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Volatility ETFs: It’s Quiet Out There…Too Quiet

tlydon@globaltrend.com (Tom Lydon)

The largest exchange traded product designed to track CBOE Volatility Index futures fell nearly 3% on Monday to a new all-time low as investors grow more confident the market won’t be derailed by Europe’s debt crisis or a slowdown in the U.S. economy.

The iPath S&P 500 VIX Short Term Futures ETN (VXX) was down 65.8% heading into Monday’s trade. [ETF Chart of the Day: Volatility-Linked Funds and the VIX]

Despite the exchange traded note’s miserable performance in 2012, it still has a market capitalization of $1.5 billion, according to issuer Barclays. Clearly, there is demand for a market hedge from some nervous investors. [Top ETF Wealth Destroyers]

Perhaps part of the ETN’s size can be explained by the high level of short interest – about 38% according to XTF.com.

VXX and other volatility-linked funds are geared to track VIX futures contracts so they won’t follow the spot price.

“The VXX is down nearly 97% since it was first introduced. The last time the fund announced a reverse split (one-for-four announced back in October 2010), the VXX had traded as low as a nominal level of $12.35, so I expect we may see another split soon,” writes Richard Bloch at SeekingAlpha.

Even though VXX is one of the worst-performing exchange traded products over the last three years, the ETN has seen $4.8 billion of inflows during the period. [Investors Buy Worst-Performing ETFs]

“Sophisticated investors with long-term outlooks could use this fund to partially hedge their portfolios against future downturns but must first understand the unusual mechanics of this exotic vehicle,” Morningstar says in an analyst report on VXX. “Volatility futures have a large negative roll yield in steady markets, so the insurance provided by this fund can be very costly even if volatility remains constant.”

Other volatility-linked products include ProShares VIX Short-Term Futures ETF (VIXY) and VelocityShares Daily 2x VIX Short-Term ETN (TVIX) .

iPath S&P 500 VIX Short Term Futures ETN