Compliance Alert - Volatility-Linked Exchange Traded Products (ETPs)
You know what an ETF is, but do you know what an ETP is?
Exchange Traded Products (ETP) are securities listed on an exchange that seek to provide exposure to the performance of an index, benchmark or actively-managed strategy. ETFs are the most common ETPs. Other ETPS include Exchange Traded Notes (ETNs) which track an index or benchmark, but are debt obligations of an issuer and hold no underlying portfolio. Volatility linked ETPs provide exposure to volatility as an asset as represented by the VIX or other similar index. These products typically track derivatives (usually futures) to achieve volatility exposure and have been structured as commodity pools, ETFs or ETNs. These types of ETPs are complex products and care must be taken to ensure your clients are suitable for these securities before investing.
Why is this important?
With the market's recent gains (today may not be one, though), I wanted to share some details on a recent Regulatory Notice and fine that was published on Volatility-Linked ETPs for you to be aware of in case a client asks about the VIX or products that may track it. Last month, Wells Fargo was ordered to pay $3.4 Million back to clients as ETP trades were found to be unsuitable as the clients were not made aware of the risks or features of the products. The Wells Fargo advisors involved believed the ETPs were to be used as long-term hedges on the client's equity positions in the event of a market downturn ---- they were wrong in their thought process. In actuality, volatility-linked ETPs are the exact opposite ---- they 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 (New Account Forms should be marked for the investment objective as Aggressive Growth or Speculative with High or Max Risk for these clients and a leveraged/inverse ETF disclosure form should be signed). IPI is not promoting this trading strategy. FINRA requires that we provide you training on this subject; therefore, please read through this email, review the attached documents and the hyperlinks. If you have any questions, please give me a call to discuss.
Volatility Index - General Info and Risks to Investors:
In 1993, the Chicago Board Option Exchange (CBOE) introduced its Volatility Index (VIX), which has become the most comprehensive index of volatility available. The VIX measures the expected 30-day volatility by calculating the implied volatility of thousands of put and call options related to the S&P 500 Index. The VIX is roughly based on the expected movement of the S&P Index over the upcoming 30-day period, annualized. A volatility number is derived, which moves in the opposite direction to the stock prices in the index. When stocks go up, the VIX goes down and vice-versa — when stocks go down, the VIX goes up. Most experts consider VIX a coincident indicator. The VIX is quoted in percentage points that represent an expected annualized change in the S&P 500 Index over the next 30 days. For instance, when the VIX is 8, it represents an expected annualized change of 8% over the next 30 days. In other words, the index option markets expect the S&P 500 to move up or down by the annualized rate (8% ÷ 365 × 30) over the next 30-day period.
The VIX does not move independently of the stocks — it moves when stocks move. Some experts maintain that the VIX can be used as a trend-confirming indicator because it trends in the opposite direction of the stock market. As an example, the VIX was above 80 during the 2008 recession and has dropped to below 10 in mid-2017. Because FINRA has seen a rise in complaints related to misconceptions about investible volatility, firms and representatives who offer index-based volatility products to retail investors must understand the following:
If you use this strategy, what should you do?
The suitability review for these strategies is twofold. First, the firm must have a reasonable basis that the strategy must be suitable for at least some investors. IPI allows these securities to be offered by our advisors to their clients; therefore, the first suitability requirement has been met. Second, the advisor must have a reasonable basis for a specific client that it is a suitable strategy. We have previously sent out a few times the Leveraged/Inverse ETF disclosure form as well as information on why it is needed, see attached. Please use this form prior to your clients investing in these types of securities. A recent review of the firm's trades did not show a prevalence of volatility linked ETNs held by our clients.
For those clients in which you have determined are suitable for volatility linked ETPs, please ensure that you have discussed and documented in your notes the topics in the attached ETP Risk Disclosure and obtain a Leveraged/Inverse ETF disclosure form. You may also provide the ETP Risk Disclosure document to any clients who are purchasing ETPs and I will have it placed on our website under the Client Login page as well for public viewing. Additionally, we have previously provided an Equity-Linked CD Disclosure Form for clients interested in those products, see attached.
I do not expect that this will affect very many clients, if any, however, I would be remissed if I did not provide this information to you relative to our regulators notices on this subject. If you have any questions, please let me know. Thanks, Renee