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Investments - Unsuitable

A Lesson in Volatility ETPs, Courtesy of JPMorgan

September 21, 2020

[Image: Volatility /]



by Howard Haykin



JPMorgan Securities recently agreed to pay over $658,000 in fines and restitution to settle FINRA charges that it failed to adequately supervise certain of its 27,000 registered reps who solicited customers to purchase and hold volatility-linked exchange traded products (“Volatility ETPs”).



Volatility ETPs are complex products that ... attempt to track a widely-followed indicator of equity market volatility and investor sentiment, the CBOE Volatility Index (the "VIX") – aka the “Fear Gauge” or the “Fear Index.” In finance, “Volatility” refers to the degree of variation of a trading price series over time. Inasmuch as the VIX cannot be bought or sold directly, investors must trade and exchange in Volatility ETPs that track or hold investments in VIX futures indexes. The first Volatility ETP available to retail investors - the iPath Series B S&P 500 VIX Short-Term Futures ETN ("VXX") - was introduced in 2009. Since their introduction in 2009, Volatility ETP sponsors have warned about the risks associated with such securities. 


Why are Volatility ETPs so popular?  Volatility ETPs are simple to execute (i.e., they trade on exchanges like stocks), they are usually low-cost alternatives to mutual funds and actively-managed funds, and their prices can spike way up when U.S. equity markets plunge.


Why are Volatility ETPs inappropriate for long-term investing?  Two big challenges, according to Fidelity Investments.

  • First, Volatility ETPs actually track VIX futures indexes and not the VIX – and, by any measure, VIX futures indexes (and therefore, VIX ETPs) do a lousy job emulating the VIX index. Over periods of a month or a year, the return pattern of VIX ETFs will differ radically from that of the VIX index.  
  • Second, VIX ETPs tend to lose money - significant money - in the long run. VIX ETPs are at the mercy of the VIX futures curve, which they rely upon for their exposure. However, by their very nature, the underlying futures contracts expire periodically throughout the year, at which point they must be replaced by new, costlier futures contracts that carry later expiration dates. This turnover and substitution process creates double-digit losses over the course of a typical year, meaning that Volatility ETPs and similar securities products almost always lose money long term.



WHAT WENT WRONG AT JPMORGAN … OR JPM’S 5-YEAR ITCH WITH VOLATILITY ETPs.    JPMorgan Securities had what might be described as a ‘Five-Year Itch' with Volatility ETPs.


Beginning in 2010, the firm approved VXX for use in certain non-brokerage accounts – i.e., on a restricted basis given the firm's concern that VXX seemed more appropriate as a tool used by traders than as a buy-and-hold option. Yet, by June 2011, VXX was removed from JPMorgan's “approved list” - in part because VXX had a high tracking error with the VIX.


In 2015, JPMorgan once again added VXX to its approved lists - this time, for certain brokerage customers. By May 2016, VXX was once again removed from the list - a decision prompted by a FINRA investigation which revealed that certain of JPMorgan’s customers had purchased Volatility ETPs on a solicited basis and, contrary to their general use as a short-term trading vehicle, inappropriately held them for lengthy periods of time.


In 2020, JPMorgan settled FINRA charges that it had failed to ensure that its brokers understood the potential risks with these complex products. FINRA specifically cited JPMorgan for: (i) not providing any training or guidance to its brokers or supervisors specifically regarding Volatility ETPs; (ii) not identifying risks associated with Volatility ETPs in its WSPs; (iii) not conducting reasonable post-approval review of the products' performance and risk profile; and, (iv) not taking other reasonable steps to supervise solicited sales of the products to customers.



[For further details on the above case, click on … FINRA Case #2018057508101.]

[For further discussion on Volatility ETPs, click on Financialish post … Investing in ‘Volatility ETPs’ Can Be a Crapshoot.]