The Securities Litigation Expert Blog

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.

For information about securities expert Jack Duval, click here.


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

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.


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.



[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:; 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.

For information about securities expert Jack Duval, click here.


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

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 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.


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.



[1]       Barclays iPath S&P 500 VIX Short-Term Futures ETN pricing supplement; July 18, 2018; Available at:;  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

Volatility-Linked Exchange-Traded Products

Posted by Jack Duval

Oct 20, 2017 8:04:35 AM

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

VXX LT Chart.gif

The VXX has declined from 11,940 to 34.39 (split adjusted).  Source: Bloomberg.

A recent FINRA Acceptance, Waiver, and Consent (“AWC”), with Wells Fargo and the issuance of FINRA RN 17-32, highlights the risks of volatility-linked exchange-traded products (“ETPs”).  In particular, using them as part of a buy-and-hold strategy is virtually certain to produce losses.

Wells Fargo AWC

On October 16, 2017, FINRA ordered Wells Fargo to pay $3.4 million in restitution to clients who had been recommended volatility-linked exchange-traded products.  FINRA found that Wells Fargo registered representatives had sold the volatility-linked ETPs without fully understanding their risks and features and that the firm had failed to supervise solicited sales of the products.

The FINRA AWC press release stated:[1]

Certain Wells Fargo representatives mistakenly believed that the products could be used as a long-term hedge on their customers’ equity positions in the event of a market downturn.  In fact, volatility-linked ETPs are generally short-term trading products that degrade significantly over time and should not be used as part of a long-term buy-and-hold investment strategy.

FINRA RN 17-32 – Volatility-Linked Exchange Traded Products

The language in the Wells Fargo AWC press release is echoed in FINRA RN 17-32:[2]

… many volatility-linked ETPs are highly likely to lose value over time.  Accordingly, volatility-linked ETPs may be unsuitable for certain retail investors, particularly those who plan to use them as traditional buy-and-hold investments.


Using a buy-and-hold strategy with volatility-linked products is almost guaranteed to produce losses for investors.  These products are designed to be traded intra-day or over one day holding periods.  Even relatively short-term holding periods of a week or two can be enough to lock in losses.  Longer holding periods can produce catastrophic losses.

How these losses are built into the structure of volatility-linked ETPs will be explored in my next post.



[1]       FINRA News Release; Available at:; Accessed October 19, 2017.

[2]       FINRA RN 17-32; Volatility-Linked Exchange-Traded Products; October 2017; Available at:; Accessed October 19, 2017; 1.

For information about securities expert Jack Duval, click here.


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

DOL Fiduciary Rule Expert Jack Duval Interviewed on Podcast

Posted by Jack Duval

Jun 8, 2017 9:29:03 AM

Jack Duval DOL Fiduciary Expert.jpg

Jack was a guest on The Investment Advisors Podcast with Kattan Ferretti Financial this week and discussed several topics including the DOL Fiduciary Rule, the securities litigation landscape, complexity risk, and his background.

Episode 15 Description:

In episode 15, you’re going to hear about Duval’s exposure to pioneers such as Dick McCabe.  We talk facts that you might find surprising, like 30,000 ultra high net worth investors in the USA or, there are 3,000 arbitration claims from FINRA every year, and there are somewhere between 400-450 people kicked out of the industry every year.

In this industry, there is motive and there is opportunity, as they say.  It’s unfortunate there are set-ups that are ripe for abuse.  Which we might add has created the service gaps in this industry that motivated us to start Kattan Ferretti Financial.

Take note at how thoughtful and deliberate Jack’s approach is to discussing his life and the topics at hand.  We were thoroughly inspired by his demeanor, especially in an industry that can’t help pounding the table, even when they sit down to a full bowl of soup.

Click here to go to the podcast.


Click to view useful links on our DOL Fiduciary Rule - Securities Litigation Resources page.

To learn more about fiduciary rule expert Jack Duval, click here.


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Topics: securities litigation, Complex Investments, fiduciary obligations, erisa fiduciary expert, dol fiduciary rule

Money Market Fund "Liquidity"

Posted by Jack Duval

Dec 22, 2016 8:16:00 AM

This blog post continues a series looking at liquidity in common investments such as ETFs and mutual funds.  See previous posts on high yield and the Third Avenue Focused Credit Fund.

Greek Bank Run.jpg

Bank run at the National Bank of Greece                                 


As the banks and brokers/dealers have reduced their risk appetites (and balance sheets devoted to market making/inventory) liquidity has shifted to investment funds.

