Do We Need To Protect Investors From Themselves? AKA: That ETN Problem

Herb Greenberg asked me via Twitter if I thought that the SEC made a mistake in approving products like $TVIX in the first place.  I think that in a way, I already wrote a post related to that question last year: “Protecting People From Their Own Ineptitude.”  But let’s write another one:

First, I want to step back, and point out that when you put aside the crazy price action in TVIX over the last month and get back to “basics”  it’s still a product that is beyond the understanding of most retail investors.  It’s a relatively complicated product, and there’s a lot to understand in terms of the difference between the ETN vs ETF structure, the effect of contango in the VIX futures curves, the long term holding issues based on this contango, etc.

None of that means that the product shouldn’t exist – it serves a specific purpose, and I think that traders should generally be free to seek the exposures that they want.

It seems clear, however, that many people do think that someone needs to protect them from their own – what word do I use here – ineptitude?  ignorance? unsuitability?   In other words, one can certainly argue that Ma and Pa Kettle probably shouldn’t be trading TVIX from their Etrade/Fidelity account.   In my world, my response is “If you don’t understand it, you shouldn’t be trading it.”   I find it hard to understand how people argue with that claim, but anyway, if you want, we can certainly figure out ways to restrict individual trading “Freedoms.”   I’m not a big fan of more regulation and Big Government, but my goal here would be to remove all doubt and “blame” – in essence to remove any ability for anyone to say “I didn’t know” after the fact.   The goal is to allow people to self-certify their own aptitude, and thus take responsibility for their decisions.

One must already indicate a level of experience or competence in order to trade options, and I wouldn’t have an issue if we instituted something similar for ETFs, leveraged ETFs, closed end funds, ETPs based on futures products which exhibit contango, etc.   I envision a test that you must take in your online broker that would ask you things like

1) What is the Net Asset Value of TVIX?

2) Do you understand that if the VIX futures curve has 5% contango, that the underlying index will lose money each month, as the new level gets calculated off of the next month’s future?

3) If you buy shares of a closed end fund at a premium to NAV, do you understand that the premium could evaporate at any time, based on supply and demand for the shares, and irrespective of the movements of the underlying assets in the fund?

etc etc etc

We could do this for mortgages too – an idea I’ve floated previously – so that we don’t have to deal with “that big evil bank got me into a product I didn’t understand” issues.    Adjustable rate mortgage pop quiz:

1) What is the current interest rate you are paying on your mortgage?

2) how long does this rate last?

3) when the rate resets, what value does it reset to?

4) what does the change in rates do to your monthly payment?

etc etc etc

Again, my goal is not to create – as Onlooker From Troy, a regular commenter on my blog put it – a “nanny state,”  but rather to simplify the issues so that there can be no debate after the fact about who misled who.  I would prefer that to the current state of people making mistakes and then looking around for others to demonize instead of owning up to their errors, taking responsibility for them and learning from them.

If you don’t understand a complicated product, it doesn’t mean the product shouldn’t exist – it means you shouldn’t buy it. 

That concept shouldn’t be controversial, and shouldn’t be one that gets debated.  Yes – some of these prospectuses are insanely confusing, long, and impossible to understand.  Guess what – DON’T TRADE THE PRODUCT in that case.

One other thing: I liked @Douglas_blake ‘s idea of having all “broken” ETPs get their tickers amended with another letter – like the “Q” that gets tacked on to companies filing for bankruptcy.   Of course, there are potential problems there as well: if we flag every ETP where the creation/redemption mechanism is halted, there may be the implication that all other ETPs are trading right at their NAV.  Although this is usually a fairly reasonable assumption, it may not always be the case, and may lure people into a false sense of security.  Judging from the trading action in TVIX, though, it seems hard to argue that it would make matters worse.

related:

Leveraged ETFs: Protecting People From Their Own Ineptitude

TVIX: Not Your Daddy’s Blue Chip

TVIX: Mess with the bull, get the horns

TVIX: So you got killed in TVIX yesterday? CSFB may be your salvation

GAZ: The Ultimate Greater Fool Trade

-KD

no positions in $TVIX. Short $GAZ

glossary: ETP = exchange traded product – ETN, ETF, closed end fund

 

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