What is VEQTOR?

Recently, we have seen quite a bit of discussion on the S&P VEQTOR Indices. Most of the discussion focuses on its use of VIX futures, complicated allocation process, short back test history, and performance drag. This post is meant to to clarify a couple of the unique characteristics of this index.

Initially it is worth noting that the purpose of this index is to simulate an allocation algorithm that has low correlation with the equity market and provides efficient hedge in black swan events. This is main reason why for a majority of the time, VEQTOR allocates 10% to VIX and generally has a performance drag. The index is not supposed to be an alternative to the S&P 500. I think of it as similar to why I pay for health insurance and adjust my insurance plan every year according to my expectation of next year’s health care expense. As a young professional, more often than not I would have saved money if I simply went uninsured. However, this extra expenditure makes me sleep better. And that’s exactly why some market participants choose to allocate a portion of their assets to VEQTOR, despite its performance drag.

While it is true that VIX spot and futures are related, it is also true that they are quite different. But VIX future’s hedging property is undeniable, especially in black swan events. In a strong bear market, the VIX futures curve tends to flip from contango to backwardation, and the roll process tend to generate extra yield.  Refer to the following two papers for a discussion of VIX spot and futures: “Identifying the Differences Between VIX Spot and Futures” and “Access to Volatility Via Listed Futures.”

VEQTOR acknowledges the roll cost of the VIX futures and attempts to dynamically adjust its allocation between VIX and equity by monitoring market signals. Complicated at the first glace, its allocation process actually only uses two quantitative signals: realized volatility and implied volatility trend. They essentially tell you what has happened and what could happen in the market. The cutoff points (10%, 20%, 35% and 45%) of the realized volatility are driven by the long term performance of the S&P 500. Since the index is designed to address equity market tail risk, we picked the numbers close to the 20th-, 80th-, 95th– and 98th-percentile of monthly realized volatility. To establish the trend of implied volatility, we compared VIX weekly average with its monthly average. A week is roughly 5 trading days (Happy Memorial Day! We work one day less this week!), and a month is roughly 20 trading days. And VEQTOR monitors them for 2 weeks to determine whether the trend is substantial. Why 5? Why 20, not 21 or 22? Why 10? Honestly, a slight change in those numbers (give or take one or two days) would not change the essence of the VEQTOR framework or significantly impact its allocation results.

If you are interested in VEQTOR allocation process, please refer to its methodology and our white paper, “Dynamically Hedging Equity Market Tail Risk Using VEQTOR” from May 2014.

 

The posts on this blog are opinions, not advice. Please read our disclaimers.

One thought on “What is VEQTOR?

  1. Pingback: Could VEQTOR Fail to Deliver? | S&P Dow Jones Indices

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