Jeff Steckbeck didn’t read the prospectus. He didn’t realize the price was inflated. He didn’t even know the security he read about online was something other than an exchange-traded fund.
The 56-year-old civil engineer ultimately lost $45,000 on the wrong end of a volatility bet, or about 80 percent of his investment, after a Credit Suisse Group AG note known as TVIX crashed a week after he bought it in March 2012 and never recovered. Now Steckbeck says he wishes he’d been aware of the perils of bank securities known as exchange-traded notes that use derivatives to mimic assets from natural gas to stocks.
“In theory, everybody’s supposed to read everything right to the bottom line and you take all the risks associated with it if you don’t,” he said this month by phone from Lebanon, Pennsylvania. “But in reality, you gotta trust that these people are operating within what they generally say, you know?”
The ETN market has only gotten bigger since Steckbeck’s loss. Now U.S. regulators are ratcheting up pressure on banks to more clearly explain the risks after investors increased their holdings more than 50 percent to $24 billion since the end of 2012, according to data compiled by Bloomberg.
After getting banks last year to show customers that privately traded notes are worth less than they’re sold for, the U.S. Securities and Exchange Commission is negotiating with them to beef up disclosures on securities like the TVIX, according to people with knowledge of the matter.
Steckbeck was among a group of investors who sought arbitration from regulators to recover losses after the ETN sank.
Nicole Sharp, a spokeswoman for Credit Suisse in New York, declined to comment on the bank’s ETNs, as did William Lloyd, a managing director at VelocityShares LLC, which licenses names and trademarks to the bank. Christina D’Amico, a spokeswoman for the SEC, declined to comment.
As individual investors increasingly wager their money on exotic derivatives, they still aren’t sufficiently savvy about how the notes work, even after the TVIX plummeted two years ago, according to Robert Whaley, a finance professor at Vanderbilt University in Nashville, Tennessee.
“They’re treating this market much the same way as they treat going to Las Vegas and playing blackjack,” Whaley, who designed the Chicago Board Options Exchange Volatility Index, or VIX, said in telephone interview. “I don’t agree that these people are particularly informed.”
The VIX is a measure of future stock-market volatility derived from options prices on the Standard & Poor’s 500 Index.
Even as investor holdings surge, returns on the securities have been dwarfed by stock-market gains.
Exchange-traded notes returned an average 2.9 percent in the 12 months through April 16, data compiled by Bloomberg show. The S&P 500 gained 21 percent with reinvested dividends over the same span, while dollar-denominated bank bonds tracked by a Bank of America Merrill Lynch index returned 2.2 percent.
ETNs gained notoriety in February 2012 with the TVIX, a security that’s based on shifts in volatility.
Credit Suisse, which issues the note, stopped selling new offerings of them that month. Rising investor demand bumped up against the bank’s preset limits for outstanding shares, it said at the time. The TVIX ended up veering as much as 89 percent away from the index it’s supposed to reflect.
The bank started issuing more TVIX notes in March 2012. In July that year, the Financial Industry Regulatory Authority, a non-governmental watchdog group, issued a warning that ETNs may trade at a higher price than their underlying index.
The TVIX declined more than 75 percent in the past year.
ETNs were introduced in the U.S. in 2006, when the SEC permitted Barclays to sell two relatively simple securities. In that period the universe of ETNs has expanded to about 200 securities that use leverage, short-selling, and other more complex designs.
The ETN market is dwarfed by that for exchange-traded funds, which appeared in the U.S. 21 years ago and make up about $2.4 trillion in assets.
The SEC’s probe intensifies pressure after the regulator asked banks last year to increase disclosures on prospectuses for privately traded securities known as structured notes.
Banks had to include the securities’ estimated initial value, which is typically two to four percent less than what investors paid for them, data compiled by Bloomberg show. They were also asked to use a narrative rather than mathematical explanation of the derivatives included.
There are about $82.7 billion of outstanding structured notes in the U.S., according data compiled by Bloomberg tracking the securities sold since January 2010.
“All of a sudden there are a lot more issuers approaching the SEC, becoming issuers of ETNs,” Keith Styrcula, chairman of the Structured Products Association, an industry group, said in a telephone interview. “There’s been a plethora of new ETNs and some of them are getting a little bit more exotic with leverage or access to certain illiquid asset classes. I see it as a healthy thing as long as there’s not over-reach.”
The SEC is asking banks to make revisions to their ETN prospectuses, according to a letter sent to lenders in February from Amy Starr, head of the agency’s office of capital markets trends in Washington.
Some ETNs, particularly those with the word “shares” in the title, may be ambiguous enough for investors to think they’re buying stocks or exchange-traded funds, the letter says.
Some fail to adequately explain that banks can bet against the very notes they’re selling or suspend new offerings or take other actions that can affect their value, according to the letter.
More recently, the SEC has been seeking to gather more information on the value of the derivatives the notes are tied to, according to the people with direct knowledge of the conversations, who asked not to be identified because they’re not authorized to speak publicly.
The regulator is seeking to determine whether banks should include that measure, known as the indicative value, in prospectuses, the people said.
“My experience with ETN prospectuses is that they’re very clear about the fees and the risks and the transparency,” Styrcula said. “Any investor who invests without reading the prospectus does so at his or her own peril, and that’s the way it should be.”
The offering documents for the VelocityShares Daily 2x VIX Short Term ETN, the TVIX, says on the first page that the security is intended for “sophisticated investors.” The note “is likely to be close to zero after 20 years and we do not intend or expect any investor to hold the ETNs from inception to maturity,” according to the prospectus.
While Steckbeck said a supervisor at Clermont Wealth Strategies advised him against investing in TVIX in February 2012, he bought 4,000 shares the next month from his self-managed brokerage account. The adviser, whom Steckbeck declined to name, didn’t say that the price had become unmoored from the index it was supposed to track.
David Campbell, president of Clermont Wealth Strategies, declined to comment.
Steckbeck, who found the TVIX on the Yahoo Finance website, doesn’t have time to comb through dozens of pages every time he makes an investment, he said.
“Engineers -- we’re not dumb,” said Steckbeck, who founded his own consulting company in 1990. “We’re good with math, good with numbers. We read and understand stuff fairly quickly, but we also have our jobs to perform. We can’t sit there and read prospectuses all day.”
Steckbeck was among 29 named investors whose arbitration claim made via Finra was withdrawn after Credit Suisse sued to block it, arguing that the buyers of TVIX notes didn’t fit the Finra definition of “customer,” court records show.
Credit Suisse dropped its case after the defendants withdrew the claim, according to court papers filed Dec. 20 in federal court in Baltimore.
The investors weren’t the bank’s customers because they didn’t buy the securities from Credit Suisse and never entered into an agreement to obtain investment advice from it, the lender said in the complaint. Sharp of Credit Suisse declined to comment on the court document.
Although ETNs are debt securities, they allow individual buyers, sometimes called retail investors, to track assets such as futures or options, financial instruments that may otherwise require certification that the purchaser is a sophisticated investor.
Futures are contracts to buy or sell assets at a set price, allowing them to create a position, or a view, on the market. Options give the buyer the right, but not the obligation, to buy or sell a security at a set price.
“The whole point of making these things exchange-traded was to make them accessible to retail investors,” said Colbrin Wright, assistant professor at Brigham Young University in Provo, Utah, who has written academic articles on the indicative values of ETNs. “The majority of ETNs are overpriced, and about a third of them are statistically significant in their overpricing.”