The stock market is volatile. Exchange-traded products that measure the volatility of the stock market are even more volatile. Yes, volatility is volatile. When used properly (and managed daily), adding an extremely volatile volatilty ETN to a stock portfolio can reduce the overall portfolio volatility. That is the essence of diversification.

I welcomed the introduction of the first two VIX ETNs from Barclays almost two years ago. However, I never got comfortable with the need to monitor and rebalance positions on an almost daily basis to achieve the desired results. Hence, I have not used volatility ETNs extensively.

Given the dramatically different behavior of iPath S&P 500 VIX Short-Term Futures ETN (VXX) and iPath S&P 500 VIX Mid-Term Futures ETN (VXZ), I’ve often wondered if there wasn’t some way to combine them to improve the results and make them easier to use in the process. Now I’m wondering if someone at UBS was reading my mind.

The UBS E-TRACS Daily Long-Short VIX ETN (XVIX) began trading a couple of days ago on December 1, 2010. The return on the XVIX is linked to the S&P 500 VIX Futures Term-Structure Index ER, which measures the return from taking a 100% long position in the Mid-Term Index and a 50% short, or inverse, position in the Short-Term Index.

In other words, XVIX is the equivalent of a 100% long position in VXZ hedged with a 50% short position in VXX, and rebalanced daily. Alternatively, the hedge could be a 50% long position in the newer iPath Inverse S&P 500 VIX Short-Term Futures ETN (XXV).

The result is an underlying index that would have gained 24.3% annually for the nearly 5-year period from 12/31/2005 to 11/26/2010. A period when the S&P 500 and VIX short-term futures lost money and VIX mid-term futures gained only 8.3% annually. Standard deviation data is not supplied, but graphically it appears to be similar to the S&P 500. XVIX will track this new VIX Futures Term-Structure Index ER minus the 0.85% annual fee.

XVIX is an unsecured debt obligation of UBS, its issuer. Therefore, like all ETNs, there is credit risk. In its second day of trading, it is already attracting enough volume to make hundreds of other ETPs jealous.

This product is worthy of further consideration. For more information, please refer to the summary page, fact sheet (pdf), and prospectus (pdf).

Disclosure covering writer, editor, and publisher: No positions in any of the securities mentioned. No positions in any of the companies or ETF sponsors mentioned. No income, revenue, or other compensation (either directly or indirectly) received from, or on behalf of, any of the companies or ETF sponsors mentioned.