THE BLOG
04/01/2012 07:54 pm ET | Updated Jun 01, 2012

See You at the Bottom

The second biggest story this past week on the financial news networks, behind "How many tickets did you buy for Mega Millions", was the saga of the TVIX, a levered volatility ETN, in the wake of its 2-day 50 percent drop. The gist of most stories was outrage at financial institutions for allowing Ma and Pa investor to get caught in such a dangerous product. I'm a Wall Streeter that thinks the financial sector is too big for the country's good so I'm inclined to get behind a story critical of banks. But I don't buy what the media is selling here. Credit Suisse, the issuer of the ETN was called in to question for pushing the product on unsuspecting investors. Was it not proper warning that Velocity Shares (the CS sub that originated the ETN) wrote on the first page of its 2-page product description that the ETN would likely go to zero in the long run? Even if an investor can't be bothered to read two pages about the product he seeks to profit from, he could see at the click of a mouse that the price of the TVIX had dropped from 100 to 15 in the 4 months BEFORE its headline grabbing dive from 15 to 7.5. What is it about an 85 percent price move that tells someone this asset is not risky? Does a recreational skier staring down from the top of the Hahnenkamm need to be told that this mountain could present dangers?

The media called financial institutions other than CS in to question. Why, they wondered, did brokers allow their unsophisticated clients to trade these instruments? In response Charles Schwab has said they may institute a pop-up that warns a user before trading certain ETNs. The notification will essentially say "this product is risky and should you have questions call a Schwab rep." This is not a solution unless the customer rep at Schwab tells the caller "I really don't understand this product and unless you do I wouldn't put any more money in to it than you would in to a slot machine." I trade for a living and it took me a week of research and phone calls to the ETN manager to have a reasonable idea of how the VXX (the unlevered version of the TVIX) works and might perform in various scenarios. There is no person, Schwab-trained or otherwise, who fully understands every ETF and ETN.

And if we think these pop-up warnings are a good idea, are we not opening Pandora's Box? Any financial instrument can be risky, even prosaic ones such as common equity. Eighteen months ago our fund bought a stock called Wilmington Trust (WL). Two days later WL announced they had received a takeover offer and agreed to the price. Hooray! Upon further review the takeover price was half the previous day's closing price and we lost 50 percent on our investment overnight. I would like to congratulate the management of WL on their ability to keep secret from the market how dire their condition was such that they were happy to accept such a discounted offer. Infuriating or not, it wasn't the first, and not even the last stock that our fund owned that dropped 50 percent in a very short span. If we start warning on certain ETNs that opens the door for investors to say "well, you didn't warn me that Research in Motion (RIM, aka Blackberry) could drop 66 percent in a quarter and now that it has I'm going to sue you for implicitly indicating it was safe by not warning me like you did on TVIX." Investing is a voluntary activity, and it is our decision as investors, even part-timers, how much we choose to understand the products we trade. The information is generally out there (more so with TVIX than WL, though you wouldn't know if from the media reaction) and if it's not, we can choose to pass.

The question the media should be asking (and to be fair some are) when it comes to TVIX is should any levered exchange traded products be allowed? An investor can leverage in old fashioned ways (i.e. buying on margin) so the levered product doesn't add any arrows to the quiver of an un-caffeinated investor. Plus, the daily reset of the levered products makes them very likely to underperform twice the position in an unlevered asset over the long run (hence the Velocity Shares warning) -- more so as their assets grow. Is there justification for their existence? This is an important issue for the SEC to consider.

But this isn't as neat and attention-grabbing a story as a 50 percent price drop in two days AND the name of an investment bank in the same sentence. A drop, by the way, that was telegraphed to any investor who took the sensible step of asking "is this note trading at its NAV?" It is ironic that the financial news sources aren't hesitant to ready the tar and feathers for financial institutions that put investors in harm's way, yet the media itself can often incite people to make bad financial decisions. A recent example was Suze Orman's advice on CBS Sunday Morning (yes, I watch and very much enjoy the show) that anyone who is going to "live in their current house forever" should pay off their mortgage and anyone who isn't shouldn't. And there is Thomas Kee's piece on marketwatch.com that the VXX could double or triple. More generally there are the business network TV shows (Mad Money, Fast Money, et al) that may be well done but implore viewers to trade more frequently even as it's well documented (at least I think so) that frequent trading is the surest way to underperform the market. And it's not just the trade-happy shows, the very existence of financial news networks provides a steady message to the viewer: "trade more." If the banks have opened the Hahnenkamm to recreational skiers, the financial networks have put a sign at the top saying "Just point 'em downhill!" Downhill indeed. And to that one might add the subscript "See you at the bottom!"