The Securities Litigation Expert Blog

Leveraged and Inverse ETFs - Tracking Error

Posted by Jack Duval

Mar 12, 2018 8:07:34 AM

This blog post continues a series exploring leveraged and inverse ETFs.  Our previous posts can be read here and here.

February was a volatile month for the S&P 500.  Leveraged and inverse ETFs that track the S&P 500 saw volatility commensurate with their leverage.  However, compared to their un-leveraged peers, the major leveraged and inverse ETFs did not track the market closely.

Because of the constant leverage trap, we know that leveraged and inverse ETFs are forced to buy high and sell low on a daily basis.  This, plus the management fees of the funds, essentially lock in losses.

On a day to day basis, these factors are de minimis.  Over time, they are fatal.

Table 1: Leveraged and Inverse ETF Performance - February 2018

Screen Shot 2018-03-12 at 7.44.04 AM.png

Source: Bloomberg

As can be seen in Table 1, all the ETFs underperformed.  The underperformance increased with leverage and being directionally wrong.

As with all investments, volatility hurts returns.  For investors in leveraged and inverse ETFs, volatility leads to significant underperformance even over short holding periods.

Because of this complexity risk, these products are only suitable for sophisticated investors wishing to speculate by day trading or for one-day holding periods.

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Topics: suitability, Leveraged and Inverse ETF, Complexity Risk, Tracking Error

Jack Duval Launches RIA Firm Bantam Inc.

Posted by Jack Duval

Mar 4, 2018 7:28:11 AM

Bantam Logo Web-07.png

 

I'm pleased to announce the official launch of Bantam Inc. a registered investment advisory firm.

Bantam is brining a new level of fiduciary guidance to our clients for all aspects of their finances and investments.

A number of traits set Bantam apart:

  • Flat-fee pricing;
  • Ability to consult with clients on stand-alone projects without them having to move their assets;
  • Bantam is registered as a New York benefit corporation.  This means the firm is fiduciary bound at the advice level (as an RIA) and at the corporate level (as a benefit corporation).

To learn more, please visit the Bantam website.

As a side note, I am still very much in the litigation consulting business and will be taking cases for the foreseeable future.  Please feel free to reach out to discuss Bantam or potential cases.

Careers

I am in the process of hiring an investment advisor. I'm looking for someone who wants to join a dynamic startup and can grow with the firm.  The position would include salary, bonus, and equity that vests over time.

If you know anyone with a legal and/or accounting background, who is interested in working with high- and ultra-high net worth investors on complex problems, please forward their names to me.

We are securing office space in Manhattan, close to Grand Central Terminal.  More information is available on our Careers page.

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Topics: Bantam Inc.

Protecting Senior Investors - Nationwide Elder Fraud Sweep

Posted by Jack Duval

Feb 27, 2018 7:49:13 AM

Accelerant - Senior Investors DOJ Image-1.jpeg 

This blog post continues a series I began in 2012 highlighting regulatory efforts to protect senior investors.  (My previous blog posts on protecting senior investors can be found here.)

On February 22, 2018, the Justice Department announced a nationwide sweep that resulted in over 200 criminal charges for financial crimes targeting the elderly.

Attorney General Jeff Sessions was quoted, saying:

The Justice Department and its partners are taking unprecedented, coordinated action to protect elderly Americans from financial threats, both foreign and domestic... Today's actions send a clear message:  we will hold perpetrators of elder fraud schemes accountable wherever they are.  When criminals steal the hard-earned life savings of older Americans, we will respond with all the tools at the Department's disposal - criminal prosecutions to punish offenders, civil injunctions to shut the schemes down, and asset forfeiture to take back ill-gotten gains.

Today is only the beginning.  I have directed Department prosecutors to coordinate with both domestic law enforcement partners and foreign counterparts to stop these criminals from exploiting our seniors.

The Perpetrators

As I have written about before, many of the perpetrators were known to the victims.  The DOJ press release gave this description:

The actions charged a variety of fraud schemes, ranging from mass mailing, telemarketing and investment frauds to individual incidences of identity theft and theft by guardians.  A number of cases involved transnational criminal organizations that defrauded hundreds of thousands of elderly victims, while others involved a single relative or fiduciary who took advantage of an individual victim.  (Emphasis added)

While few crimes could be more heinous than those targeting senior investors, those perpetrated by guardians, relatives, or fiduciaries would qualify.