This shift has occurred during a globally coordinated central bank easing/asset purchase cycle heretofore unknown in financial history.  Liquidity has not been needed because all assets (with the exception of volatility) have risen in price.

When asset prices fall, liquidity will be needed again.  With the banks and broker/dealers less willing to buy, liquidity will be at a premium.  It will be a buyers market and prices will have to fall further to entice liquidity back into the markets.

As will be explored, the potential for suspended redemptions is very real, often in places where investors least expect it.

Money Market Funds - Your Money is Safe with Us (from you)

Most investors would be surprised to learn that their money market fund has a "gate" just like a hedge fund.  Yet that is the case with the vast majority of money market funds.  In addition to a gate, most money market funds also have the ability to charge a one or two percent fee for investors to redeem their shares, if certain conditions are met.

Vanguard Prime Money Market Fund

The Vanuard Prime Money Market Fund is the second largest in the world.  Here are some excerpts from the prospectus that might surprise its investors (emphasis added):

You could lose money by investing in the Fund. Although the Fund seeks to preserve the value of your investment at $1.00 per share, it cannot guarantee it will do so. The Fund may impose a fee upon sale of your shares or may temporarily suspend your ability to sell shares if the Fund’s liquidity falls below required minimums because of market conditions or other factors. An investment in the Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The Fund’s sponsor has no legal obligation to provide financial support to the Fund, and you should not expect that the sponsor will provide financial support to the Fund at any time.

Emergency circumstances. Vanguard funds can postpone payment of redemption proceeds for up to seven calendar days. In addition, Vanguard funds can suspend redemptions and/or postpone payments of redemption proceeds beyond seven calendar days at times when the NYSE is closed or during emergency circumstances, as determined by the SEC. In connection with a determination by the board of trustees, in accordance with Rule 22e-3 under the Investment Company Act of 1940, a money market fund may suspend redemptions and postpone payment of redemption proceeds in order to facilitate an orderly liquidation of the fund. In addition, in accordance with Rule 2a-7 under the Investment Company Act of 1940, the board of trustees of a retail or institutional money market fund may implement liquidity fees and redemption gates if a retail or institutional money market fund's weekly liquid assets fall below established thresholds.

 Discretionary liquidity fee. The Fund may impose a liquidity fee of up to 2% on all redemptions in the event that the Fund’s weekly liquid assets fall below 30% of its total assets if the Board determines that it is in the best interest of the Fund. Once the Fund has restored its weekly liquidity asset to 30% of total assets, any liquidity fee must be suspended.

 Default liquidity fee. The Fund is required to impose a liquidity fee of 1% on all redemptions in the event that the Fund’s weekly liquid assets fall below 10% of its total assets unless the Fund’s Board determines that (1) the fee is not in the best interest of the Fund or (2) a lesser/higher fee (up to 2%) is in the best interest of the Fund.

 In addition to, or in lieu of, the liquidity fee, the Fund is permitted to implement temporarily a redemption gate (i.e., suspend redemptions) if the Fund’s weekly liquid assets fall below 30% of its total assets. The gate could remain in effect for no longer than 10 days in any 90-day period. Once the Fund has restored its weekly liquidity assets to 30% of total assets, the gate must be lifted.

I am not picking on Vanguard, every money market fund (with the exception of some government money market funds), has identical language in their prospectuses.

Suitability and Alternatives to Money Market Funds

In light of the liquidity risks to holding mutual funds, it is not suitable for investors to hold all of their cash equivalents in money market funds.  Instead, investors should hold three-month Treasury bills and just roll them four times a year.  They will have a lower yield than the money market funds, but this is trivial compared to a suspension of redemptions or a two percent haircut on the proceeds.


While the losses from a one or two percent redemption fee are limited, the secondary effects of preventing clients from making investments they otherwise could have made, will be considerable.


Supervisors at banks and broker-dealers should make sure their advisors are aware of the potential gates and liquidity fees and encourage diversification out of money market funds.

Complexity Risk

While money market funds have traditionally been less complex than other investments, the new regulations have changed that.  As we have discussed here, here, and here, investment complexity is a frequent destroyer of capital.

For money market funds, investors can be harmed by market events unrelated to the money market fund they hold.  For example, a Bloomberg stress test on the Vanguard Prime Money Market Fund shows that another Russian Financial Crisis would hit the fund's P&L for 1.32 percent.  This is enough to break the buck and/or require the fund to close the gate or implement liquidity fees.

Vanguard Prime MM - BBG Stress Test.gif

If you think this is an extreme event, consider that it is merely a "18-year storm".



 For information about securities expert Jack Duval, click here.


