(MoneyWatch) Exchange-traded products (ETPs) that are linked to futures contracts on the CBOE S&P 500 Volatility Index (VIX ) have grown dramatically in volume and assets since their inception in 2009. They’re now among the most heavily traded ETPs. For example, the Barclays iPath S&P 500 VIX Short-Term Futures ETN (VXX ), the largest volatility-based ETP, has assets of about $1 billion and daily trading volume of about 40 million shares.

The reason for the growth of volatility-based ETPs is the perception that they offer a hedge against stock market losses. It’s important to understand that the VIX is a forward (not historical) measure of volatility. It represents investors’ expectations of future market volatility. If investors become fearful, their demand for portfolio insurance will increase, driving up the price of the VIX. As such, the media often refers to it as the fear gauge. And there’s a negative correlation between the changes in the VIX and changes in the S&P 500. That negative relationship (the VIX tends to increase when stock prices fall) is likely what tempts investors to try to hedge stock portfolios using the VIX. However, since the VIX itself is simply a calculated index value, you can’t invest in it directly. Investors can only gain exposure to the VIX through futures and options contracts whose payoffs depend on future values of the VIX. VIX futures-based ETPs do provide access to the VIX futures market in a convenient exchange-traded form.

The authors of the paper, Are VIX Futures ETPs Effective Hedges? studied whether the reality matched the perception. Before looking at their findings, it’s important that you understand that returns on the VIX are heavily impacted by the fact that VIX futures tend to trade in contango — future prices are higher than spot prices. When I checked this morning, the VIX was at 12.46. However, the March, April and May contracts were trading at 14.30, 15.43 and 16.27, respectively. In other words, the VIX index would have to rise from 12.46 to 14.30, an increase of about 14.8 percent, before the expiration of the March contract to just break even. The breakeven percentages for the April and May contracts are about 23.8 percent and 30.6 percent, respectively. The state of contango produces what’s referred to as a negative roll — if the spot VIX remained unchanged at 12.46 and you bought the March futures at 14.30, you would have a loss of 1.84, and in order to maintain your hedge you would have to rollover your contract to the next month, facing the same prospect once again.

The following is a summary of the author’s findings:

• While the VIX does tend to increase when large stock market losses occur, ETPs which track short term VIX futures indices aren’t effective hedges for stock portfolios because of the negative roll yield accumulated by such futures-based ETPs.
• Medium-term futures suffer less from the negative roll yield than does the nearest month because the price of longer-dated futures contracts tends not to decline as fast with the passage of time as the price of the near-term futures. However, the correlation with stock returns isn’t as helpful. Thus, they only appear to be somewhat better hedges for stock portfolios than shorter-term futures.
• Investing in volatility ETPs substantially lowers the returns of the hedged stock portfolio and decreases the Sharpe ratio (measure of risk-adjusted returns), suggesting that short-term VIX futures exposure fails to provide a reasonable hedge against general stock market fluctuations.

The authors concluded: Our findings cast doubt on the potential diversification benefit from holding ETPs linked to VIX futures contracts.

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