Supervisory Implications

The financial abuse of senior investors is not an isolated problem.  The DOJ press release stated that the schemes undertaken by the alleged criminals caused more than $500 million in losses to over a million victims.  

These sweep results should be a call to action to broker-dealers, RIA firms, and banks across the country to raise their supervisory oversight of senior investors accounts.

In the past, there has rightfully been significant focus on cases that involve senior investors with Alzheimer's or dementia.  However, unsophisticated and wholly trusting senior investors, who do not have the wherewithal to question recommendations, can also be subject to abuse by unscrupulous advisors.

Compliance and supervisory personnel at all financial firms need to be aware of the potential for abuse and should have special policies and procedures in place to monitor the activity in the accounts of senior investors.  At a minimum, these policies and procedures should detect financial fraud such as: unnecessary trading, unsuitable investments, and suspicious withdrawals.

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Topics: fraud, Senior Investors, supervision, Protecting Senior Investors, Elder Abuse, dementia, Alzheimer's, financial exploitation, Justice Department

Volatility-Linked Products - Complexity Risk Strikes Again

Posted by Jack Duval

Feb 6, 2018 10:41:24 AM

This blog post continues a series exploring volatility-linked exchange-traded products.  Our previous posts can be read here, here, and here.

The VIX S&P 500 volatility index ripped higher by 115 percent yesterday.  This effectively destroyed most, if not all, inverse VIX ETPs.

Common sense will inform that if an index increases by more than 100 percent, an investment vehicle designed to give the opposite (inverse) performance should decline to zero.  (In most cases, if an investment doesn't use leverage, a potential loss is limited to 100 percent.)

Indeed, experience is now bearing this out.

VelocityShares Inverse VIX Short Term ETNs (XIV)

The XIV ETN halted trading yesterday and fund manager Credit Suisse is almost certain to close the fund.

The prospectus language allows Credit Suisse to shutter the fund if the Intraday Indicative Value is equal to or less than 20 percent of the prior day's Closing Indicative Value (among other reasons).  That has happened.

Table 1: XIV Indicative Value

XIV - Indicative Value.gif

Source: Bloomberg

The XIV Indicative Value collapsed from 108.37 to 4.22, a 96 percent decline, and well under the 20 percent threshold.

The difference in the XIV price and indicative value was widening over the past few days of the market selloff, and then blew out yesterday.

Chart 1: XIV Price and Indicative Value

XIV Price v. XIV Indicative Value Chart.gif

Source: Bloomberg

Unfortunately, a significant amount of hot money had been flowing into this ETN due to it's returns over the past few years.  The XIV market cap was just off its all-time high, at $1.48B yesterday.

Chart 2: XIV Historical Market Cap

XIV Market Cap Chart.gif

Source: Bloomberg

A Bitter Irony

In a classic example of complexity risk, investors who bought the XIV at the close yesterday (thinking that the VIX had risen too far, too fast), will be wiped out, just like longer term holders.

As of this writing at 10:20am, the XIV is down 31 percent, meaning that those buyers would have been directionally correct, but will suffer virtually complete losses anyway with no chance to get out.

Suitability and Supervision of Volatility-Linked Products

For years, investors have been seeing their principal destroyed as unknowing advisors bought and held inverse and leveraged ETPs.  Indeed, the XIV prospectus (PS-16) gives this warning:

Screen Shot 2018-02-06 at 9.16.52 AM.png

Advisors putting their clients into inverse and leveraged ETPs should have known about the risks of long-term holding and the risk of complete overnight ruin.

Likewise, firms that allowed their advisors to sell these products should have implemented special training for them.  Furthermore, specific policies and procedures should have been written to insure these products were only utilized in speculative accounts, and for sophisticated investors, who were aware of, and accepted the risk of, total loss.

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Topics: suitability, supervision, Complex Investments, Complexity Risk, volatility-linked products, XIV, VelocityShares Inverse Short Term ETN

Protecting Senior Investors - FINRA FAQs

Posted by Jack Duval

Jan 17, 2018 7:48:00 AM

 

accelerant - senior investor fraud.jpg

 

This blog post continues a series that I began in 2012 highlighting regulatory efforts to protect senior investors.  (My previous blog posts on protecting senior investors can be found here.)

On January 3, 2018, FINRA posted guidance in the form of Frequently Asked Questions (“FAQs”) relating to protecting senior investors.