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Topics: suitability, supervision, Complex Investments, Complexity Risk, Money Market Funds, Liquidity

The Illusion of Liquidity in High Yield and Distressed Debt

Posted by Jack Duval

Dec 22, 2015 7:04:42 AM

This blog post continues our series on the ongoing crisis in high yield and distressed debt bond funds.  For our previous coverage, see: "What's Going on in High Yield and Distressed Debt?" and "The Third Avenue Focused Fund Implosion".


Formerly liquid market: Aral Sea, Kazakhstan.


The suspension of redemptions in the Focused Credit Fund (an open-end mutual fund) is remarkable. Although all mutual funds have the right to suspend redemptions, until now, it has been an extremely uncommon occurrence. This may change in the new market reality of reduced bond (and bond fund) liquidity.

The Focused Credit Funds suspension will last until investors are given interests in a liquidating trust that will hold the Fund's assets and sell them over time.  (It is unlikely that a liquid market will develop for interests in the liquidating trust.) This is similar to a Chapter 7 bankruptcy, where a trustee is appointed to liquidate a debtor's assets and use the proceeds to pay the claims of the firm’s creditors.[1]

The travails of the Focused Credit Fund arise out of a liquidity mismatch: the Fund owns highly illiquid investments in a vehicle that provides investors with daily liquidity.

This is something like a liquidity Ponzi: as long as asset prices are rising and money is still coming into the Fund, it will work. If nothing else, redeeming investors can be paid out from new investors. However, as soon as prices start to fall and new money stops coming in, the gig is up.

This is very similar to what happened in the Auction Rate Securities ("ARS") market. As long as there continued to be clients putting money into ARS, they functioned as a liquidity provider for other clients who wanted to sell.   However, as soon as the new money stopped coming in, the broker-dealers that were the liquidity of last resort quickly got their fill of ARS and backed away from the market.

Two significant events have led to less liquidity in fixed income markets since the financial crisis:

  • Federal Reserve open market purchases of trillions of dollars of US Treasury bonds and mortgage backed securities;
  • Wall Street firms have dramatically reduced their inventories, by some counts up to 75 percent.[2]

Chart 1: Primary Dealer Positions[3]


 The Illusion of Liquidity

Liquidity is, and always has been, mostly an illusion. Ask yourself a simple question: can all the owners of any security, currency, or contract have liquidity at the same time? The answer is obviously "no".

So who gets liquidity?

Certainly sellers who are selling into a rising market get liquidity. Also, sellers when the market is flat. However, the story changes when the market is in decline. The first sellers can get out (albeit at lower prices) but when a lot of sellers hit the market at the same time, buyers can just disappear. In this case the only buyers left are vultures, buyers of last resort who are willing to take securities from forced sellers, at cents on the dollar.

This is the situation the managers of the Focused Credit Fund find themselves in, and is why they have suspended distributions and put the assets in a liquidating trust.

The problem for them is that everyone now knows they are sellers only, and to make matters worse, everyone knows what they own. They are unlikely to see any improvement in the marks on the bonds and loans they have.

Simply put, all distressed and high yield bond funds are now sellers as their client’s submit redemptions. Even clients who would prefer to stay in a fund are motivated to redeem their shares as they get hurt by their panicked co-owners.

In my next post, I will examine the suitability of complex, illiquid, and high risk investments.



[1]       U.S. Courts; “Bankruptcy Basics”. Available at Accessed December 14, 2015.

[2]       SEC Commissioner Daniel M. Gallagher. Speech delivered on March 10, 2015; “A Watched Pot Never Boils: the Need for SEC Supervision of Fixed Income Liquidity, Market Structure, and Pension Accounting”. Available at:; Accessed December 17, 2015.

[3]       BBVA Research; “Heightened Bond Liquidity Risk is the New Normal”; September 3, 2015. Available at:; Accessed December 17, 2015.

For information about high yield and distressed debt expert Jack Duval, click here.


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Topics: high yield, Complex Investments, Investment Suitability, Illustion of Liquidity, Third Avenue Focused Credit Fund, Illiquid Investments, distressed debt

Jack Duval Quoted on Wells Fargo AWC over Complex Investments

Posted by Jack Duval

Aug 7, 2015 1:26:06 PM


Accelerant Managing Partner Jack Duval was quoted in a Thomson Reuters Regulatory Intelligence article.  The article can be found on the Thomson Reuters Risk website here.  (Behind a paywall.)  For thost without access, the entire article is copied below:



Wells Fargo Fined Over Investment Product Too Complex for Brokers, Clients

Aug 05 2015 Richard Satran, Regulatory Intelligence

The sale of an investment that the U.S. securities industry regulator found too complicated for the amount of training and preparation on the part of Wells Fargo's sales team has generated a long tail of fees and legal costs for the broker dealer.

