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ETF Specialist

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

An alternative ETF that had equitylike returns and lower risk.

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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 (VQT) 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.

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Timothy Strauts does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.