VXZ Chart

We all know the problems with the VXX, by now, right? That’s the iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX). Contango in nearer month VIX futures basically puts a weight on top of it. All other thing in VXX being equal (i.e., not soaring) and VXX will fall.

But the VXZ, i.e. the iPath S&P 500 VIX Mid-Term Futures ETN (NYSE: VXZ)? That’s a different animal. It proxies VIX futures of four to seven month duration. And out that far, option trading investors rarely see much of a slope between VIX futures. There’s about a 50 cent premium each successive month out, versus $1.60 difference between the near two months now. So issues rolling out to maintain duration have far less impact. So when you see VXZ drop, it’s simply a combo of the CBOE Volatility Index (VIX) dropping and the futures all contracting.

And as you can see on the chart here, VXZ has had an awful 2011. Its down about 20%, vs. an 11% drop in VIX itself. Under normal circumstances, VXZ only captures one-quarter or so of VIX, so that’s incredible underperformance.

It’s not tough to see what’s going on here. Futures premiums have caved in. Not that long ago, a VIX future with six months to go could fetch $8-$10 over VIX. No more, that’s down to the $5-$6 range.

What’s it all mean?

Well, since 2008, we have had almost a permanent assumption that volatility was just in a fleeting calm before the next onrushing storm. But as time has gone on, those volatility spikes have become less frequent, and more blip-like when they do happen. And as such, futures premiums have eroded. And frankly, why shouldn’t they? The year 2008 was more outlier than sign of future times. Over the course of time, VIX has averaged about 20. But it spends extended stretches well below there. In fact it spent almost the entirety of four full years in the teens (or lower) not that long ago. From 2003 to 2007, 20 VIX seemed like a panic.

On a contrary basis, we can call the drop in VXZ bearish for the market on account of creeping complacency. If you want to buy a volatility ETN for whatever reason, I’d certainly pick VXZ over VXX. That’s not to say its without risk though. Even though VIX premiums have decline substantially, there’s no saying we don’t have more to go. After all, if VIX in the mid-teens is fair, then VIX futures will ultimately work their way to the mid-teens too.

Follow Adam Warner on Twitter @agwarner.