Some people may have some 'splaining to do.
The matter at hand concerns two exchange-traded securities that were designed to profit from falls in the VIX, or volatility index, which roughly tracks the volatility of the S&P 500.
On Monday, the two funds in question, ProShares Short VIX Short-Term Futures exchange-traded fund (SVXY) and the VelocityShares Daily Inverse VIX Short-Term exchange-traded note (XIV), saw massive one-day losses resulting in the latter fund getting shuttered. Both funds profit when the price of VIX futures fall, and vice versa.
In September last year, I wrote a story for The Wall Street Journal quoting Peter Tchir, now with Academy Securities, which warned that both funds were at risk from a wipeout if significant volatility ever returned to the market. Monday market volatility jumped, sending VIX futures prices higher, and the two funds took a beating.
The event, especially the VelocityShares fund closure, raises a lot of questions.
Are such funds appropriate for small investors? "When we are talking about short volatility, it is highly doubtful that the average retail investor can comprehend that," says Joe Brusuelas, chief economist at professional services firm RSM in New York. "It is questionable whether retail [small] investors should have access to such sophisticated and risky products." In other words, if you don't understand the product you probably shouldn't invest.
The Securities and Exchange Commission, the agency which regulates U.S. stock markets, already has a rule that says some investments are available only to so-called qualified investors. The 'qualified' designation includes institutional investors and well-heeled individuals, both of whom are supposed to be either sophisticated or have the resources to pay for savvy financial advice. The 'qualified' designation opens up a world of investments that the rest of us cannot buy.
Clearly, that distinction wasn't made with the two VIX funds in question.
Should these VIX funds be available to small investors? My libertarian side says yes, let 'buyer beware.' But three things go against that view. First, as mentioned, the SEC has rules to enforce who is a sophisticated investor and who is not. To me, there appears to be a prima facie case that perhaps these funds shouldn't be a retail investment.
Second, even employees of the Federal Reserve show less than perfect financial knowledge, according to a study I wrote about in 2015. The general population is less knowledgeable. Given this knowledge-deficit, it does seem to make some sense for the government to decide who can own what in the investing sphere.
Third, before the widespread use of exchange-traded products, it was harder for retail investors to buy products similar to the VIX funds. "I think the ETFs do give access to products that people wouldn’t have had access to because they wouldn't qualify," says Tchir, noting that buying the futures contracts, such as those tracked by the two funds, would have meant opening a futures trading account. The hurdles to doing that are typically higher than for opening one for stock-trading. "There is often a reason that these products weren't available," he says. These days I could buy the ProShares fund via my retirement account. I haven't done so.
Should the SEC determine these funds inappropriate for small investors? Via email, I asked the SEC the following question: "Is the SEC considering ruling that such funds should be available only to qualified investors?" There was no immediate response.
If the SEC cannot limit who can buy such funds, should the law be changed? Not that more laws necessarily make things better, but it should be considered.
How many small investors owned units in the two short VIX funds? Or put another way, were retail investors flocking to this investment? If not, it may not be a big issue because sophisticated investors knew or should have known the risks.
Tchir notes that the two funds did well explaining how the funds worked. "They performed exactly as outlined in the prospectus," he says. "The problem is that the prospectus documents tend to be long and in legalize, which can be hard work when you aren’t used to them." Many retail investors don't even bother reading them.
To find out the extent of retail investor exposure, I requested information on what type of investors there were in the two funds. So far, no data has been forthcoming.
It's hard to even guesstimate. I once asked the Investment Company Institute if they knew what portion of ETFs in general, were owned by small investors. ICI knows that around 90% of stock mutual funds are owned by individual/small investors. With ETFs, they have anecdotal evidence that it is around 50%, but they say they don't have hard data. When its hard to know the ownership of the broader ETF marketplace, doing so for a single fund is next to impossible.
