Earlier this year, Britain-based Barclays Bank PLC launched a set of exchange-traded notes that track futures contracts on the Chicago Board Options Exchange’s volatility index (a.k.a. the VIX).

Although the launch came without much fanfare, these ETNs may go down as being among the more important tools for helping those of your clients looking for a way to diversify their portfolios. That’s because these products can effectively reduce the long-term risks associated with equities.

ETNs are debt instruments that promise to pay a return on an index. Like most debt instruments, they are issued by a bank. But because they are debt instruments, they carry a credit risk — unlike exchange-traded funds, which are more like mutual funds and carry only market risk.

Barclays has issued two ETNs on VIX futures contracts: iPath S&P 500 VIX Short-Term Futures ETN (symbol: VXX) and iPath S&P 500 VIX Mid-Term Futures ETN (symbol: VXZ). Both trade on the New York Stock Exchange, but the VXX is the more popular product, being larger and more liquid.

The theory is that VXX will track a long position in VIX futures. Because the VIX tracks options based on the S&P 500 composite index, it serves as a measure of implied volatility. And because the VIX will tend to spike during periods of market volatility — as it did during the bear market of 2008-09 — it is known as the “fear gauge.” The conundrum has always been how to capture directly the returns on the VIX, and VXX now offers a way to do this.

According to Barclays, VXX “offers exposure to a daily rolling long position in the first- and second-month VIX futures contracts and reflects the implied volatility of the S&P 500 composite index at various points along the volatility forward curve. The index futures roll continuously throughout each month from the first-month VIX futures contract into the second-month VIX futures contract.”

So, does VXX work? A recent University of Massachusetts study showed that although the S&P 500 lost 27.9% in the last five months of 2008, VIX futures soared by 269.5%. Of course, five months is hardly a reasonable time frame to draw any sensible conclusions, but an all-equities portfolio diversified with a VIX futures product would have softened the downside considerably certainly during the study period.

However, you should exercise caution when recommending VXX to clients, as it is suited more to an active approach rather than a buy-and-hold strategy.

Long-term returns in the VIX can be flat or negative. The VIX can never go to zero, as that would imply that the equities markets would not move up or down for a considerable period of time. Conversely, the VIX also cannot go to infinity. At a point along the curve, fear abates, and the VIX will decline. Generally, you should expect the VIX to trade between 15 and 30, which would roughly translate into US$35 to US$55 for a VXX unit.

It’s when the VIX spikes during periods of market turmoil that the usefulness of VXX becomes apparent — specifically, as a diversifier within a broader portfolio.

A diversifier is an asset that tends to have low or, ideally, negative correlation to the longer-term, riskier assets within a portfolio. Which is to say, you want something to mitigate some of the risks associated with equities in much the same way as some investors use gold to hedge their exposure to the broader equities markets.

What makes volatility such a good diversifier is that volatility itself is quite volatile. Note the 269.5% rally in VIX futures at a time when the underlying U.S. equities market declined by 27.9%. A good diversifier has a low or negative correlation to the asset class you are trying to hedge against — the more volatile the diversifier, the less of it you need to provide the hedge.

For example, if the diversifier theoretically moves at 10 times the rate of the asset class you are diversifying, you need only 10% of the diversifier in the portfolio in order to hedge your position.

In that sense, VXX is a useful tool. But you need to recognize, of course, that VXX does not exactly mirror the VIX. Whereas the VIX instantaneously measures the volatility being implied by the options on the S&P 500, VIX futures (such as VXX) measure traders’ expected view about volatility one, two and three months out — and traders’ expectations may or may not reflect current market conditions.

@page_break@Still, you would expect VIX futures — including VXX — to provide a reasonable proxy for the VIX, and as such, be a reasonable hedge. It’s not a perfect strategy, but it’s not bad, either. IE