When we wrote How to Protect Profits as QE2 Comes to an End back on May 23, we presented three ways to protect your profits:

• Sell desired shares to reduce or eliminate market risk.
• Purchase put options while volatility/premiums are relatively low.
• Purchase CBOE Volatility Index (VIX) futures or ETFs/ETNs that track VIX futures.

The first two suggestions would have served investors well while the third proposition involving ETFs/ETNs that track VIX futures would have left some scratching their heads.

[Click to enlarge]

As we can see, iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX ), iPath S&P 500 VIX Mid-Term Futures ETN (NYSEARCA:VXZ ), and UBS E-TRACS Daily Long-Short VIX ETN (NYSEARCA:XVIX ) did not come close to tracking the VIX, resulting in a less than desirable portfolio protection. Based on a chart above, the widely used VXX provided some protection while the less favored VXZ and XVIX provided no to negative protection.

Many will ask, Why such a wide discrepancy? The answer is contango, the market condition wherein the price of a futures contract is trading above the expected spot price at contract maturity. The futures curve is typically upward sloping (normal curve), since contracts for further dates would typically trade at higher prices. Because the normal course of a futures contract in a market in contango is to decline in price, an ETF/ETN composed of such contracts buys the contracts at the high price (going forward) and closes them out later at the usually lower spot price. The money raised from the low priced, closed out contracts will not buy the same number of new contracts going forward. Therefore, VIX ETFs/ETNs can and have lost money even in stable to down markets.

Its surprising to note that XVIX was the worst performer because it was specifically designed to combat contango and offer the long exposure to forward-implied volatility of the S&P 500 Index by investing in futures contracts linked to the VIX. The VXX is designed to offer the 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 Index at various points along the volatility forward curve. The VXZ is designed to offer exposure to a daily rolling long position in the fourth, fifth, sixth and seventh month VIX futures contracts and reflects the implied volatility of the S&P 500 Index at various points along the volatility forward curve.

Conclusion

Investors looking to protect their portfolios with VIX ETFs/ETNs should think twice before taking the plunge because the inherent risk of contango is too great to ignore. Until there is a better product that tracks the VIX, investors might consider inverse ETFs such as Short/Bear ETFs in lieu of VIX ETFs/ETNs.