Ian Mathers reckoned stocks were due for a slide as the Standard & Poor’s 500 Index approached a three-year high in February.
So the 34-year-old Medevac pilot and day trader bought an exchange-traded note from Barclays Plc (BARC) that’s designed to profit when stock prices get more volatile. Mathers didn’t realize the note tracks a different volatility index from the widely followed S&P 500 VIX benchmark, and could produce much different results. The confusion cost him 6 percent of his investment over two days.
The Barclays note (VXX:US), called the iPath S&P 500 VIX Short-Term Futures ETN (VXX:US), is among a slew of new products allowing individual investors to make the kind of sophisticated bets on price swings that were only available to institutional buyers as recently as three years ago. The security is poorly suited for a buy-and- hold strategy, having plunged 96 percent since inception. Mathers noticed that even when the VIX was unchanged, he lost money.
“I got burned,” Mathers said in a telephone interview. “You wouldn’t get what you think you’d pay for. It’s a dangerous product.”
Banks such as Barclays and UBS AG (UBS:US) are pitching ETNs tied to volatility as a way for investors to bet on spikes or declines in the stock market and to protect against losses. About 30 volatility products have been listed since January 2009. The Barclays note was first and has $1.8 billion in assets, making it the largest tied to volatility.
‘Not a Stock’
Many investors don’t understand that investments linked to volatility don’t react in the same way as traditional products, said Jim Strugger, a derivatives strategist for MKM Partners LLC in Stamford, Connecticut.
“It’s not a stock. That’s inherently the problem,” Strugger said in a telephone interview, as too many investors oversimplify the gauge. “When bad things happen, volatility goes higher.”
The U.S. Securities and Exchange Commission is probing price gyrations in a Credit Suisse Group AG (CSGN) volatility ETN that lost half of its value in two days, a person familiar with the matter said in March.
Regulators Crack Down
Regulators have already cracked down on leveraged or inverse ETFs that Wall Street markets and sells to retail customers. The Royal Bank of Canada said today it agreed to reimburse Massachusetts investors as much as $2.9 million and pay a $250,000 fine over sales of those types of ETFs.
The Financial Industry Regulatory Authority, the industry- backed regulator, also fined banks including Wells Fargo & Co. (WFC:US), Citigroup Inc. (C:US), Morgan Stanley (MS:US), and UBS about $7.3 million yesterday to settle claims they failed to properly supervise sales of similar ETFs. The firms also didn’t have a reasonable basis for recommending the securities to their clients, Finra said.
Exchange-traded notes are contracts between investors and banks that are less regulated than mutual funds and can be more complex than exchange-traded funds. ETNs are backed only by their issuer’s credit, unlike ETFs and mutual funds, which hold assets. The notes are about a $17 billion market, a fraction of the $1.2 trillion in ETFs.
Investors use volatility products to protect against sudden losses in the S&P 500. The VIX has moved in the opposite direction of the S&P 500 about 80 percent of the time, data compiled by Bloomberg show. Buyers earned 14.8 percent on the Barclays note the Monday after the U.S. was stripped of its top credit rating last August, while the S&P 500 lost 6.7 percent.
Mathers bought the Barclays note expecting it to move in lock-step with spot VIX, as the Chicago Board Options Exchange Volatility Index is known. Instead, the note tracks futures contracts, which means it won’t necessarily match the performance of that gauge.
Shares outstanding for the Barclays note hit a record 114 million on March 23 even as the security had lost more than 51 percent of its value this year as of that date.
Mathers, the pilot, bought 75 shares of the Barclays ETN on Feb. 21 when volatility closed higher at 2.31 percent, except the note fell 0.13 percent. It dropped an additional 2.82 percent the following day, while the VIX was unchanged. Since the notes are tied to futures, they can lose their value because of a market phenomenon known as contango, when later contracts cost more than earlier ones.
That issue isn’t disclosed until page 15 of the note’s prospectus: “The existence of contango in the futures markets could result in negative ‘roll yields’, which could adversely affect the value of the index underlying your ETNs and, accordingly, decrease the payment you receive at maturity or upon redemption.”
Kristin Friel, a spokeswoman for London-based Barclays, declined to comment.
ETFs betting on volatility also have declined because of contango. The ProShares VIX Short-Term Futures ETF, which tracks a similar index as the Barclays note, has fallen 57 percent since inception in January 2011.
Inexperienced traders looking to make a “quick buck” are behind some of the demand for volatility notes, said Bill Luby, founder of the VIX and More blog who has traded the securities. These investors “are probably not sophisticated enough to buy options,” Luby said in a telephone interview, so they buy notes tied to volatility. Options are contracts that give the purchaser the right, but not the obligation, to buy or sell a security.
When investors buy ETNs, they loan money to banks, which promises to pay them the performance of an index, minus fees. If the issuer goes out of business, investors must stand in line with other creditors to try to recoup their money. That’s what happened to investors in ETNs issued by Lehman Brothers Holdings Inc (LEHMN:US)., when the firm declared bankruptcy in September 2008.
“Banks can invest that money any way they want to,” said Colby Wright, assistant professor of finance at Central Michigan University. “Some investors would be surprised to know that there is no portfolio underlying the returns that are being generated.”
The complexity of ETNs mean they may not perform as people expect, said Samuel Lee, an ETF analyst for Morningstar Inc. (MORN:US) in Chicago.
“These are products that are developed by very sophisticated folks in the industry and I wonder to what degree they are developed with the retail investor in mind,” said Matt Kitzi, securities commissioner of Missouri.
Because of their structure, ETNs can be created on anything, said Kyle Schaffer, senior investment adviser at Ballentine Partners LLC in Waltham, Massachusetts. “I could in theory sell you an ETN that promises to go up by 1 percent for every run the Red Sox score.”
That’s an advantage of ETNs, Schaffer said. There aren’t too many ways to get volatility exposure, for example, which is why investors may look to the notes, he said. They’re also tax efficient. Investors generally don’t get taxed until they sell and profits are taxed at capital gains rates, which usually are lower than rates on income. Schaffer’s firm invests in a Barclays commodity ETN for clients, who have at least $20 million in net-worth.
It’s often hard for investors who aren’t very comfortable digging through prospectuses to figure how much they’re paying for the notes, said Morningstar’s Lee.
“The fees in these exchange-traded notes can be very opaquely disclosed, buried under mounds of math,” he said.
The average ETN annual investor fee is 0.84 percent, according to Morningstar data. That doesn’t include a lot of the tacked-on charges, Lee said. The UBS short VIX ETNs, for example, add about a 4 percent annual fee for “event-risk” hedging, leading to a total cost of 5.35 percent, he said.
Christiaan Brakman, a UBS spokesman, declined to comment.
The complexity of ETNs hasn’t scared away buyers. Investors looking to protect against declines in the S&P 500 created so much demand for an ETN tied to equity volatility that Credit Suisse stopped issuing shares on Feb. 21.
That resulted in an 89 percent premium in the note’s price on March 21 over the index it tracked. The note lost more than 50 percent of its value in two days.
Mathers, the pilot who bought the VIX note, said he won’t invest in volatility products again and thinks buyers should be warned before investing.
“We all have to better understand what we’re trading.”
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