Volatility became a household word during the turbulent days following the collapse of Lehman Brothers one year ago this week.

Not surprisingly, most people’s portfolios have experienced volatility thanks to the past year’s stock swoon and subsequent rebound rally, but should your portfolio have some volatility in it? 

Clearly more market participants think so.  Trading this month has quintupled in some relatively new products -- exchange-traded notes -- that trade like stocks and are designed to rise if the stock market should sell off.

“We’re big fans of them in a modern portfolio theory, post-2008,” says Scott Burns, Director of ETF Research for Morningstar. 

The iPath VIX short-term (VXX) and long-term (VXZ) Futures ETNs each track a basket of futures for the stock market’s de facto “fear gauge”, the CBOE’S Volatility Index (VIX).  The VIX generally rises when stock prices fall and investors are fearful, and vice-versa. 

Buying the VXX is a bet on volatility rising over the next month, while the VXZ would reflect an expectation of higher volatility a few months from now.

And after a 50% run off the March lows, investors are wary of any downturn in the markets that would increase volatility.

“It’s good insurance,” says Morningstar’s Burns.

These ETNs were introduced in January, ironically enough, by the firm that bought many of Lehman’s U.S. operations, Barclays Bank (BCS).  The volatility ETNs debuted during days of high anxiety caused by a period of almost unprecedented whipsaw trading that sent markets tumbling to lows not seen in more than a decade. 

The VIX itself surged to record highs last fall as Lehman’s demise helped set off a chain reaction that choked off the credit markets, sank stocks, and even called into question the value of some money market funds.

The recovery in the credit and stock markets has eased the fear factor, sending the VIX down to its pre-Lehman-collapse levels.  But futures prices indicate traders are betting on higher prices in the next few months.

Additionally, investors with longer memories know that September has historically been one of the worst months for stocks.  And October has had its moments as well.  The last bull market ran out of steam in October 2007; then, there was the crash of 1929, Black Monday in 2007, and last year’s credit crunch cascades during the Congressional votes on the Troubled Asset Relief Program, or TARP. 

That may explain why professional traders say some large bets are being placed that the VIX will jump up once again before the calendar flips over to 2010.

The new products may work well as a hedge or long-term bet on a more volatile market, but advisors eschew recommending them to individuals for a variety of reasons.

Certified financial planner Doug Flynn, of Flynn, Zito Capital Management, says the ETNs are better suited for the pros: “We have only used volatility in small, select cases and not as a major trading strategy.  We haven’t found the need to bring these in en masse to our clients.”

Flynn would consider shorting stocks or other strategies to profit from any stock market drops.

Michael McCarty, managing partner of Differential Investment Partners, has created strategies to trade volatility for institutional clients.  He is not a fan of these new volatility products, or ETNs in general.  “I don’t like products that may have other issues aside from doing what they’re supposed to do.”

The issues McCarty references are related to the structure of the ETN itself.  ETNs are debt obligations by the backing bank, whereas an exchange-traded fund represents an actual portfolio of assets.  This distinction was underscored during the financial crisis as investors and analysts were concerned over the balance sheet and ability of Barclays and other ETN-backing banks to pay off these obligations. 

Sean O’Hara, president of RevenueShares, says the structure is not the only drawback for his clients, noting that “there is counter-party risk, and from a tax efficiency standpoint, they lack some of the traditional ETF benefits.”

O’Hara says most people “don’t have the time or discipline required” to benefit from the ETNs.

“I believe that the majority of usage for the Volatility ETNs is institutional.  Very few advisors on the retail side have the level of sophistication necessary for implementing such strategies.”

Morningstar’s Burns also cautions individuals to look closely and think twice about the complexity of the investment before jumping in, “The ETNs are for more sophisticated investors and they must understand how futures work, as well as the VIX and its relationship to volatility.”

“We’re not currently recommending people buy it.  If you don’t have a crash, they lose money over time.  There’s a natural decay to your investment.”