The Financial Industry Regulatory Authority said Tuesday it had reached an agreement with Wells Fargo on a censure and fine of $500,000 for the broker dealer's failure to educate and train brokers on the risk of the complicated floating-rate loan fund first sold in 2008 by the company's predecessor, Wachovia.

"This is one of those cases where complexity itself is the risk," said Jack Duval, managing partner of Accelerant, a securities litigation consulting firm. "The complexity comes back to bite everybody -- first at the client level and then at the broker level. Many investments have gone wrong because brokers misunderstood what they were selling." 

FINRA already has awarded restitution and assessed fines against Wells Fargo for the selling "unsuitable" investments in the case of the floating rate securities it calls STRATS, an acronym that stands for Structured Repackaged Asset-Backed Trust Securities.

Clients were sold on the STRATS for their safe, enhanced yield by brokers who were not made aware risks of the products, FINRA said in the action announced Tuesday. The STRATS were constructed from bonds whose fixed income interest payments were swapped for floating rate swap agreements. Far from simple, conservative securities, the STRATS were structured products loaded with fees for early termination and a capital security whose value fluctuated in the market.

The brokers "were generally not familiar" with the investments they were selling and the firm did not provide the training and supervision to sell them. In its investigation, FINRA reviewed internal marketing collateral and found that brokers would have "no reasonable basis for recommending the STRATS to retail customers."

The case shows how costly and time consuming a complicated financial offering can become. The broker has paid out some $10 million in fines and restitution for fund sales of only $12 million. While it pales compared with the $5.42 billion Wells reported for its quarterly profit last month the case generated untold legal costs over five years, along with reputational damage. Wells Fargo said it does not comment on FINRA cases.

In the latest action this week, Wells Fargo was still paying out for the complex investments that were initially packaged by Wachovia, a firm it acquired in a government supervised distress sale in 2008. In addition to the half-million dollars in new fines, the new agreement required new restitution of $241,974.34 in 2012 to pay customers for unexpected costs at the final redemption for those who held the securities issued six years ago. FINRA found that holders were not made aware of the risk that they would lose part of the principal on their investment on account of a termination fee.

"At the time of the STRATS termination many customers holding the STRATS received less and in some cases significantly less, than they paid for the STRATS." For Wells Fargo, the costs have also mounted for an ostensibly conservative trading instrument that kept on claiming time and money.


Learn more about complex investment expert Jack Duval.

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Topics: Structured Products, Complex Investments, Compliance, Investment Complexity, Complex Investment Expert, Wells Fargo, FINRA Regulation, STRATS, AWC

Former Brokers Sue UBS of Puerto Rico

Posted by Jack Duval

Apr 16, 2015 7:26:00 AM


Two former UBS brokers, George and Tresa Bravo, are suing UBS Puerto Rico for "deceiving employees and customers about closed-end mutual funds".  (Emphasis added. My paraphrasing of the google translation from

The brokers, who have 30 years of industry experience and managed over $120 million of client assets, are alleging that UBS "threatened, deceived, and coerced" them regarding UBS's proprietary municipal bond closed-end funds, most of which used leverage.

If true, it would appear that it is another case of brokerage firms selling complex products that are not properly understood by the firm's management, salesmen, or clients.  I have examined this phenomenon at length in my white paper: Complexity Risk: A New Risk Category.


For information about securities expert Jack Duval, click here.

For my previous coverage of the Puerto Rico municipal bond crisis, see this.






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Topics: municipal bond crisis, closed-end funds, Puerto Rico, UBS, securities litigation, Complex Investments, Complexity Risk

Manufacturing Investment Complexity - The Wall Street Playbook

Posted by Jack Duval

Dec 16, 2014 6:11:00 AM

This blog post continues my series on complex investments.

If you have followed my work on investment complexity, you might have wondered how investments came to be so complex.

The answer is simple:  complexity is highly profitable. In fact, complex products and strategies have a number of traits that are desirable to Wall Street firms:

  • They require the use of experts to understand them for the client;
  • They are difficult to commoditize;
  • Fees and profit opportunities can be buried in their construction and maintenance.

For Wall Street firms, this is a trifecta. Most broker-dealers have a ready network of licensed salespeople who can sell complex products and strategies to their clients; they can use complex products to blunt the now complete commoditization of their traditional stock and bond trading business; and they have various business units that can all profit from their respective participation in the creation and maintenance of complex products and services.

