Barclays' notes tied to S&P 500 Dynamic Veqtor debut novel, enhanced-beta volatility hedge

By Emma Trincal

New York, Feb. 10 - Barclays Bank plc's plans to price notes linked to the S&P 500 Dynamic Veqtor Excess Return index gives investors for the first time exposure to an investable volatility enhanced-beta index that dynamically allocates between equity and volatility, a senior executive at Barclays said in an interview.

The structure is intended to offer investors a new volatility hedge designed to outperform the U.S. equity market, he noted.

Pioneering deal

"This is the first time the S&P 500 Dynamic Veqtor index is used for the reference of a publicly registered note," Samson Koo, head of equity structuring at Barclays, told Prospect News. "It's a follow-up product to the S&P 500 VIX short-term futures index."

Barclays plans to price 0% Super Track Notes due March 7, 2013 linked to the S&P 500 Dynamic Veqtor Excess Return index, according to an FWP filing with the Securities and Exchange Commission.

The payout at maturity will be par plus 130% to 136% of any index gain, with the exact participation rate to be set at pricing. Investors will be exposed to any index decline.

The S&P 500 Dynamic Veqtor Excess Return index "is not a Barclays index," Koo noted. The index's sponsor is Standard & Poor's.

"But Barclays has been working together with S&P to co-develop the index, and we're using this index as the reference for a Barclays publicly issued note," said Koo.

Algorithmic allocation

The Veqtor index uses an algorithm to allocate its notional investments among three components: equity, volatility and cash. The equity component is represented by the S&P 500 Excess Return index, and the volatility component is represented by the S&P 500 VIX Short-Term Futures Index Excess Return, according to the filing.

The index allocates a greater proportion of its notional value to investments in the U.S. equity markets during periods of low market volatility and can allocate a greater proportion of its notional value to investments in a reference asset that tracks implied volatility during periods of high market volatility.

The index also incorporates a "stop loss" mechanic that shifts the entire value of the index to a non-interest-bearing cash investment under certain exceptional circumstances.

Historical trend

A historically observed trend shows a negative correlation between S&P 500 prices and the volatility of the S&P 500, Koo said. "It means that there is a tendency for volatility to go up when the S&P goes down and vice versa. That's the reason why investors have been using the S&P 500 VIX Short-Term Futures index as a hedging tool," he said.

Koo said that the Barclays iPath S&P 500 VIX Short-Term Futures exchange-traded notes have now reached $1 billion in size. "A lot of investors are already using it," he said.

The iPath S&P 500 VIX Short-Term Futures ETN is Barclays' most-traded iPath ETN, according to a trading strategy report for November filed with the SEC. It debuted in the market a year ago.

Second generation

Koo explained that the launch of the iPath S&P 500 VIX Short-Term Futures ETN was only the beginning of a process pioneered by Barclays with the goal to give investors new ways to play volatility.

"The first step was to develop an investable volatility index, which was done with the S&P 500 VIX Short-Term Futures index," Koo said.

Veqtor adds a product that will enhance beta or, in other words, outperform the benchmark, he explained.

"The S&P Veqtor index is an algorithmic allocation between the S&P 500 index and the S&P 500 VIX Short-Term Futures index. It is a way to combine an investment in the S&P 500 with the S&P 500 VIX Short-Term Futures index," Koo said.

"It gives investors an algorithm allocation between equity and volatility so that as the market goes up, the algorithm allocates more to the S&P 500. And when the market is more volatile, the allocation gets shifted from equity into volatility," Koo said.

This type of investment strategy is called a "volatility hedge."

"Based on historical data, such allocation has consistently outperformed the S&P 500 itself, which is why the Veqtor index is a volatility enhanced-beta index," said Koo.

But before creating an enhanced-beta index, Barclays, in cooperation with S&P, had to create an investable index, Koo added.

"The first step was the creation of the S&P 500 VIX Short-Term Futures index, which made the volatility index investable. Veqtor is a follow-up that permits the creation of an enhanced-beta version," he said.

Beta, not alpha

The strategy, while it is designed to outperform the market - hence the term "enhanced beta" - still remains dependent on the performance of the S&P 500, Koo noted.

That's because the "volatility hedge" of the strategy is limited to a maximum allocation of 40%, with the remaining 60% of the index exposed directly to the S&P 500, according to the prospectus.

Even if the algorithm succeeds in dynamically allocating between equity and volatility, there is no guarantee that the value of the index would not drop as a result of a sharp decline in the S&P 500, according to the prospectus.

The notes will price March 3 and settle March 8.

Barclays Capital Inc. is the agent.

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