Photographer: Krisztian Bocsi

How Wall Street Finds New Ways to Sell Old, Opaque Products to Retail Investors

Proprietary indexes spread.

As securities watchdogs crack down on complex investments that promise mom-and-pop investors access to strategies of trading pros, Wall Street is finding a way to sell the same products in places those regulators don't reach.

The investments, which follow proprietary indexes developed by banks including JPMorgan Chase & Co. and Credit Suisse Group AG, are quietly spreading into more opaque retail markets. Once popular in structured notes, a form of bank debt bundled with derivatives, they are now helping pump up sales of certificates of deposit and insurance annuities. Specialized indexes now underpin more than a fifth of the $13.8 billion market for indexed annuities—investments that target retirees.

The shift moves oversight largely out of the purview of the U.S. Securities and Exchange Commission, which levied UBS Group AG with a $19.5 million fine in October for allegedly misrepresenting the transparency of such products, and into a patchwork of state and federal regulation. That may frustrate efforts to supervise a burgeoning array of products that regulators have questioned for their complexity, fees and actual returns that often fail to live up to "backtested" results generated by computer models.

“These kinds of products are terrible for retail investors,” said Frank Partnoy, a University of San Diego professor who once structured complex investments for Morgan Stanley. “They often are similar to what I’ve called the ‘wolf in a sheep’s clothing.’ Because it’s proprietary, it can contain risks that some investors don’t understand.”

'Elaborate Formulas'

While sales of proprietary index notes shrunk to $157.9 million in 2014, some Wall Street banks use the strategies in a significant amount of the structured certificates of deposit they sell, according to Dayna Kleinman, senior product manager for alternative investments at Robert W. Baird & Co. in Chicago. The CDs, which the Federal Deposit Insurance Corp. guarantees for as much as $250,000, generally aren’t supervised by the SEC, so data are often incomplete.

The DB Allocator Total Return Index was created in June of 2010. Deutsche Bank sold three structured notes tied to the Allocator, starting the next month, on July 13. While the index grew about 16 percent annually on backtested performance charts, not long after the notes were issued, it began sliding. Its level fell during the life of two of the three notes.
The DB Allocator Total Return Index was created in June of 2010. Deutsche Bank sold three structured notes tied to the Allocator, starting the next month, on July 13. While the index grew about 16 percent annually on backtested performance charts, not long after the notes were issued, it began sliding. Its level fell during the life of two of the three notes.

Specialized indexes, including proprietary ones, accounted for about $3 billion in annuity sales in the third quarter last year, according to Wink’s Sales & Market Report. The products, which typically guarantee the return of principal, are overseen by individual states rather than the SEC or Financial Industry Regulatory Authority because they’re not considered securities.

Judith Burns, a spokeswoman at the SEC, declined to comment beyond a speech given by Amy Starr, chief of the office of capital market trends, in May in which she expressed concerns about the complexity and lack of transparency of proprietary indexes in structured notes.

Proprietary indexes can be useful, said Steffen Scheuble, chief executive of Solactive AG, which has created about 700 of them. "If you’ve got a rules-based strategy, it’s cheaper and more transparent" than sticking your money with an active manager, he said.

Banks that sell proprietary index notes include warnings of their risks in offering documents, such as that investors may not receive any returns.

The indexes became popular right after 2008, when the Standard & Poor’s 500 Index plunged the most in seven decades, according to Vinit Srivastava, who manages strategy indexes at S&P Dow Jones Indices. They used elaborate formulas to capture the performance of a changing grab bag of assets that included commodities, stocks, bonds and currencies. They were often agile, adjusting underlying assets, in ways that tamped down risk.

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Only five of the 163 U.S. notes sold in 2010 tracked proprietary indexes that had historical growth rates that were negative, according to performance charts in offering documents. Meanwhile, more than two-fifths of notes followed indexes that looked like clear winners, jumping more than 10 percent a year, based on compound annual growth rates. The results were largely the product of backtesting. (Note: Some notes tracked multiple proprietary indexes. Also, annual returns for some indexes couldn't be reliably calculated, so they were excluded.)

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How the indexes actually performed, from sale date to maturity, made for a stark contrast. For almost two-fifths of the notes for which levels could be calculated, the indexes dropped. (Note: A decline in the index doesn't necessarily mean the structured note had a negative return; that depended on the terms of the note. Also, for the 11 notes that haven't matured yet, returns were calculated through Dec. 30 of last year.)