Given the way complex products and services fit with Wall Street business models, there is a perverse incentive for brokerage firms to increase complexity.

Complexity as a Response to Pricing Pressure

Wall Street firms have faced at least two historical events when the commission-driven business model was challenged. In both instances, they responded by moving away from the threatened area and into an adjacent area with increased complexity.

The first event was the 1975 deregulation of fixed commissions, better known as “Mayday” because it went into effect on May 1, 1975.  In the time leading up to Mayday, brokerage firms had charged fixed fees for executing stock trades. This removed competitive pressure from commissions and the firms enjoyed high profit margins.

After Mayday, Wall Street firms were free to discount their commissions and this introduced competition into commission pricing. It is no accident that the discount brokerage pioneer, Charles Schwab, started his eponymous firm in 1973, and started offering discounted stock trades on May 1, 1975.[i]

The effect of deregulating commissions was significant. As Jerry Markham writes[ii]:

Between 1970 and 1989, commission charges for institutional investors dropped on average from twenty-six to less than five cents per share.  The result was that revenues from commissions for broker-dealers declined from about 65 percent of industry revenues in 1972 to about 40 percent in 1983 and to about 17 percent in 1989.  Commissions made up over 50 percent of Merrill Lynch’s total revenues in 1972 but only 15 percent by 1988.

These declining commissions were doubly significant because they were most pronounced for institutional investors.  Institutions not only had the most negotiating power, but their share of trading volume was growing dramatically over the same time period.  This was a one-two punch to broker-dealer commission revenue.

The response from Wall Street firms was to take the asset facing pricing pressure, equities, and package them into more complex investments, mutual funds.  The mutual funds carried high fees of four to six percent and also paid annual “trailers” of one-quarter of a percent or more. 

Furthermore, mutual funds fit right in with the typical Wall Street business model.  Firms could hire portfolio managers to run the funds, use their trading desks to execute the trades, and have their sales force sell the funds to their clients. At Wall Street firms, many beaks could get wet at the mutual fund troth.

In addition, mutual funds provided consistent revenues for issuing firms.  The internal management and 12(b)1 fees were typically from 1.5 to 2.5 percent per annum and were deducted quarterly.  These consistent revenue streams smoothed out broker-dealer revenues and were much less volatile than transaction commissions, which ebbed and flowed with the markets.

While mutual funds seem relatively simple by today’s standards, they represented a leap in complexity that was an order of magnitude higher than simply buying stocks.  Investors had to navigate dense prospectuses that covered a wide variety of issues, including:

  • Fee structures;
  • Investment strategy and discipline;
  • Pooled investment structure;
  • Tax considerations;
  • Liquidity constraints;

Importantly, all the issues listed above are unique to the mutual fund vehicle itself and do not include any of the traditional economic and financial issues that are part of any equity investment.

The shift in focus from equities to mutual funds was instantaneous and sustained and the fund business grew from a small niche investment vehicle to the default in about a decade.

Indeed, in the wake of Mayday, mutual fund AUM enjoyed their highest five-year compound annual growth rates (“CAGR”) on record, notching gains of:  24.1, 26.3, 43.4, 39.3, and 31.4 percent from 1980 to 1985, respectively. [iii]   In the 10-year period from 1975 to 1985, mutual fund AUM grew from $45.87 billion to $495.39 billion, an increase of 9.8x, for a 10-year CAGR of 26.9 percent.[iv]

For higher resolution charts, click here.

Chart 1:  Mutual Fund Assets Under Management and Five-Year Rolling CAGRMutual_Fund_AUM


Driving the dramatic increase in AUM were new sales in mutual funds, which also expanded at their highest  growth rates in the years immediately following the 1975 Mayday deregulation.

Chart 2:  Mutual Fund Annual Sales and Five-Year Rolling CAGR


A new page had been added to the Wall Street playbook:  if a revenue stream became commoditized, take that product and use it to create a new (and more complex) product, to protect the firm's profit margin.  In my next post, I will examine how this page of the playbook was used again 27 years later in the fixed income markets.


Learn more about complex investment expert Jack Duval.

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[i]       Charles Schwab Company History; Available at; Accessed December 2, 2014.

[ii]      Jerry W. Markham, A Financial History of the United States, Volume II, (New York, Routledge, 2001), 182.

[iii]     Investment Company Institute, 2014 Investment Company Fact Book; Available at:; Accessed December 11, 2014.

[iv]      Id.



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Topics: Complex Investments, Investment Complexity, Complex Investment Expert

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