Under the Hood of a Market-Timing Exchange-Traded Note

It is 2012, but investors are still reeling from the confidence-sapping effects of the 2008 financial crisis. Despite the great equity returns of the past three years, investors as a group have shied away from the stock market. In response to these fears, demand for alternative investments that produce more consistent returns with less risk has skyrocketed. The main downside to most alternatives is that, while they have low risk, they often produce low returns to match.  Barclays S&P 500 Dynamic VEQTOR ETN  is among a new breed of investments that use dynamic asset allocation to reduce risk in a portfolio but attempt to produce equitylike returns. Many alternative funds seek to mitigate volatility by going long and short at the same time. VQT takes a different approach by dynamically shifting its exposure among the S&P 500 Index, S&P 500 VIX Short-Term Futures Index, and cash, depending on market volatility. The overall effect is a portfolio with below-average risk that can actually rise in a down stock market.

How It Works
Because VQT uses VIX to partially hedge against future downturns, we must first understand the unusual mechanics of this exotic vehicle. S&P 500 VIX Short-Term Futures Index provides exposure highly correlated to the volatility of the S&P 500. Volatility jumps in tandem with stock price crashes, spiking whenever the stock market collapses. Expected volatility, thus, serves as a proxy for market uncertainty, affording the VIX Index its common moniker of "The Fear Index." VIX futures prices are based on the prices of S&P 500 options. When the market expects higher volatility, options prices go up in value because there is a higher probability that the option will expire in the money. This relationship between volatility and price makes vehicles that follow the VIX good diversifiers for equity-based portfolios. Some assets, like commodities and government bonds, show near-zero correlation, but volatility has a strong negative correlation with stock prices. When stocks are falling volatility usually rises dramatically.

VQT tracks the S&P 500 Dynamic VEQTOR Total Return Index. To determine the relative weightings of the components, there is an allocation process. First, the current direction of volatility is determined. Volatility is either in an up-trend, down-trend, or no trend. An up-trend is when five-day implied volatility is greater than 20-day implied volatility for at least 10 consecutive days. A down-trend is the opposite condition, and no-trend is when there haven’t been 10 consecutive days of any trend. The trend is important because volatility trends very strongly. If it has risen recently, it is likely to continue rising, and conversely if it's falling, it will likely continue falling. As you can see in the table the potential allocation to S&P 500 VIX Short-Term Futures is based on the current trend. If the trend is up you want a higher percentage volatility allocation, and if the trend is down you want to reduce exposure to volatility.

The second step is to look at the current realized volatility. If current volatility is high, you want a higher exposure to VIX, and when it's low you'll want a lower allocation. Based on current volatility and the volatility trend a target allocation to volatility is determined that adjusts daily based on current readings. Because volatility can move very quickly there is a built in stop-loss feature to VQT. If the five-day return of the index is ever less than negative 2%, the allocation switches to 100% cash and stays there until the five-day return rises above negative 2%.

As an ETN, VQT has the credit risk of Barclays Bank which is rated AA- by Standard & Poor’s. While credit risk is a concern, there are tax advantages to the ETN structure. Under current rules investors are subject to capital gains tax based on the investor’s holding period. VQT does not distribute income so an investor could theoretically hold VQT for 10 years  paying tax only at the end and get long-term capital gains treatment.

The Proof Is in the Pudding
Since its inception in August 2010, VQT has returned 35%, which is slightly better than the S&P 500’s return of 33%. It is impressive that during a strong bull market that VQT could keep pace with the S&P 500. A closer examination of the returns shows the different ways the two got to where they are.

From VQT’s inception to July 22, 2011, the S&P 500 was up 30%. Over the same period, VQT was up only 10%. In the strong bull market, VIX futures dropped dramatically and because VQT maintains a small allocation to volatility as a hedge its performance was hurt by losses in the volatility hedge. While VQT’s performance was disappointing compared with the S&P 500, it did great when compared with its counterparts in the multialternative Morningstar category. Over the same period the multialternative category returned only 6%.

After July 22, 2011, the market dropped suddenly as concerns about the European debt crisis pushing the world into another recession ran high. From July 22 to today, the S&P 500 has risen only 4% but VQT has skyrocketed 22%. As the S&P 500 was falling, volatility rose dramatically and VQT was able to take advantage. The allocation to volatility rose at one point to the maximum of 40%. Because the strategy is able to change its positions daily, it was able to react effectively to the quickly changing market environment.

One of benefits of the dynamic allocation strategy is that it reduces portfolio risk. Over the past one-year period, the S&P 500 has had a standard deviation of 16%, while VQT has had a standard deviation of only 12%. For slightly lower returns investors got a portfolio with 25% less risk.

Note of Caution
While the ETN has performed well in its short existence, it may not always do so well. For example, the strategy will not protect against a sudden spike in volatility such as a natural disaster or act of war. When these events occur, the equity market is likely to drop abruptly and the VIX rise suddenly. The ETN won’t adjust its positions until the following day when it may be too late. Also, if there is a prolonged bull market with low volatility the small VIX position will be a drag on returns. The strategy is also very complex and investors should take the time to fully understand the strategy before investing.

Fees and Alternatives
This ETN charges an annual investor fee of 0.95%. This is a high fee but, considering the unique exposure the fund offers, we consider it fair. Many people use VIX products to hedge their equity portfolio, but VQT is the only fund available that combines equities and VIX vehicles in the same investment product. If you’re only interested in a VIX vehicle to hedge your equity exposure, consider  iPath S&P 500 Dynamic VIX ETN . 

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Disclosure: Morningstar, Inc., receives fees for licensing its indexes to ETF/ETN providers. These fees are mainly based on fund assets under management. BlackRock Asset Management; First Asset; First Trust; Invesco; Merrill Lynch; Northern Trust; and Scottrade currently license Morningstar Indexes. These ETFs and ETNs are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on the Morningstar Indexes.