Volatility indexes offer hedge for investors

NEW YORK (Fortune) -- Volatility may be the only certainty in the stock market these days.

As the stock market racks up day after day of triple-digit changes, it's worth looking at two exchange-traded notes (ETNs) tied to volatility that started trading last month.

On January 30, Barclays Capital launched ETNs designed to track the Chicago Board Options Exchange Volatility Index, or VIX. Those new ETNs give investors the opportunity to buy insurance for their bull-market bets in a way that many hedge funds and large investment houses do.

"These intriguing new exchange-traded products allow access to an exotic asset class that used to be the preserve of institutions that could trade complex options strategies or enormous futures contracts," Bradley Kay, an ETF analyst with fund-tracking firm Morningstar in Chicago, wrote in a recent report.

To understand how these ETNs work, it's worth taking a look at the CBOE Volatility Index -- often called the fear index.

That label may make the VIX sound like some blend of stocks and "Saw VI," but the underlying reality is a bit tamer. Volatility is a measure of certainty in the market. When investors, in aggregate, have a good handle on what a particular stock or basket of stocks is worth, the price won't fluctuate much and volatility is low.

On the other hand, when the value of stocks is clouded, investors will buy and sell at a much larger range of prices and volatility is high. The VIX, then, is a measure of certainty and stability in the market. Each month, the Chicago Board Options Exchange uses the prices of options on the S&P 500 index to measure market sentiment about coming volatility.

The resulting VIX index has a strong negative correlation with stock prices, meaning that the volatility index rises when the market takes a big tumble. That makes volatility an excellent diversifier and one that has become more popular with sophisticated money managers and institutions.

The new ETNs, the iPath S&P 500 VIX Short-Term Futures ETN (VXX) and iPath S&P 500 VIX Mid-Term Futures ETN (VXZ), essentially allow investors to buy (or sell) the implied volatility of the S&P 500. That means that these new ETNs should allow investors to hedge their portfolios against the next big crash.

Before you rush out and buy the either of the new ETNs, though, consider the risks and drawbacks involved.

First, as noted earlier, the volatility index tends to spike when the market plummets; it hit an all-time high above 89 in late October. Over time, though, the VIX has tended to revert to an average value around 25, Morningstar's Kay says and in calmer times it can drop into the teens. The index will yo-yo as market conditions change, but it won't continue to climb over time or steadily produce long-term gains. That means owning the VIX can provide some insurance in case of a steep market drop, but it won't appreciably help a portfolio in other times. In fact, the ETNs should lose slightly over time. As the futures near their expiration date, their value will decrease, meaning that these new ETNs on their own will actually drop in value before being rolled over to the following month, according to Kay. That gradual loss can drag down overall results in bull markets by tying up assets that would be otherwise invested.

Second, the iPath ETNs don't track the VIX index itself. Instead, they hold a basket of futures that help gauge where the index will trade in coming months. The short-term ETN tracks futures one and two months in the future, while the mid-term ETN offers exposure to futures four to seven months out. Those futures contracts don't move as dramatically as the index, Kay notes, so buying a volatility ETN won't fully replicate the benefits of the index. "It never goes as low as the spot VIX index, and it also never goes as high as the spot VIX index," says Kay. "You are not getting the full advantages that the spot VIX has."

Finally, it's worth mentioning that exchange-traded notes have a different structure than the exchange-traded funds, or ETFs, that have become so popular with investors. Unlike ETFs, which own a basket of underlying stocks, ETNs are unsecured debt instruments. That structure means that investors who own these notes bear credit risks tied to the issuer, similar to buying individual bonds. In the case of these new iPath ETNs, the issuer is Barclays, a bank whose shares now trade around $6. Also, each of the VIX-related offerings carries a yearly fee of 0.89%.

With all those issues factored in, trading volatility by using these new ETNs probably makes more sense for sophisticated professional investors and traders than for small buy-and-hold investors. "They're definitely meant to be short-term trading vehicles," says Tom Lydon, president of Global Trends Investments and editor of ETFtrends.com. "That's not necessarily bad, but if you're an investor it's not something you can buy and tuck into your portfolio and forget about either."

Kay echoes that warning. "We believe these new ETNs could provide an interesting new tool for asset allocators who want a small slug of insurance against any sudden market crashes," he wrote. "However, due to their complex structure and the current worries about ETNs, we would suggest that only the most sophisticated investors try to find a place in their portfolio for these funds."