They did this in advance of FINRA Rule 2165 – Financial Exploitation of Specified Adults and Rule 4512 – Customer Account Information becoming (respectively) effective and amended on February 5, 2018.  Both rules were approved by the SEC in March 2017 and discussed in FINRA RM 17- 11.

I summarize and discuss a few of the more important points made in the FAQs and how they relate to account supervision.

Rule 2165 – Financial Exploitation of Specified Adults[1]

Q.1.1. May a member place a temporary hold on a securities transaction pursuant to Rule 2165?

A. Rule 2165 provides a safe harbor for a member to place a temporary hold on a disbursement of funds or securities from the account of a specified adult if the member reasonably believes that financial exploitation of the specified adult has occurred, is occurring, has been attempted or will be attempted. (Emphasis added)

This FAQ illustrates one of the key deficiencies with Rule 2165, that trading may continue in accounts where financial exploitation is occurring.  This is especially relevant to instances where the perpetrator of the exploitation is the Registered Representative.  In these instances, the Registered Representative could generate excessive compensation for herself without triggering a red flag under Rule 2165.  Indeed, it is conceivable that abusive trading could occur even if the account was under a temporary hold.

In these instances, the Registered Representative would be making withdrawals from the account through the broker-dealers own compensation mechanism.

An example of this could be the selling of a long-held low cost basis stock and using the proceeds to buy a high commission products.  The Registered Representative would get paid twice, once on the stock sale and once on the product purchases.  The payment of the commissions would not be reflected as a “disbursement of funds” and thus not flagged by a compliance system.

This scenario is not far-fetched.  I have seen cases where Registered Representatives have churned accounts after the client has died.

Supervisors must know the clients and their accounts well enough to detect abuse by Registered Representatives.

Q.1.2 Under Rule 2165, may a member that has a reasonable belief of financial exploitation of a Specified Adult regarding a disbursement or disbursements place a temporary hold or restrictions on an entire account if the member permits legitimate disbursements from the account?

A. FINRA has stated that, where a questionable disbursement involves less than all assets in an account, a member should not place a blanket hold on the entire account. Each disbursement should be analyzed separately.  (Emphasis added)

Here FINRA wants to avoid the failure of paying of legitimate bills and other disbursements even if a temporary hold has been placed on the account.  This would require significant diligence from the supervisor and Registered Representative to insure the disbursements were legitimate.

Rule 4512 – Customer Account Information[2]

Q.3.2. does the requirement in Rule 4512(a)(1)(F) to make reasonable efforts to obtain the name and contact information for a trusted contact upon the opening of a non-institutional customer’s account or when updating account information for an existing non-institutional account apply to all non-institutional accounts?

A. Rule 4512(a)(1)(F) provides that the trusted-contact provision “shall not apply to an institutional account”.  Accordingly, the trusted-contact provision applies to any account that does not meet the definition of an “institutional account” in Rule 4512(c), including accounts of non-natural persons that do not meet the definition.

FINRA defines an “institutional account” as:[3]

(1)  A bank, savings and loan association, insurance company or registered investment company;

(2) An investment adviser registered either with the SEC under Section 203 of the Investment Advisers Act or with a state securities commission (or any agency or office performing like functions); or

(3) Any other person (whether a natural person, corporation, partnership, trust or otherwise) with total assets of at least $50 million.

The key provision of this guidance is that member firms should try to obtain trusted contact information for all accounts, including entities such as trusts, corporations, and partnerships.

Also, in my experience, even if a client meets the “institutional” account criteria by having assets of $50 million or greater, they are just as subject to potential abuse as anyone else.  Furthermore, having more assets does not imply greater sophistication or protection from bad actors.

Supervisors should monitor these accounts with the same diligence as they do other accounts.

Q.3.4. When is a member required to seek to obtain the trusted-contact information for accounts in existence prior to the effective date of the amendments to Rule 4512 (“existing accounts”)?  When is a member required to update the trusted-contact information?

A. Consistent with the current requirements of Rule 4512(b), a member would not need to seek to obtain the trusted-contact information for existing accounts until such a time as the member updates the information for the account either in the course of the member’s routine and customary business or as otherwise required by applicable laws or rules.

Since knowing the client is an ongoing duty[4], asking clients for trusted contact information should be done at least as soon as the next contact with the client.  Client contact could be when making a trade recommendation, when presenting an account review, or for other reasons.

