The new attempt to slay the ETF market's white whale

If you think volatility is about to rise, what should you buy? One veteran of exchange-traded products hopes he has come up with a new answer to that question.

For years, an exchange-traded product that tracks the popular CBOE Volatility Index (INDEX: .VIX) has been, in some ways, the white whale of the ETF world. That is, while there is clearly investor demand for a product that can be used to hedge against or speculate on future rises in volatility, no such thing exists — nor most likely could it.

The VIX is itself derived from a complicated mathematical formula based on the prices of options on the S&P 500 (INDEX: .SPX). This means that the VIX does not represent reality in the same way that, say, the S&P itself does. If one's portfolio is made up of all the stocks within the S&P 500 at their appropriate weightings, that portfolio should track the S&P with great accuracy — but one can perform no such similar exercise to track the VIX.

Among retail investors, the most popular VIX tracker is the iPath S&P 500 VIX Short Term Futures TM ETN, better known by its ticker symbol, VXX (NYSE Arca: VXX). While this $1.5 billion product has a decent-sized correlation to the VIX's daily moves, it tends to move about half as much as the VIX on a given day. For instance, while the VIX rose 6.3 percent on Tuesday, the VXX rose 4.4 percent. Last Thursday, as the VIX jumped 10.5 percent, the VXX rose 5.9 percent.

Greg King knows the VXX product well: At Barclays, he headed the iPath group that came up with it. Now at REX Shares, King has launched two VIX-tracking ETFs that appear an attempt to improve on the VXX's methodology.

While the VIX itself is not an investable product, VIX futures are. These derivatives products trade at prices reflecting expectations of the future value of the VIX, and it is these futures contracts that the VXX uses in order to gain exposure to the VIX. Yet partially because the VIX is mean-reverting (meaning it will tend to rise or fall back to historical average prices), these monthly futures do not fully reflect the index's daily fluctuations, and therefore, neither does the VXX.

King's new strategy relies on a new product, weekly VIX futures contracts, which only launched in October. Since these products adhere closer to the level of the VIX, an exchange-traded note based on such futures could enjoy a higher beta to the volatility index.

"The main difference is that while the most popular products track 30-day exposure, we're tracking something that's closer to spot VIX," King said Tuesday on CNBC's " Trading Nation ."

There are a few potential issues, however. VIX futures are not particularly liquid, which is why the new ETF products — VMAX (BATS: VMAX) for long VIX exposure, and VMIN (BATS: VMIN) for short exposure — give their managers room to use monthly futures as well, and to have discretion about when to enter and exit the contracts. In addition, with the greater management role come greater expense ratios: 1.25 percent for the VMAX and 1.45 percent for the VMIN versus 0.89 percent for the VXX.

In addition, VIX futures expiring further out in time tend to be more expense than ones expiring sooner, contributing to a negative drag over the course of the year, as one repeatedly has to sell something cheaper in order to buy something more expensive. Partially due to this effect, the VXX is down 16 percent in a year's time, even as the VIX has risen 34 percent. The impact may be even more deleterious for a weekly futures strategy, which will inevitably require more frequent "rolling" into ever-longer-dated futures.

These new ETFs "are not designed as buy and hold instruments," King said. Instead, they appear destined for use by short-term punters who have a strong view about what the VIX will do in a given day or week.

The futures issue actually gets to the heart of why crafting a VIX-tracking product is so difficult (most recently, the maddeningly complex VXUP (NASDAQ: VXUP) and VXDN (NASDAQ: VXDN) funds were a particularly high-profile failure, as chronicled cogently here). To wit: If you think the VIX is too low, you may be right — but the market is probably way ahead of you.

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For instance, while the VIX started Wednesday trading at 15.47, the September VIX futures opened at 20.65. That means that if you want to bet the VIX will rise back above its classical historical average of 20 over the next few months, what you really want to do is buy something below its prevailing market price. (To experience for yourself why this won't work, try asking your colleague if you can buy her $20 bill for $16.)

On the other side of the coin, one could take advantage of this dynamic by buying a product like VMIN, which is designed to inversely track the VIX. The futures market structure should make it so that this product gains even if the VIX remains stable. But one takes on a great risk by doing so, given that the VIX has the potential to rise much more substantially than it can fall. In addition, VIX spikes tend to reduce the already thin weekly VIX futures market, potentially causing additional problems.

At the end of the day, there is little free money in financial markets, and one who has as obvious a take as that volatility should rise to normal levels should not make any money off of that insight. Still, for those who think the VIX will rise abnormally high in a given session, the new VMAX ETF may prove to be a better mousetrap — albeit one that still needs to do the proving part.

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