These Investments Should Come with a Warning Label

by: Richard A. Anderson

Exchange-traded products (ETPs) have been lauded by investors and investment professionals for helping to democratize investing. The most popular type of ETP is the exchange-traded fund, better known by its acronym ETF. Exchange-traded notes (ETNs) are a lesser known type of ETP. ETNs differ from ETFs in that ETNs don’t hold underlying securities, like stocks or bonds. Rather, they are unsecured debt instruments issued by a bank that promises to pay the performance of an underlying investment, typically an index or basket of securities.

Over the past few years, the growth in assets for ETPs has sky-rocketed. Most of the growth in ETP assets has gone into broadly diversified equity investments, like ETFs that track the S&P 500 Index. These types of ETFs have lowered the barrier to investing, lowered the cost of investing, and allowed investors the ability to access broadly diversified portfolios in an efficient manner.

There are many characteristics that distinguish ETPs and mutual funds. The most often cited benefits of ETPs over mutual funds are improved tax efficiency, greater portfolio transparency, intra-day trading, and no minimum investments. No minimum investment is no doubt a positive, as investors can purchase as little as one share of an ETP rather than some mutual funds that require a minimum investment of say $1,000.

While the growth of ETPs is generally viewed as a positive for investors, there are some potential negatives associated with the expanding investment opportunities available through ETPs. The lack of an investment minimum, in particular, is a double-edged sword.

Many asset management companies have tried to take advantage of the popularity of ETFs by offering more niche asset classes, like alternative investment strategies. Hailed as the democratization of investing, the expansion of ETPs provides all investors with access to more niche asset classes and strategies that have traditionally been available only to institutional investors. This creates a major problem because many investors can now access high-risk strategies without having the proper education or performing the necessary research to determine if the strategy is appropriate for their investing needs.

Earlier this year, this risk came to light when the VelocityShares Daily Inverse VIX Short Term Exchange-Traded Note (XIV) lost 90% of its value in one day. XIV was liquidated shortly after, leaving investors with big losses. XIV was an ETN that tracked the Chicago Board Options Exchange Volatility Index, commonly referred to as the VIX. The fund promised to pay the inverse of the VIX. If the VIX went down, XIV would go up by that amount, and vice versa. The fund accomplished this goal by buying and shorting VIX futures.

Investors in XIV filed a lawsuit against Credit Suisse, the notes issuer, because of the losses. The essence of their lawsuit is that they didn’t understand the investment. These are sophisticated products and there is no simple disclosure to alert investors as to the risks involved. The risks are disclosed in the prospectus, but many investors don’t read an investment’s prospectus because it is a dense document which includes a significant amount of legal and industry jargon.

Investing in products that use options, short selling, or leverage requires additional consideration beyond plain vanilla index-tracking products. These strategies are often designed for institutional use, but there is no barrier to prevent “mom and pop” investors from getting involved. An extra line of defense to protect investors from themselves should be required for investing in these products. If an investor wanted to invest in options or use leverage in their brokerage account, they would need to sign additional paperwork citing their goals, objectives, and experience with these types of investments. It may not seem like much, but at least it’s a speed bump for an investor to say, “what am I investing in?” The investment prospectus, on the other hand, is largely ignored, only to be reviewed after large losses have already occurred.