may be an ideal choice in this shaky environment (read Top Three Precious Metal Mining ETFs).

The fund, the Barclays ETN+ S&P VEQTOR ETN (VQT - ETF report), looks to track the S&P 500 Dynamic VEQTOR Total Return Index which seeks to dynamically allocate among the three asset classes outlined above. Basically, the goal is to keep exposure in equities when volatility is low, push into VIX-related investments when volatility is high, and then completely move into cash when neither side of this trade is working. While it should be noted that the fund is kind of expensive at 0.95% a year, the ETN structure allows for sharp shifts in allocations among the components without incurring transaction fees, suggesting that total costs could be less with this approach as opposed to investors doing it on their own. Furthermore, the fund also uses a rule-based methodology which looks to take the guesswork out of the various allocations that are involved (read ETFs vs. ETNs: What’s The Difference?).

VEQTOR ETN Methodology

In order to determine the weightings between the three components, the ETN undergoes a multi-step process. First, realized volatility is classified into one of five bands; less than 10%, 10%-20%, 20%-35%, 35%-45%, and greater than 45% in order to ascertain the current fear level in the market. Then, both the five day and 20 day moving averages of the VIX index are observed in order to establish a trend line for implied volatility. If, for ten consecutive business days, the five day average is less than the 20 day average, it is considered a downward trend while if the five day average exceeds the 20 day it is considered to be in an uptrend (implied volatility isn’t considered to be in a trend if it doesn’t fall into either of the categories listed above). Based on these metrics, the components are divided up as follows (courtesy of a PDF on the website of Barclays Capital):

Lastly, if the five day performance falls below 2.0% the index will shift entirely into cash in order to protect against truly shaky market environments in which neither volatility nor stocks seem like a good option (see BDCL: Yield King Of Leveraged ETNs).

Performance

The real question is obviously if this strategy can pay off and more importantly, if it is worth the outsized expense ratio over an ETF that just tracks the S&P 500. After all, the fund does intend to be allocated towards the S&P 500 for a large part of the time suggesting that during these periods, the expense on the VQT is more than 10 times that of broad market tracking ETFs such as (SPY - ETF report) or (IVV - ETF report).  Luckily for this ETN, the fund has broadly outperformed SPY over the last twelve month period.  However, it should be noted that VQT has underperformed SPY by a wide margin over the past three months and that the vast majority of the outperformance for VQT came in early August of 2011. In this time period, roughly from July 20th to August 22nd, VQT gained close to 8.7% while SPY slumped by nearly 15.1%, a huge difference in this tiny time-frame.

The above example of last summer shows that VQT certainly has great potential to outperform, but only when markets are extremely shaky and volatility is broadly rising. In these times, the shift towards VIX-focused assets can greatly help this ETN to outgain its less-dynamic rivals and this outperformance makes the fund a star performer for long periods afterwards. However, when markets are flat or rising, or when we remain in periods of low volatility, VQT, thanks to its high expense ratio and small allocations to VIX instruments no matter what, simply cannot compete with broad based products that are ultra cheap (see Ten Best New ETFs Of 2011).

So the real dilemma for investors has to be what their perceptions of volatility are in the near term. For those that expect low levels of volatility, this is probably not a good fund to be in as it seems very likely to underperform. Yet, for those looking for another event like we saw in the fall of 2008 or the late summer of 2011, VQT looks to be a quality product that could provide a solid hedge that can help to offset any broad market losses if fear returns to the marketplace.

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