November 5, 2015
You may have heard of the Fear Index, which is traded in the form of the VXX and similar products. If you read the ongoing commentary about this product, you will be struck by the chorus of naysayers: both industry professionals and regulators. Notwithstanding the concerns raised about such matters as correlation and cost/benefit, traders (both professional and otherwise) dive into this trade as both a way to gain exposure to volatility and to hedge long equities positions. All of which brings us to an uncomfortable compliance and regulatory ground where you got a product that trades and that many folks love to day trade but the product is not in favor with Wall Street's cops. Consider this recent FINRA regulatory settlement.
Case In Point
For the purpose of proposing a settlement of rule violations alleged by the Financial Industry Regulatory Authority ("FINRA"), without admitting or denying the findings, prior to a regulatory hearing, and without an adjudication of any issue, John D. Kavaler submitted a Letter of Acceptance, Waiver and Consent ("AWC"), which FINRA accepted. In the Matter of John D. Kavaler, Respondent (AWC 2013038125501, November 2, 2015).
In 1986, Kavaler entered the securities industry and eventually registered with eight FINRA member firms, of which his most recent registration began on January 9, 2009, with Ameriprise Financial Services, Inc., where he remained until November 12, 2013.
The VXX Hedge
The AWC asserts that in 2012 and 2013, Kavaler recommended that several of his customers employ a VXX hedge against various large-cap equity securities positions. Purportedly, Kavaler viewed the VXX hedge as protection against market downturns, which was a particularly acute possibility during the so-called "fiscal cliff" of 2012. As presented in the AWC, FINRA offers this commentary about the VXX:
The VXX is an exchange-traded note that offers investors exposure to the returns of one- and two-month futures contracts on the CBOE Volatility Index (the "VIX Index"). The VIX Index -- referred to by some as the "fear index" -- is calculated using one month put and call options on the S&P 500 Index and is designed to measure the market's expectations of volatility in large cap U.S. stocks over the next 30-day period. The VXX is generally considered a bearish investment, as market volatility typically is negatively correlated with market returns (although not directly correlated to the movement of the market as a whole or to specific equities). The VXX essentially tracks market negativity as reflected in the price of futures contracts. It is rarely if ever considered a suitable hedge for specific equity positions.
Although the VXX and similar products move in the opposite direction of the indices they track, they have their own independent risks. Most significantly, they are generally expected to lose value as time moves on, and thus they are rarely if ever considered to be prudent long-term investments. The value of futures contracts on the VXX Index generally decreases over time. As a result, the VXX is rarely if ever suitable as a long-term holding, but instead is generally held for brief periods measured in days rather than months or even weeks.
Adding to the Hedge
The AWC asserts that, at times, Kavaler had customers dollar-cost-average their VXX position after they had sustained losses on earlier purchases. Pointedly, the AWC asserts that:
[B]ased on Kavaler's recommendations, two customers bought 3,500 VXX shares-during March and August-2012 for a total investment of almost $58,000. They later sold these shares after holding periods of 79 and 402 days, suffering losses in excess of $28,000. Another customer -- also based on Kavaler's recommendation -- invested more than $290,000 to buy a total of 27,000 VXX shares between February 2012 and February 2013, ultimately losing more than $114,000 after holding those shares for periods ranging from 30 to 288 days. These customers all held long positions in the same two large-cap equity securities.
FINRA deemed Kavaler's recommendations as set forth in the above quoted paragraph as "unsuitable" because the customers:
did not understand the nature and risks of the VXX, and it was not reasonable to expect VXX shares to increase in value, or even retain their value, over the extended periods through which Kavaler's customers held them. lt likewise was not reasonable to expect VXX shares to serve as an effective hedge against a potential market downturn anticipated from the "fiscal cliff" or other potential future events the timing of which was either unpredictable or known to be at least several months away.