Q.4.1.  What is a member allowed to disclose to the trusted contact about a customer’s account?

A. Supplementary Material .06(a) to Rule 4512 requires that, at the time of account opening, a member disclose in writing (which may be electronic) to the customer that the member or an associated person is authorized to contact the trusted contact and disclose information about the customer’s account to address possible financial exploitation, to confirm the specifics of the customer’s current contact information, health status, or the identity of any legal guardian, executor, trustee or holder of a power of attorney, or as otherwise permitted by Rule 2165.[5]

… A member also could reach out to a trusted contact if it suspects that the customer may be suffering from Alzheimer’s disease, dementia or other forms of diminished capacity.

The disclosures should be limited to what the trusted contact would need to know to help make a determination as to any suspected exploitation or diminished capacity.  In most instances, it would not be necessary to disclose the total account value and details about a client’s investments with the trusted contact.

In the case of suspected possible financial exploitation, the focus would likely be on distribution requests.  If diminished capacity is suspected, no financial information would need to be disclosed, unless it was part of the indicia of the diminished capacity.

_________________

Notes:

[1]       Frequently Asked Questions Regarding FINRA Rules Relating to Financial Exploitation of Seniors;  January 3, 2018; Available at: http://www.finra.org/industry/frequently-asked-questions-regarding-finra-rules-relating-financial-exploitation-seniors; Accessed January 15, 2018.

[2]       Id.

[3]       FINRA Rule 4512 – Customer Account Information; Available at: http://finra.complinet.com/en/display/display.html?rbid=2403&element_id=9958; Accessed January 16, 2018.

[4]       See FINRA Rule 2111 – Suitability, regarding client profiling, and FINRA Rule 2090 – Know Your Client regarding diligence in the maintenance of client accounts.

[5]       FINRA also confirms that disclosures of financial information to a trusted contact would not be in violation of Regulation S-P (the SEC’s Privacy of Consumer Financial Information rule), since any disclosures would have been made with the customer’s consent.  See Regulation S-P Final Rule, available at: https://www.sec.gov/rules/final/34-42974.htm.  Accessed January 17, 2018.

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Topics: fraud, Senior Investors, supervision, Protecting Senior Investors, Elder Abuse, dementia, Alzheimer's, financial exploitation

Jack Duval Quoted in MarketWatch Article on CoCo Bonds

Posted by Jack Duval

Jan 2, 2018 10:46:12 AM

Accelerant Managing Partner Jack Duval was quoted in a MarketWatch article on contingent convertible ("CoCo") bonds.

What the article didn't mention is that Deutsche Bank and other CoCo issuers have been exploring making a market in total return swaps on CoCo's, including those issued by themselves.  If implemented, these derivitives would set up highly complex and perverse incentives where the bank (as counterparty) could profit from weakening it's own financial strength.

Banco Popular Bail-In

In a pattern that is repeated frequently in securities markets, in early- to mid-2017 Banco Popular common equity declined 80 percent while the Banco Popular 8 1/4 perpetual CoCo's only declined 20 percent.  This relationship existed until a month before the CoCo's were wiped out in the reorganization, thus "bailing-in" the bank by being completely written off.

Banco Popular CoCo v. Common Equity Chart.gif

Source: Bloomberg

Suitability of Complex Products

As I have discussed here and here, contingent convertible bonds are highly complex and subject to extraordinary risks that are not typical of traditional bonds.  They are only suitable for highly sophisticated investors who can evaluate the company specific and regulatory risks and are willing to lose their entire investment.  This eliminates virtually all retail investors and most institutional investors.

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Topics: Contingent Convertible Bond, CoCo, Banco Popular, Bail-in, MarketWatch

The Accelerant Arbitration Market Indicator - December 2017 Update

Posted by Jack Duval

Dec 18, 2017 11:09:30 AM

The Accelerant Arbitration Market Indicator was 2.37 at the end of October.  This is another new all-time high.  Complacency rules the markets as investors embrace risk assets with perceived impunity.

New FINRA arbitration claim filings continue to run at cycle-lows, as they have for the past four years. The current annualized rate is 3,418 for 2017.  

Historically, high readings from this indicator have presaged market declines.

 

 AAI + Forward Return-3.jpg

FINRA Arbitration Claims v. S&P 500-3.jpg

 

For a higher resolution version of these images, click here.

