Despite the controversial discussion about ETNs focused on volatility, these instruments have caught a lot of interest from investors. However, it's difficult to judge whether it's mainly retail investors with a buy and hold approach or traders using these instruments for short term trading/hedging or even sophisticated investors like hedge funds who invest/trade these instruments.

In my view the biggest critique seems to be the fact that both ETNs - iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX) and the iPath S&P 500 VIX Mid-Term Futures ETN (NYSEARCA:VXZ) - are constantly loosing value. I will present a quick study which clearly shows that these ETNs are viable hedging instruments even for a traditional buy and hold investment approach. However, before I get into some very important features of the underling volatility indices tracked by the mentioned ETNs it makes sense to give a brief background about the VIX itself.

**The Volatility Index VIX**

The VIX is a volatility index based on option prices rather than stocks. Actually, the index value is based on calls and puts on the S&P 500 Index (NYSEARCA:SPY). If the market price of an option is available one can easily derive the expected volatility of the underlying over the period until the maturity. That forward looking volatility expectation of the market participants is also called implied volatility as it is derived from option prices. Given the construction mechanism of the VIX index it measures the expected return volatility of the S&P 500 Index over the next 30 days. For a thorough discussion of the VIX pricing methodology please see the Chicago Board of Options Exchange "CBOE" VIX white paper (pdf). In addition, the VIX Index reveals if options on the S&P 500 are cheap or expensive.

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The chart above shows the historically realized volatility of the S&P 500 Index against the volatility expectation implied in the option prices, calculated accordingly from the VIX Index methodology. The most important fact revealed by the chart is that the implied volatility is most of the time above the realized volatility. Just in some instances the realized volatility is above the implied volatility which occurs during volatility shocks. The phenomenon that implied volatility is most of the time above realized volatility is called volatility premium. Basically, that is the premium market participants are willing to pay for being long volatility and being able to hedge their equity portfolios against volatility shocks. As that protection premium is defined by market forces it's obvious that protection is more expensive when demand is high and it's relative cheap when demand is low. But keep in mind that the protection premium collected by a short seller on specific day is based on his/her expectation about the future volatility and may or may not be enough to cover the losses from that transaction.

**Futures on the VIX Index**

After having covered the basics of the VIX itself, we now should move on to the futures based on the VIX as these are the underlings of the volatility ETNs mentioned above. Technically, it's almost impossible to track the VIX directly. Therefore, both the S&P 500 VIX Short-Term Futures Index and the S&P 500 VIX Mid-Term Futures Index are based on futures prices as these are the only liquid and exchange traded financial products on volatility directly. Basically, the price of the VIX future with the shortest maturity (called front month) is the expected value of the VIX Index on the maturity date. Simply speaking it's expected volatility expectation on the maturity date. In other words you just trade expectations of the expectations.

After having clarified what exactly VIX futures prices are about, we should have a deeper look into the volatility futures term structure.

The chart above shows that the VIX futures curves normally trades in contango, as the front month trades at the lowest price of all VIX futures available. The most intuitive interpretation of the upward sloping line is that the market is anticipating a rise in the future volatility expectations which is caused by the fear of a real volatility spike.

As we all know from the commodities futures markets, a contango situation causes roll losses for an investor who is continuously rolling over the front month. The iPath S&P 500 VIX Short-Term Futures ETN is designed to mimic a 30-day futures contract on the VIX spot index whereas the iPath S&P 500 VIX Mid-Term Futures ETN is designed to mimic a futures contract with a constant maturity of 5 1/2 months. Chad Gray describes the rolling mechanism in detail in his recent article.

A look at the volatility term structure chart above clearly shows that the curve's steepness normally is higher at the front end than at the part between the fourth and seventh futures, which are the futures used for calculating the VIX Mid-Term Futures Index. Therefore, the roll losses are much higher for the iPath S&P 500 VIX Short-Term Futures ETN than for the iPath S&P 500 VIX Mid-Term Futures ETN. However, the reduced rolling losses come at a price of lower sensitivity/correlation of the VIX Mid-Term Futures Index to the VIX spot, which investors normally look at when they consider buying a volatility ETN.

**Portfolio Protection**** with VXZ**

Despite the mentioned short comings of the two volatility ETNs at the first look, they are still a viable hedging instrument for a buy and hold investors as long as the investors' core portfolio delivers some alpha, which can be used for buying volatility protection. Over a mid to long-term investment horizon an investment in volatility protection via the iPath S&P 500 VIX Mid-Term Futures ETN does pay off.

I recently presented in an article the concept of equally-weighted risk contribution (ERC) portfolios. Let's take the U.S. Style ERC Portfolio, which consists of IVW, IVE, IJK, IJJ, IJT and IJS, as the core equities portfolio. That portfolio exhibits a return of 5.4% p.a. from 12/20/2005 until 04/29/2011, with volatility of 25.9% p.a. In comparison the benchmark the SPDR Dow Jones Total Market (TMW) returned 4% p.a. with a volatility of 26.1% over the same period. The core portfolio generated an alpha of 1.4% p.a. even at a slightly lower volatility than the benchmark. The chart below shows the portfolio supplemented by a small allocation to the iPath S&P 500 VIX Mid-Term Futures ETN.

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By adding a small position in VXZ the return of the portfolio can be increased up to 6.8% p.a. while the volatility can be reduced down to 19.1% p.a., which improves the risk-adjusted performance significantly (see chart on the left). Furthermore, the maximum drawdown of the portfolio can be reduced to 43.5% compared to the benchmark's maximum drawdown of 55.1% during Oct 2008.

**Summary**

Given its much higher roll losses, the iPath S&P 500 VIX Short-Term Futures ETN seems in my eyes not to be an appropriate instrument for hedging buy and hold equity investments, rather than a suitable tool for short term trading. But adding a small position of iPath S&P 500 VIX Mid-Term Futures ETN to a successful equities portfolio can improve its risk adjusted performance significantly and cut of some of the tail risks.

**Disclosure: **I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.