According to FINRA's BrokerCheck report as of November 5,
2015, Ameriprise "Discharged" Kavaler on October 15, 2013, based upon
ADVISOR WAS TERMINATED FOR COMPANY POLICY VIOLATIONS RELATED
TO SUITABILITY, USE OF DISCRETION, AND MISMARKING TRADES
Violations and Sanctions
Based upon the suitability issues cited above, FINRA deemed that Kavaler's conduct constituted violations of the Suitability Rule as promulgated in NASD Rule 2310(a) (for conduct before July 9, 2012) ; FINRA Rule 2111(a) (for conduct after July 9, 2012);and also violations of FINRA Rule 2010.
In accordance with the terms of the AWC, FINRA imposed upon Kavaler a $15,000 fine and a three-month suspension from association with any FINRA member firm in all capacities.
Bill Singer's Comment
Missing from the AWC is that actual full name of the VXX, which is the Barclays Bank PLC iPath S&P 500 VIX Short-Term Futures ETN. In contrast to FINRA's description of the product, let's consider what's provided on the iPath website's Product Summary:
The iPath S&P 500 VIX Short-Term FuturesTM ETNs (the "ETNs") are designed to provide exposure to the S&P 500 VIX Short-Term FuturesTM Index Total Return (the "Index"). The ETNs are riskier than ordinary unsecured debt securities and have no principal protection. The ETNs are unsecured debt obligations of the issuer, Barclays Bank PLC, and are not, either directly or indirectly, an obligation of or guaranteed by any third party. Any payment to be made on the ETNs, including any payment at maturity or upon redemption, depends on the ability of Barclays Bank PLC to satisfy its obligations as they come due. An investment in the ETNs involves significant risks, including possible loss of principal and may not be suitable for all investors.
The Index is designed to provide access to equity market volatility through CBOE Volatility Index (the "VIX Index") futures. The Index offers exposure to a daily rolling long position in the first and second month VIX futures contracts and reflects market participants' views of the future direction of the VIX index at the time of expiration of the VIX futures contracts comprising the Index. Owning the ETNs is not the same as owning interests in the index components included in the Index or a security directly linked to the performance of the Index. For additional information regarding the risks associated with the ETNs, please see "Selected Risk Considerations" below.
Under the Correlations Tab for the Product Summary (as of 09/30/2015"), we are informed on the iPath webpage that:
Correlation is a term used to describe the statistical relationship between two or more quantities or variables. Perfectly correlated assets will have a correlation coefficient of one, while the correlation coefficient will be zero when returns on two assets are completely independent.
The "Correlations" presented on that webpage for the VXX disclose:
S&P 500 VIX Short-Term Futures Index TR: 1.00
Barclays US Aggregate Bond Index: 0.16
Bloomberg Commodity Index Total Return: -0.37
MSCI Emerging Markets Net Total Return Index: -0.61
MSCI EAFE Net Total Return Index: -0.76
S&P 500 Total Return Index: -0.82
So . . . what are we to make of this? How do we reconcile FINRA's warnings about the use and suitability of the VXX with the online disclosures by iPath?
Many market professionals question the utility and integrity of VXX. As such, given FINRA's ongoing concerns about the efficacy and suitability of VXX for some investors, why is this product allowed to trade -- or allowed to trade without more regulatory restrictions? We have specific approval protocols for trading options and pennystocks, why are there not similar restrictions on this ETN and other similar so-called exotic instruments? Mind you, I am not necessarily calling for such restrictions but in the role of an agent provocateur raising the issue.
Assuming that, arguendo, Kavaler is personally liable for the unsuitability of his VXX recommendations, where was his firm's Compliance Department? After all, if the unsuitability of this product - or this product as a suggested hedge - is so clear to FINRA, why didn't a compliance officer immediately reject or cancel the trade as patently unsuitable as a hedge?
For some background on the VXX, watch industry pundit Shah Gilani's video interview below on "Case In Point with Bill Singer."
November 3, 2015: Bill Singer talks with Shah Gilani, a market analyst with Capital Wave Forecast and Short Side Fortunes, on his trading career and popular investment newsletters; the downside of the rise of electronic stock exchanges; the connection between regulatory issues and volatility; how the SEC has been complicit in the rise of High Frequency Trading; and the implications of scandals like LIBOR and foreign currency manipulation. "Volatility is the new face of the market," Gilani says. "It's here to stay, it's going to increase and it will drive the markets." WATCH