Is the time right for the Chicago Board Options Exchange (CBOE) to create an ETF on its popular options volatility index, the VIX? Morningstar’s Bradley Kay would like to see one.

“Equities not only provide a return, but they also have a volatility that estimates how risky they look in the near future. […] While it has historically hovered around 20, the VIX falls during quiet market periods and spikes when a flurry of trading activity buffets the stock market.

“An investment in this index would provide a valuable hedge against periods of heightened uncertainty, and since volatility has traditionally been higher in bear markets, it would also somewhat hedge losses in equities. Individual investors currently have a hard time speculating on the VIX, as futures in the index require minimum investments well over $10,000, but an ETF could open this valuable diversifier to the masses.”

On first glance, this seems like a fantastic idea. But we can think of three potential problems:

The Devil is in the Details

The implementation of this product would seem to be a real challenge. We’re not sure how such a product would work, even conceptually. It would have to track the VIX on a tick-by-tick basis.

Mimicking the daily performance approach of the inverse ETFs (SDS, QID, etc.) wouldn’t work, or would at least make it a very different product, since so much of the drama on any VIX chart comes from wild intraday action. And what about expenses? The Proshares Ultra and Ultrashort ETFs all have expense ratios of about 0.95%. We would expect a VIX ETF to cost at least that much, and possibly a lot more.

Why Bother?

Second, it’s not clear that a VIX ETF would provide anything special as a portfolio hedge, and it could even give false assurance to individual buy-and-hold investors.

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Volatility in general, and the VIX in particular, do not have a precise inverse correlation to price movement in the underlying. As we are eternally prodded into pointing out, VIX movement is informative on a relative basis, not an absolute one.

Here’s what Morningstar’s Kay says:

“An investment in this index would provide a valuable hedge against periods of heightened uncertainty, and since volatility has traditionally been higher in bear markets, it would also somewhat hedge losses in equities.”

Obviously, any hedge (including cash) is better than none during a bear market. But it’s not clear that this VIX product would do anything special vs. the other inverse and balanced products already available.

The table below displays the performance of four $20,000 portfolios started at the close of the recent market top on Dec. 11, 2007. The first iteration buys SPY alone. The second buys a 5% hedge in this hypothetical VIX ETF, and puts the rest in SPY. The third buys a 10% VIX ETF hedge. The fourth buys BEP alone — an S&P 500 covered call fund.

The best performer during this period was hands-down the covered call fund. And we’re giving the VIX ETF as much slack as we can:

• Obviously, the bigger the hedge during a bear market, the better performance will be; but then you give up more upside during bull markets — so we expect the relative performance of the VIX-hedged portfolios to be worse for any longer period.
• We’re also assuming that investors can top-tick the market perfectly and put hedges in place just in time. That’s a rather generous assumption.
• We’re excluding expenses over this period. SPY has an expense ratio of 0.08%; BEP, a closed-end fund, charges 1.06%; as we mentioned above, we have to think that a VIX ETF would cost even more.
• Finally, we excluded dividends for all of these examples — including them would worsen the VIX hedge portfolios further on a relative basis.

One might object that savvy traders will trade around those famous VIX spikes, dumping their hedges for a nice profit when VIX moves above 28 (or whatever the magic number du jour is). But it remains to be seen whether a sufficiently liquid, accurately tracking ETF could even be constructed. And remember that a volatility ETF product would be targeted at less sophisticated individuals and institutions, who are less likely to trade around intraday movements.

Active traders already have a universe of vehicles for accomplishing the goals of this product – they are called “listed options.” Given that investor focus, we are skeptical about the usefulness of a VIX ETF for hedging equity portfolios on a buy-and-hold basis.

Victim of Its Own Success

Finally, assume we’re completely wrong about everything we’ve said above. Assume that this VIX ETF becomes the most celebrated product of 2009, that it is liquid and accurate and has rock-bottom expenses. Pensioners and value investors all over the country start calling their financial advisers to add VXY to their portfolios (in the tradition of overly cute names for ETFs – think Spyders, Diamonds, and Qubes — perhaps the VIX ETF will be “The Vixy,” ticker VXY).

Once everybody and his brother is in this product, there will be less need for the traditional hedges on the basis of which the VIX number is calculated, namely, SPX options. We have already seen this happen to some degree as inverse ETFs and their options see increased volume.

Maybe, in a more moderate scenario, the volatility ETF would become a kind of slightly underperforming ghetto where retail traders and pensions and balanced funds would go, while the big boys stick with their traditional tools. But if this product did start to pull serious volume from SPX put buyers, the VIX itself might become less accurate and useful, rendering the ETF less useful by extension.

We don’t mean to rain on any parades, but we wonder whether the only people who would really benefit from such a product would be the ETF sponsors.

Condor Options is a research and trading firm specializing in market neutral options strategies. Condor provides a members-only trading newsletter focused on iron condor options spreads as well as free periodic reports at their Web site.