XIV Lawsuit Shows Peril That Lurks Within Democratized Investing

(Bloomberg) -- XIV, the now infamous exchange-traded note that imploded last month, is dead and buried. But its legacy lives on in the court system.

Credit Suisse Group AG, which issued the derivative-based product, was sued this week by an investor accusing the Swiss bank of failing to disclose manipulation. The case follows several suits that allege unknown parties manipulated instruments linked to volatility futures.

Even though XIV’s prospectus warned its value could fall to zero, the fund’s passing has prompted a bout of soul searching in the $3.6 trillion market for exchange-traded products. Some critics and supporters wonder whether brokers, issuers or regulators should do more to educate and protect unsophisticated investors.

“In my experience, the problem tends to be much more in the distribution function than product development,” said Barry Barbash, a partner at Willkie Farr & Gallagher and former director of the Securities and Exchange Commission’s division of investment management in the mid-1990s. “It’s not so much the product itself and what it’s doing, but it’s the manner in which it was sold.”

Reputational Risk

Retail investors account for an estimated 60 percent -- or more than $2 trillion -- of assets invested in U.S. ETPs. Clearly they’re not just buying the S&P 500 Index. XIV, for example, was designed to be a trading vehicle for professional investors. But as betting against volatility in the stock market became increasingly popular, it spread far beyond hedge funds.

There was Seth Golden, who quit his job as logistics manager of a Target store to short volatility. A thread dedicated to XIV believers showed up on internet discussion board Reddit. Two guys even recorded a song about volatility after the trade blew up.

Of course, most investors were informed of the risks in the trade. Charles Schwab Corp. delivers a pop-up warning to those trying to buy a leveraged or inverse ETP that requires the investor to acknowledge the risks. And TD Ameritrade Holding Corp. puts a yellow banner at the top of the screen that outlines increased margin requirements and cautions that such products are not suitable for all investors.

But some fund managers privately wish brokerages would do more to keep their products away from the naive or ignorant. Their thinking is that what they might lose in assets, they’d recoup in minimizing the reputational risk that now casts a pall over their products.

‘Ongoing Conversation’

“We feel good about the disclosures that we have right now for leveraged and inverse, and what we’ve done and the level of support and education we have for clients,” said Heather Fischer, vice president of ETF and mutual fund platforms at Schwab. “But this is an ongoing conversation at Schwab and probably at every firm as new products get launched.”

Regulators are taking an interest. SEC Commissioner Kara Stein called out volatility-related ETPs and leveraged funds in a speech last month that compared financial engineering to resurrecting dinosaurs in ‘‘Jurassic Park.’’ The issue isn’t “can we create complex and esoteric products, but should we,” she said.

Representatives of the SEC declined to comment.

The Commission has already cracked down on how these products are sold via financial advisers, fining Morgan Stanley last year for not ensuring clients understood the risks involved in buying inverse ETFs. The Financial Industry Regulatory Authority, meanwhile, sanctioned four banks in 2012 for incorrectly recommending the securities.

Reading Required

Both overseers have traditionally favored disclosure over blanket restrictions. But within ETPs, not all disclosure is equal. Funds sold under the Investment Company Act of 1940 come with a summary prospectus that details the risks over a few pages. ETNs and products backed by commodities, such as volatility, aren’t subject to those rules, leaving a buyer to wade through lengthy complicated documents.

“Too many investors might be intimidated and might not read as much as they should,” said Stacy Fuller, a partner at K&L Gates.

That could be one area for review. Retail investors have repeatedly pushed back against any attempt to curb their ability to buy more complicated instruments. A proposed rule to limit derivative use by ETFs prompted a slew of letters to the SEC from individual investors in 2016. And even those burnt by XIV have expressed thanks that they were able to buy the note.

Ultimately, the occasional blow-up may be a price that investors are willing to pay for access to complex, high-yielding products, if issuers and regulators can stomach the resulting litigation.

As Winston Churchill said, “no one pretends that democracy is perfect or all-wise. Indeed it has been said that democracy is the worst form of government -- except for all those other forms that have been tried.”

©2018 Bloomberg L.P.