 Get Updates on the Accelerant Arbitration Market Indicator

 

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Topics: Jack Duval, Accelerant Arbitration Market Indicator, FINRA Arbitration, Securities Expert

Volatility-Linked Products - Bank of America Strategic Return Notes

Posted by Jack Duval

Dec 1, 2017 10:07:27 AM

This blog post continues a series exploring volatility-linked exchange-traded products.

In this post, I examine the Bank of America Strategic Return Notes Linked to the Investable Volatility Index (“SRNs”), which were issued on November 23, 2010 and matured on November 27, 2015.

The SRNs were supposed to offer investors exposure to a volatility index over a five-year period.  However, due to high upfront and ongoing annual fees and the negative roll yield (previously discussed here and here), the investment resulted in almost a complete loss.

What is remarkable is that anyone who understood volatility products and negative roll yield would have known this ex-ante, that is, before the product was brought to market.  This is an example of how complexity risk manifests itself in investments, the people who created the investment didn’t understand it.

Disclosures, Negative Roll Yield, and Principal Destruction

The SRN Pricing Supplement lists the two percent upfront fee and the 0.75% annual internal fee as costs but does not mention the negative roll yield as a cost.  This is remarkable given that the negative roll yield is the primary cost of the strategy as it was to be implemented.

There was one disclosure in the SRN Pricing Supplement (on page 14) which addressed the negative roll yield (however, the phrase “negative roll yield” was not used):[1]

If the level of forward implied volatility is higher in the more distant S&P 500 Index options expirations months than it is in the nearer expiration months, then the level of the Index could be adversely affected as the Index positions are rebalanced daily to maintain a constant maturity.  The rebalancing involves increasing exposure to more distant forward implied volatility and decreasing exposure to more near-term forward implied volatility which may decrease the payment you receive at maturity or upon exchange.  Historically, the more distant expiration months have typically had a higher level of forward implied volatility than the nearer expiration months.

This explanation does not make it clear that the negative roll yield will be an almost certain daily destroyer of the investor’s principal.  Given the five-year term of the investment, the negative roll yield, coupled with the two percent up-front fee, and the 0.75% annual internal fee are virtually guaranteed to result in a catastrophic loss to the investor.

Of course, that is what happened.  The SRN’s were issued at $10/share and matured at $0.50/share.[2]  A 95 percent loss.  The negative roll yield was costing between four and 12 percent per quarter in 2011.[3]

Complexity Risk

This is a classic example of complexity risk, which I have written about extensively here and here.  Merrill Lynch broker Glen Ringwall was quoted saying:[4]

The roll costs are far larger than we ever understood or were disclosed to us…  This is borderline crooked.

To Mr. Ringwall’s point, if we assume that the negative roll yield was four percent per quarter that equals 16 percent per year.  Apply that over the five-year term of the SRNs and you get an 80 percent decline in principal.  Add the 5.6 percent total term costs from the front-end load and the ongoing management fees and the SRN is programmed to decline by 85.6 percent over its lifetime (assuming no movement in the underlying index).  Put another way, the underlying index would need to have and 85.6 percent return just to break even.

It is hard to believe that anyone associated with the SRNs creation understood these economics.  It appears that the brokers who sold it certainly did not understand.  And I can assure you that not one client who was sold the SRNs understood them.

DIY Client Due Diligence

In fairness, the SRN Annex to the Pricing Supplement did provide these user-friendly explanations what would help clients understand how to calculate the negative roll yield themselves:[5]

 

Screen Shot 2017-12-01 at 8.16.17 AM.png

Screen Shot 2017-12-01 at 8.16.29 AM.png

Screen Shot 2017-12-01 at 8.16.45 AM.png

Obviously, no client is working through these equations.

The written and formula disclosures above illustrate the primary point of investment complexity risk:  the more complex an investment is, the more likely it is to behave in ways that are unexpected.

This is the reason why complexity should generally be avoided and even sophisticated institutional investors should have a complexity risk budget to track and limit their exposures.

Supervison

As I have discussed in my previous posts, there are other volatility products such as the iPath VXX ETN trading today that have the same internal negative roll yield dynamics.

Supervisors must be knowledgeable about these investments and how they are not meant to be held longer than one day.  Supervisory policies and procedures should be implemented to insure that any holding periods longer than one day are flagged in exception reports and remedied immediately.

_________________

Notes:

[1]       Strategic Return Notes Pricing Supplement; PS-14.