Jerry Miccolis, a New York financial adviser, recalls the first proprietary index note he bought for his clients in February of 2010. It included a Deutsche Bank AG strategy nicknamed "Emerald," described by the bank as aiming to "monetize any negative serial correlation exhibited by the S&P 500 Index by periodically buying daily volatility and selling weekly volatility." Miccolis, 63, who co-wrote the book Asset Allocation for Dummies, spent months figuring out how the product worked.

The Emerald note turned out to be surprisingly good, returning 33 percent in a little more than a year, he said.

More often though, returns of such products were disappointing, according to a Bloomberg analysis that looked at performance, fees and conflicts of interest for the record $1.31 billion of U.S. proprietary index notes sold in 2010. All but 11 of the 163 securities issued that year have matured.

On average, the proprietary indexes rose 2.4 percent annually during the life of the notes, the Bloomberg review showed. In offering documents given to investors, however, they jumped an average 9.5 percent a year for periods lasting up to two decades.

Blame it on Backtesting

One problem was, some of the stellar historical gains weren’t real. More than two-fifths of the notes followed indexes created less than a year earlier, according to the Bloomberg study. In one case, a performance chart boasted a 50 percent climb during five years for an index that had been around for barely a week.

Banks often projected their rules-driven formulas back through time, a common practice known as "backtesting." While they did disclose which periods of the charts showed such results, "the only indexes being brought to the market in the form of new products are the ones that have done well in backtest periods," said Joel Dickson, head of investment research and development at Vanguard Group Inc. "It’s pretty easy to run a good backtest."

Multiple fees also dragged down returns. Commissions to pay the deal’s underwriter sometimes took a bite as high as 8 percent. Other embedded expenses included adjustment factors, index fees, investor fees, early repurchase fees, and costs for holding the index members.

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Fees can severely erode returns, as can be seen by proprietary index notes from 2010 that had some of the largest expenses. A three-year note that would have paid 4.19 percent to investors instead resulted in a 1.82 percent loss of principal after more than 6 percent in fees were deducted.

On Feb. 18, 2010, Deutsche Bank sold $5.25 million of five-year notes tied to its Liquid Alpha USD 5 Total Return Index. The annual fee of 1.75 percent meant a buyer of the products wouldn’t receive a dime of profit unless the index, itself subject to a yearly fee of 0.21 percent to 0.63 percent, rose at least 9.6 percent. When the notes matured in 2015, the index had slid 7.7 percent.

Most of the notes were also vulnerable to the possibility of conflicts of interest, as for all but two the issuer also calculated the level of the index that determined investors’ profit, according to Bloomberg's review.

Even for illiquid markets, banks should use independent sources for data, according to Jasmine Tiw, a partner at Ashurst LLP in London, who advises issuers of structured products. They should avoid relying on their internal prices "so there’s no risk of manipulating the numbers," she said.

Building a Better Mousetrap

What’s at stake became clear when the SEC fined UBS last year for allegedly misrepresenting the degree of transparency of products linked to its UBS V10 Currency Index with Volatility Cap. In 2010, UBS sold $125.5 million of the notes.

UBS traders hedging the currency instruments sent transactions from London through a Swiss intermediary to a UBS currency desk for execution, according to the SEC. They added mark-ups and spreads and front-ran the trades,  dragging down the product’s returns, the SEC charged. UBS agreed on Oct. 13 to pay $19.5 million to settle without admitting or denying wrongdoing.

Erica Chase, a spokeswoman from UBS, declined to comment. Other bank spokespeople declined to comment for this article, including Oksana Poltavets of Deutsche Bank, Amanda Smith of JPMorgan, Mark Lane of Barclays Plc and Nicole Sharp of Credit Suisse.

There may be more actions to come, according to the SEC’s director of enforcement Andrew Ceresney, who at the time the UBS fine was announced said the agency had "other investigations in this area." Another SEC official, Reid Muoio, told an industry conference on Nov. 5 that the agency was looking at whether banks adequately describe the fees embedded in proprietary indexes.

As the SEC cranks up the heat, the complex strategies are popping up elsewhere, in areas beyond its reach, such as CDs and insurance annuities.

A.M. Best Co., which provides credit ratings of insurers, said in October that the new indexes are part of a complexity "arms race" in the industry. In September 2014, Iowa Insurance Commissioner Nick  Gerhart warned that backtesting of the proprietary indexes used in annuities may prove misleading.

"What they try to do is create a new mousetrap to sell the product," said Jeff Lorenzen, chief investment officer at American Equity Investment Life Holding Co. "Those don’t seem appropriate for a safe money retirement account."

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