Volatility blunders and the runaway advisor

The number of travel agents has been cut in half over the past two decades, while the financial advice industry is booming.

Both travel and investing have become much more transparent, less time-consuming and more cost-effective thanks to substantial technological innovations. So why are American now booking their own flights and hotels, but choosing to work with financial advisors?

One reason may be that the financial services industry has been more successful at making the transition from transaction-based services to holistic advice.

To be sure, travel agents are now asking to be called travel advisors, with the American Society of Travel Agents changing its name to the American Society of Travel Advisors. Indeed, the issues being faced by the travel industry as it makes this agent-to-advisor transition will sound remarkably familiar – as discussed in this 2018 piece by Christopher Elliott:

Unfortunately, these agents are still in our midst, some pretending to be travel advisors when they just want to sell you a trip with the highest commission…Mollie Fitzgerald, who runs Frontiers International Travel, says: ‘While commission income is still a meaningful part of our business, this shift to a fee-based industry has definitely helped to professionalize the way in which advisors are viewed, and most clients understand this and know that you often get what you pay for.’

Elliott closes by writing that while ‘changing their names to travel advisors is a necessary first step… it may be a while before they are recognized as full-fledged professionals like financial advisors.’

After all, there is no ‘fiduciary duty’ for travel advisors; many continue to rely on commissions, and if you know that Disney is paying your advisor 10%-16% for booking that cruise, you might rightfully wonder whether it’s actually true that the seven-day voyage is 10 times more fun than the three-day jaunt.

Financial advisors have something else going for them, too. Compared to booking travel, investing is boring, difficult, complicated, and critical to one’s wellbeing. Grave errors are both easier to make and more consequential. For instance, it would be easy for an investor anxious about rising volatility to buy the popular VIX exchange-traded note, ticker VXX, and treat it as a long-term holding. Though the product is designed to be held for just one day at the most, and is on a one-way trip to zero due to the product’s very design, a novice investor who thinks that ‘volatility will go up’ might see the VXX and choose to hold it like some would hold the GLD gold ETF or the SPY equities ETF.

Wait, did I say ‘novice investors’?
In 2016 and 2017, certain Summit Financial IARs recommended to their advisory clients that they purchase and hold VXX for durations that were inconsistent with the purpose of the product….At least 91 accounts holding VXX for extended periods lost money on their investments. And many of these accounts lost more than 75% of the value of their VXX investments….One Summit Financial IAR, who was responsible for nearly half of all client losses in VXX, did not understand that VXX’s performance was tied to an index tracking the daily performance of futures contracts… or that VXX, in fact, had lost a substantial portion of its value since inception. He further did not understand how VXX was structured, the risks inherent in investing in VXX, or how certain features of VXX could negatively affect his clients’ investment plans, particularly when used as a buy-and-hold investment.

That’s from an SEC order issued last week, and it’s one of five relating to sales of volatility-linked exchange-traded products. The RIAs and broker-dealers, including Summit, were fined a combined $3.05m. Most of the orders related to the VXX, though Securities America Advisors (SAA) was dinged for sales of XIV and VIXY.

The stories are both embarrassing and devastating:

In one instance, for example, SAA’s trade monitoring system generated an alert as a result of a trade in XIV of more than $118,000 that an investment adviser representative (‘IAR’) had made for a client. The alert was issued because the trade meant that the standard deviation for the client’s portfolio exceeded SAA’s threshold for the client’s risk tolerance. The IAR, who had discretionary authority, was notified of the alert. Without prior notice to the client, the IAR then changed the client’s risk tolerance to ‘speculative,’ and the trade was allowed with no further inquiry…The client in whose account the IAR purchased XIV was a couple in their mid-seventies with a net worth (exclusive of their home) of approximately $700,000. After changing the client’s risk tolerance, the IAR continued to trade XIV and VIXY in the account. For the Relevant Period, the client lost approximately $125,000 from the IAR’s trading in XIV and VIXY.

A comprehensive explanation of why VXX makes a poor a long-term holding can be found in Citywire RIA’s article about the SEC action. But suffice it to say that information about the hazards of VXX and XIV was not hard to come by. Months before the XIV was redeemed at a near-total loss, I wrote an article for CNBC.com headlined ‘the most dangerous trade in the world.’

Now, one could use the failures highlighted by the SEC to paint the entire advisory industry in a negative light. But I actually see it the other way.Given that even credentialed professionals were fooled by the siren song of products purporting to rise alongside the ethereal (that is: untradable) concept of ‘volatility,’ how many more individuals have fallen prey to the same thing?

Indeed, I once heard anecdotally of an elderly woman who, convinced that volatility was about to rise, and seeing VXX as a ‘hedge,’ poured some $2m of her $4m in assets into the product. She lost nearly every penny, and went looking for answers. She called her online discount broker, who directed her to the ETN provider, who directed her to the exchange that devised the VIX in the first place. While she eventually got an explanation of what had happened, she never got any money back. She had bought the wrong product for the wrong reasons, and she was responsible for her decision.

Have some advisors made similar errors on behalf of their clients? According to this SEC order, it sure appears that they did. But the reason the SEC is issuing fines is because this is the exception, rather than the rule. And as professionals, they should have known better.

If the elderly woman in question had called up your average advisor, it might have been the start of a long conversation that began: ‘Oh, you want to hedge? That’s smart. Let’s talk about your options – we could buy put options, reduce your equity exposure, look into annuities…’

It’s the rare advisor who would have suggested she plow millions of dollars into VXX. And if they had, she would have a decent case for being made whole. By paying a 1% AUM fee, she could have saved millions of dollars.

If you know a travel advisor who can offer that kind of return on investment, please send them my way. Once we have a Covid-19 vaccine, that is.

Fugitive and the Tamp

Speaking of looking for answers… what do you do when your advisor goes missing, the FBI can’t find him, the SEC charges him with fraud, and his just-divorced wife is selling their lake house for $1.1m?

If you’re like Susan Zimmerman and ‘all others similarly situated,’ you file a class action suit and name as the first defendant the large RIA and turnkey asset management program (Tamp) to which he sent money, from which he allegedly withdrew money to invest in imaginary loans, and to which he apparently returned money with the fake profits from these imaginary loans.

The Tamp, Matson Money, is nowhere accused of engaging in any fraudulent activity. But did its co-advisory relationship with Chris Burns – whereby, as the SEC puts it, ‘advisory fees were withdrawn directly from client accounts by Matson Money and paid to [Burns’ firm] Investus Advisers’ – make Matson somewhat liable for civil damages caused by his apparent wrongdoing?

For that matter, could we ask similar questions about Chris Burns’ (ex-)wife, who appears to have been living on the proceeds of fraudulent activities, and who (unlike Matson) is named as a relief defendant by the SEC suit? Then again, perhaps the benefits Meredith received are more significant and more direct. And that’s not even to mention her enhanced opportunities to perform due diligence.

Matson Money stringently denies any wrongdoing in the case (‘Matson Money processes worked in the context of our limited engagement with Mr. Burns’), while recent divorcee Meredith Burns’ lawyer told us rather enigmatically: ‘There are investors, creditors, and apparently simple breaches of contract matters, of which we already knew about but there may very well be other issues in which Chris was involved that are still coming to light.’

On behalf of Citywire RIA, I can only say: We certainly hope that they do.

This article originally appeared on CityWire.


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