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Susan Tompor: Think twice about betting on Wall Street’s ‘fear gauge’

McClatchy-Tribune Information Services

May 28, 2018


Wall Street’s rocky ride in 2018 — a level of chaos we’ve not seen in quite some time — has everyday investors fearing for their 401(k)s.

But many times, panic can drive you into pretty risky deals. The same applies to rushing into something you don’t understand because your neighbor has a convincing story on a hot new way to make money.

Ever hear someone you know try to chat you up on the wonders of trading the VIX?

The Financial Industry Regulatory Authority is warning that novice investors could lose more money than they might expect if they trade complex, speculative products that are designed to cash in on the market’s volatility.

Investors who have complained to FINRA say they’ve lost six figures on exchange-traded products that track "volatility" as an asset.

"One caller we had heard from really lost everything," said Gerri Walsh, senior vice president of investor education at FINRA, told me in a phone interview.

The investor put virtually all of his family’s assets on a volatility bet.

He was investing in an exchange-traded product that tracked the inverse of the performance of futures on the Chicago Board Options Exchange Volatility Index, or what’s known as the VIX.

The investor bought the product on margin — essentially investing with borrowed money.

The investment crashed, his money was gone and he owed so much that he faces the possibility of having to mortgage his house to pay off the margin debt.

Today, FINRA noted, the specific VIX-related product he bought no longer even trades.

We’re not talking about your typical stocks and bonds. The products are not buy-and-hold investments — and can be fairly volatile themselves. Typically, investors are tracking futures products or other derivatives pegged to a so-called "fear index."

"You’re taking a significant risk and you need to understand that," Walsh said. "There’s always risk involved with these products."

Many times, she said, individuals are hearing about such products through the financial news media and investing on their own through online brokerage accounts. But others say some brokers pushed the product, too.

A Forbes contributor wrote an article last summer that was titled: "Selling VIX Is Hitting Magazine Covers — Should You Be Worried?"

The popularity of such VIX-related products wasn’t hurt, of course, by some eye-popping gains in the past.

Some inverse volatility-linked exchange-traded products had returned more than 180 percent in 2017.

Even today, some novice investors might be attracted to volatility-linked products, as we’re seeing more swings in the stock market of late. But it’s an area where individual investors need to move cautiously — if at all.

David Sowerby, managing director and portfolio manager for Cleveland-based Ancora Advisors, noted that investors have seen higher volatility this year — with two 10 percent corrections in 2018.

But it’s nothing close to a 50 percent decline in the market meltdown nearly 10 years ago. Volatility on Wall Street was more extreme during the fall of 2008 and early 2009, he said.

Sowerby said volatility-linked products that bet on a decline in market swings — not an uptick — were not a prudent strategy for the longer-term individual investor.

"Especially when volatility or the VIX was at such historical lows," Sowerby said.

Some VIX-related products enabled investors to profit when volatility was low but then led to dramatic losses when Wall Street ran into a major stock selloff in February.

The so-called "fear gauge," as the VIX has been called, has come under more scrutiny since the brutal market sell-off in early February. The Dow Jones industrial average lost more than 2,500 points or 9.75 percent in a two-week period.

Credit Suisse Group AG’s VelocityShares Daily Inverse VIX Short-Term ETN imploded in February’s market selloff, losing nearly $2 billion in about 18 hours, according to a Bloomberg report.

The short volatility product, known as XIV, posted a 90 percent drop within hours, according to reports.

Allegations of market manipulation in the volatility-trading universe have surfaced, including reports that the U.S. Securities and Exchange Commission and Commodity Futures Trading Commission will conduct an investigation into some aspects involving the VIX benchmark.

"We will likely see a tsunami of lawsuits and FINRA arbitration claims for burned investors in this product and others like it," said Andrew Stoltmann, a Chicago-based attorney who typically represents investors who lost money.

"Unfortunately, it feels like Groundhog Day all over again," Stoltmann said.

He noted that such complex sorts of investments aren’t suitable for 99 percent of retail investors.

"But unfortunately they were heavily sold to retail investors across the United States. Brokers took a square peg in a round hole approach to recommending these products, similar to what we saw in 1999 with technology stocks and other similar investments in the last 18 years," Stoltmann said.

The VIX is not based on actual price fluctuations experienced in a given day. Instead, the VIX reflects an expectation of volatility over the next 30 days as implied by options prices.

VIX generally moves in a different direction than the broader stock market — which can hedge market performance. But experts note that movements can be sharp — such as moving significantly higher when the stock market declines sharply.

David Kudla, CEO for Mainstay Capital Management based in Grand Blanc, said individual investors can easily be confused by how some VIX products work because these are sophisticated derivative securities that "can be difficult to explain for even a math Ph.D."

"Just because something is ‘mean-reverting’ does not mean that it is in any way ‘predictable,’" Kudla said.

He noted that the magnitude of losses can be far greater when compared to the magnitude of rewards.

"We do not think there was market manipulation with the VIX. Rather, the result of almost everyone rushing into this investment (or in an inverse VIX product) over the past few years has caused sometimes peculiar behavior of the VIX Index," Kudla said.

At the same time, though, investors cannot be lulled into thinking there is very little risk here just because many people who seem to be in the know are talking about investing in volatility-linked products.

"They are certainly not intended, even by their advocates, as the sole asset in a portfolio, or as the destination to park one’s life savings," Kudla said.———