The iPath S&P 500 Short Term VIX Futures ETN (NYSEARCA:VXX) is one of the first and the most widely held exchange traded products ("ETPs") and has lost over 99% of its value since being introduced in early 2009. This situation has caused many investors to conclude that selling short the VXX to capture gains from its long term decline in price would be a viable trading strategy. In addition, there are a number of inverse ETPs that take a short position rather than a long position in the VIX futures. One example of this is the VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ:XIV) contract which has gained around 250% since its introduction just over 3 years ago. Theoretically, the daily return of the XIV is the exact opposite of the VXX (i.e. on a day when the VXX declines by .5% the XIV would be expected to increase by .5%) and in practice they have a negative correlation of about -99.6%. These VIX ETPs can be extremely volatile. The XIV, for example, despite having a large gain also has had a drawdown of about 75% since its introduction in late 2010.

Again, the logic for buying an inverse VIX product seems compelling as investors gain the persistent roll yield from the VIX futures continuing decline in value (contango) even though the VIX itself is range bound and does not have a long term trend. During stable periods in the market the VIX tends to trade between 10 and 20 although it will spike significantly higher during bear markets. For example, in early 2008 the VIX was under 20. It then spiked to almost 90 in late 2008 before falling back to under 20 in early 2010.

I have looked at the returns from the VXX to determine if these VIX products provide an independent/diversified return stream or are primarily providing leveraged exposure to the market. To do this, I compared the inverse returns of the VXX from short selling it to the return of the S&P 500 index since the inception of the. Theoretically, the XIV already provides the inverse return of the VXX but the VXX has a longer history. Therefore, I decided to use the inverse of the VXX daily return rather than the XIV to get a longer history. For purposes of this article I am referring to this as "synthetic XIV" or XIV_{s}.

The first thing to note is that the XIV_{s} has a high correlation (80% based on daily returns since 1/30/2009) with the S&P 500 index. Although the correlation is relatively high it is low enough to provide some meaningful diversification. This level of correlation is about the same as the correlation of the S&P 500 to other developed markets. The XIV_{s} ,however, is much more volatile and has a much higher maximum drawdown (as noted above) but also a much higher average daily return that the S&P 500. It is this high return resulting from the futures contango that has drawn many investors to invest in the XIV or to short the VXX. The table below provides summary statistics related to the XIV_{s}.

1/31/2009 to 12/31/2013 | XIV_{s} | SPX |

Average Daily Return (Annualized) | 84.51% | 18.21% |

Standard Deviation | 3.83% | 1.20% |

Max DD | -72.20% | -22.23% |

Correlation | 80% |

By adjusting the leverage of the XIV_{s} it is possible to reduce the volatility, drawdown and average return closer to that of the S&P 500. Adjusting the leverage of the XIV_{s} to target an equal average daily return also results in an almost identical maximum drawdown. Taking approximately 1/5th the exposure (0.2155 leverage to be exact) in the XIV_{s} provides the following results.

1/31/2009 to 12/31/2013 | 1/5th XIV_{s} | SPX |

Average Daily Return (Annualized) | 18.21% | 18.21% |

Standard Deviation | 0.83% | 1.20% |

Max DD | -22.27% | -22.23% |

The daily standard deviation for the XIV_{s} is however almost 30% lower than that of the S&P 500. I also compared the standard deviations at the monthly level and find that the XIV_{s} volatility is still quite a bit lower than the volatility of the S&P 500. This lower daily standard deviation results in a slightly higher ending value and a better Sharpe Ratio from investing in the XIV_{s} when compared to investing in the S&P 500 despite the identical average daily return. The graph below shows the growth of $100 invested in either the S&P 500 or the XIV_{s} from January 30, 2009 to December 31, 2013.

By deleveraging the XIV_{s}, we can see that the contango roll yield is primarily a reflection of the expected long term gain from owning stocks but leveraged approximately five times. Given the lower volatility of the deleveraged XIV_{s}, a viable strategy may be to invest about 1/5th (21.55%) of the cash intended for the stock market in the XIV (or short the VXX) and invest the remainder in cash. This should provide approximately the same return as the market with the same maximum drawdown but with a lower daily volatility. Another strategy given the correlation of 80% would be to mix the XIV with a traditional investment portfolio to add diversification. For example, investing 50% in the S&P 500 and 50% in the deleveraged XIV_{s} results in the same average return as an investment in the S&P 500 but with lower volatility. It also results in a slightly lower maximum drawdown that investing in either the deleverage XIV_{s} or the S&P 500 alone.

It would be preferable to extend this analysis back to include earlier periods including the last major bear market (the global financial crisis) to have greater confidence in the results. In addition, I have ignored interest that would be earned from cash not invested in the XIV_{s} and the difference in fees between the XIV and the VXX both of which would have a slight impact on returns. Finally, this strategy assumes daily rebalancing which may not be workable for some investors.

In a future article I intend to examine a longer history which can be created from VIX futures which go back to 2006. I will also look at VIX products that use longer term futures such as the VelocityShares Daily Inverse VIX Medium-Term ETN (NASDAQ:ZIV) as opposed to just the front month contracts that are used by the VXX and XIV.

In conclusion, the VXX and XIV volatility ETPs appear to primarily be leveraged versions of the market return and exhibit a high correlation (80%) with the S&P 500, although their return patterns are slightly less volatile than the market. Based on this a viable investment strategy may be to replace some or all of ones stock holdings with a long XIV or short VXX position. This should result in better risk adjusted returns at the portfolio level.

**Disclosure: **I am short VXX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

**Additional disclosure:** My positions are subject to change at any time without notice.