It is unfortunate that there are not more mutual funds or ETF’s that directly enhance long equity positions with option overlays. I have covered the enhanced Sharpe ratios (risk-adjusted returns) that often accompany these strategies. I was surprised to find out that Direxion is going to bring the S&P 500 Dynamic VEQTOR Index to the mainstream retail investor packaged nicely in a simple ETF. As a follow-up to my readers’ requests when I first described the strategy’s performance, I want to take a closer look at just how the index makes systematic calls on implied volatility and how it has achieved such stellar returns.
The S&P 500 Dynamic VEQTOR Index (Volatility EQuity Target Return) represents an investment in the broad equity market with a dynamically rebalanced volatility allocation. The strategy gains its volatility overlay through the use of short-term VIX futures. The premise of the strategy is that the VIX has a correlation with the S&P 500 of about -73%. When the S&P 500 falls sharply, the VIX spikes and then slowly reverts to a long-term mean. Under the simplest strategy, a fixed allocation to VIX futures will reduce the volatility of the long equity portfolio by providing a positive offset when the equity market corrects. This would increase the risk-adjusted returns of the portfolio by reducing the tails of the portfolio’s return distribution. If the idea is taken one step further, then we can introduce a tactical allocation in volatility wherein the investor can capture the gains from a volatility spike by reducing the allocation to volatility under the assumption that it will eventually revert to the mean.
The S&P 500 VEQTOR Index has the following characteristics:
- Daily rebalancing mechanism
- Dynamic long exposure to equities and implied volatility which are based on the realized volatility trend and environment
In order to determine the implied volatility trend, the index uses the following scheme which requires 10 consecutive daily indicators:
- Uptrend: 5-day Average Implied Volatility > 20-day Average Implied Volatility
- Downtrend: 5-day Average Implied Volatility < 20-day Average Implied Volatility
- No Trend: Neither
With our trends established, we can look at the respective allocations:
Dynamic VEQTOR Strategy Allocation Algorithm
|Realized Volatility Environment*||Implied Volatility Downtrend||No Implied Volatility Trend||Implied Volatility Uptrend|
|Less than 10%||97.5%/2.5%||97.5%/2.5%||90%/10%|
|10% to 20%||97.5%/2.5%||90%/10%||85%/15%|
|20% to 35%||90%/10%||85%/15%||75%/25%|
|35% to 45%||85%/15%||75%/25%||60%/40%|
|Greater than 45%||75%/25%||60%/40%||60%/40%|
*The realized volatility environment is determined using the last 22 trading days.
The last piece of the puzzle is the stop-loss feature. Every day, the 5-business day performance of the excess return strategy is evaluated. If there is a loss greater or equal to 2%, both equity and volatility allocations are moved to 100% cash position at the close of the following business day. The strategy will allocate back into equity and volatility once the 5-business day loss is less than 2%.
After a long-winded explanation – just how did it do?
I challenge you all to use this as a guideline for starting your own long vol / long equity strategy. I think there is a lot of promise in these types of strategies as tools for individuals and fund managers.