[2]       Jean Eaglesham, The Wall Street Journal; SEC Readies Case Against Merrill Lynch Over Notes That Lost 95%; Available at: https://www.wsj.com/articles/sec-readies-case-against-merrill-over-notes-that-lost-95-1466544740; Accessed December 1, 2017.

[3]       Id.

[4]       Id.

[5]       Strategic Return Notes Pricing Supplement; Annex A; A1-2.  I have only produced part of them here.

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Topics: suitability, supervision, Complex Investments, Complexity Risk, volatility-linked products, negative roll yield

Private Equity - Due Diligence

Posted by Jack Duval

Nov 16, 2017 8:30:16 AM

This blog post begins a series examining the risks and returns of private equity investments.

Apollo Group Structure:  Got it?

Apollo Group Structure.jpg

Source: Apollo Group S-1

On July 28, 2017, Apollo Group Management LLC announced the largest ever capital raise for a private equity fund.  While this $23.5B fund will be the largest ever, it may not hold the title for long.  The New York Times reports there are two other private equity funds in raises with higher targets.[1]

While these capital raises are impressive, they also raise questions.  As the private equity space has become increasingly crowded, returns have declined.  Industry statistics are sobering.

The most recent data from Prequin reveals that for the time period ending 2016:[2] 

  • Private equity AUM were at $2.491T, an all-time high;
  • Cash held by private equity funds was at $820M, an increase of $65B from 2015;
  • Median net IRRs have declined from 20+ percent in the early 1990’s to 12.6 percent in 2013 (the most recent vintage with meaningful numbers)
  • Likewise, median net multiples have declined from around two to around one over the same time period.

The reduction in returns has led to a number of abusive practices at private equity funds.  These abuses were highlighted by the SEC in a high-profile campaign in 2015.[3]  However, the continued bull market has helped to keep valuations high and has served to reduce litigation.  This will not always be the case.

When the market turns, successful exits will become harder to realize and this will depress IRRs.  At that point, private equity funds and the advisors who sold them may find themselves in the difficult position of having to justify total fund expenses that can amount to six percent of committed capital, annually.

While private equity remains a legitimate asset class, a tremendous amount of diligence must be conducted in order to insure that abusive practices are not being utilized by funds at the expense of their limited partners.

I will give an overview of some areas that disserve heightened diligence and then explore them in later blog posts.

Private Equity Due Diligence

Diligence into private equity funds is a time-consuming and laborious process.  Most investors are not equipped to undertake this due diligence as the private placement memorandums are written in legalese and encompass concepts from finance, economics, accounting, and law.  This is a form of complexity risk, something I have written about extensively.  Indeed, because of their complexity, many professionals are ill-equipped to properly evaluate private equity investments.

An example of private equity complexity risk can be seen at CalPERS, the massive California Pension manager.  CalPERS endured public embarrassment in 2015 when it had to admit it could not account for the fees being paid to the pension's private equity fund managers.[4]  This fact is even more remarkable in context of CalPERS’ investment staff of nearly 400.[5]

Advisors must have extensive training and experience with private equity investments before they can undertake the rigorous due diligence required to make a suitability determination.

Areas requiring heightened diligence include: 

  • General Partner/Limited Partner Conflicts, which include:
    • Non-performance based compensation;
    • Waivers of fiduciary responsibility;
    • Shifting expenses to funds (i.e. limited partners);
  • Valuation:
    • How are marks set?;
    • Assumptions used in marks?;
  • IRRs:
    • Do they reflect the economic returns to limited partners (even if “accurate” at the fund level)?;
    • Treatment of timing of flows;
    • Timing of allocation of unrealized losses;
    • Omissions of key assumptions;
  • Performance
    • Leverage-adjusted returns;
    • De-smoothed returns and volatility;

I will examine these and other factors of private equity risk and return, as well as their implications for suitability and supervision, in subsequent blog posts.

_________________

Notes:

[1]       Tom Buerkle, “Apollo’s Huge Buyout Fund Provides for a Large Margin of Error”, New York Time’s; June 28,2017.  Available at: https://www.nytimes.com/2017/06/28/business/dealbook/apollo-global-management-buyout-fund.html; Accessed November 16, 2017.

[2]       Prequin 2017 Global Private Equity and Venture Capital Report.  Available at: www.prequin.com; Accessed November 16, 2017.

