Volatility-Linked Exchange Traded Products (ETPs) Unsuitable for Most Investors

An exchange-traded product (ETP) is a security listed and traded on a securities exchange. The ETP tracks the performance of an index, benchmark, or actively-managed strategy. The most common type of ETP is the exchange traded fund (ETF). Another type of ETP is an exchange traded note (ETN), which tracks an index or benchmark but is a debt obligation of an issuer and holds no underlying portfolio.

Some ETPs provide exposure to market volatility as an asset. In very simple terms, stock market volatility measures fluctuations in stock prices. Low volatility means small fluctuations and high volatility means large fluctuations. Markets move in three directions:  up, down, or sideways. (Sideways means a market is staying within a fairly steady range.) For the most part, volatility tends to be relatively low during upward and sideways trends, but it increases substantially when markets are in downward trends.

Volatility Index

ETPs that provide exposure to volatility as an asset, as represented by the Chicago Board Options Exchange Volatility Index (VIX) or other analogous index, are called volatility-linked ETPs. The VIX is a measure of investor angst and displays the market’s expectations of near-term volatility. Because it’s used by stock and options traders to gauge the market’s anxiety level, the VIX often is referred to as the “fear index” or “fear gauge”. Put very simply, and without describing its underlying architecture, the VIX measures how much the market thinks the S&P 500 index option (symbol SPX) will fluctuate over the next 30 days. If investors expect market volatility to increase, the VIX index will fall.  And if investors expect market volatility to diminish, the VIX index will rise.

Investors can’t trade the VIX index directly, but they can trade volatility-linked ETPs that are based on the VIX.

Volatility-Linked ETPs Unsuitable for Most Investors

Volatility-linked ETPs are risky, complex products — so much so that many stockbrokers don’t even understand how they work. These investments are virtually guaranteed to lose value over time and thus are unsuitable for retail investors who plan to use them as traditional buy-and-hold investments. FINRA has warned in Regulatory Notice 17-32:

[M]any volatility-linked ETPs that seek to maintain a continuous, targeted maturity exposure to VIX futures, particularly to shorter maturities, have lost a significant amount of value over time; some have lost more than 90 percent of their value since they launched. And, such products will likely continue to lose value over longer periods of time. Moreover, the performance of VIX futures can diverge from that of the VIX, and in general, movements in the futures are smaller in magnitude than those of the VIX. For these reasons, the performance of volatility-linked ETPs that seek to maintain a continuous, targeted maturity exposure to VIX futures may also be less correlated to that of the VIX than investors might expect.

Because volatility-linked ETPs can easily be misunderstood and improperly recommended or sold by brokers, brokerage firms are required to exercise heightened oversight of ETP sales. They must ensure that their representatives and supervisors understand the risks presented by these investments, and they have an obligation to vet these and other complex products, to put reasonable supervisory controls in place, and to train their representatives and supervisors to ensure that suitability and other obligations under FINRA rules are met.

Contact an Attorney If You’ve Suffered a Major Loss

If you’ve suffered economic loss because your financial advisor failed to alert you to the inherent risks of a volatility-linked ETP, please contact a financial misconduct lawyer at McCarthy, Lebit, Crystal & Liffman today. Ask for Hugh Berkson or Jay Salamon at (216) 696-1422 or call toll free at (866) 932-1295 for a free evaluation of your recovery options.  If you prefer, email us at hdb@mccarthylebit.com.  Or leave us your contact information and a brief comment on the form to the right and we’ll call you. Our attorneys have a thorough understanding of these complex investments and can determine whether or not you are the victim of investment fraud or stockbroker misconduct.