[3]       SEC Announces Enforcement Results for FY 2015; October 22, 2015.  Available at: https://www.sec.gov/news/pressrelease/2015-245.html; Accessed November 16, 2017.

[4]       Randy Diamond; “CalPERS CIO looking at possible drastic cuts to private equity, citing transparency”; Pensions & Investments; June 19, 2017.  Available at: http://www.pionline.com/article/20170619/ONLINE/170619871/calpers-cio-looking-at-possible-drastic-cuts-to-private-equity-citing-transparency?newsletter=investments-digest&issue=20170619; Accessed November 16, 2017.

[5]       CalPERS biography of Ted Eliopoulos, Chief Investment Officer.  Available at: http://www.pionline.com/article/20170619/ONLINE/170619871/calpers-cio-looking-at-possible-drastic-cuts-to-private-equity-citing-transparency?newsletter=investments-digest&issue=20170619; Accessed November 16, 2017.

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Topics: suitability, supervision, Due Diligence, private equity, de-smoothed returns, IRR, leverage-adjusted returns

Volatility-Linked Products - Death By a Thousand Cuts

Posted by Jack Duval

Oct 25, 2017 9:11:58 AM

This blog post continues a series exploring volatility-linked exchange-traded products.

In my previous blog post, I discussed how volatility-linked ETPs are likely to lead to significant, if not catastrophic, losses if they are used in a buy-and-hold strategy.

In this post, I want to explain the mechanics of how this process works.

Constant Maturity

Most volatility-linked ETPs must, by prospectus, maintain a constant maturity.  For instance, the VXX pricing supplement states:[1]

(The VXX) is linked to the performance of the S&P 500 VIX Short-Term Futures Index TR that is calculated based on the strategy of continuously owning a rolling portfolio of one-month and two-month VIX futures to target a constant weighted average futures maturity of 1 month.

In order to keep the weighted average futures maturity of one month, the two contracts will have to be adjusted on a daily basis.  This necessarily implies buying more of the two-month VIX futures and selling the one-month VIX futures.

Having to keep buying longer dated futures and selling shorter dated futures is what creates losses over time.

Contango

Contango is a term describing the typical futures market curve where longer dated contracts are more expensive than shorter dated contracts, all else being equal.  (The opposite of this is known as “backwardation”, and is rare.)

The VXX pricing supplement describes contango as follows:[2]

… many of the contracts included in the Indices have historically traded in “contango” markets.  Contango markets are those in which the prices of contracts are higher in the distant delivery months than in the nearer delivery months.  VIX futures have frequently exhibited very high contango in the past, resulting in a significant cost to “roll” the futures.  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.  (Emphasis added)

Chart 1: VIX Futures Curve[3]

 VIX Volatility Chart.gif

 

Negative Roll Yield

In plain English, by continuously buying longer-term VIX contracts and selling shorter-term VIX contracts the VXX ETN is buying high and selling low every day.  This phenomenon is known as “negative roll yield”.

It is a mathematical certainty that negative roll yield will erode the value of any investment that maintains a constant maturity such as the VXX.  As discussed in my previous post, the longer volatility-linked ETPs are held, the longer their holders are subjected to negative roll yield.

This results in a death by a thousand cuts, one each day.  The certainty of negative roll yield over time is why constant maturity volatility-linked ETPs all head towards zero.  Due to Zeno’s paradox and the magic of reverse splits, they never reach zero.  However, that is cold comfort for anyone who has lost 99.9 percent of their investment.

Supervision

The supervisors of any firm allowing their advisors to trade in volatility-linked ETPs should be well versed in the mechanics of these products.  Clients certainly don't understand these complex products and frequently their advisors do not either.  Their suitability is limited to trading clients who want to speculate on intra-day or one-day changes in the VIX index, and they are unsuitable for a buy-and-hold strategy.

Furthermore, supervisory systems should flag any volatility-linked positions held more than a day.

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Notes:

[1]       Barclays iPath S&P 500 VIX Short-Term Futures ETN pricing supplement; July 18, 2018; Available at: http://www.ipathetn.com/US/16/en/documentation.app?instrumentId=259118&documentId=6091544;  Accessed October 25, 2017; PS-1.

[2]       Id. at PS-13.

[3]       VIX Volatility Curve; Bloomberg; Accessed October 25, 2017.

For information about securities expert Jack Duval, click here.

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Topics: suitability, supervision, Complex Investments, Complexity Risk, volatility-linked products

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