To understand what happened in the markets the week of February 5, you need an understanding of the psychological forces behind what happened. The VIX isn’t just an index that reflects what’s going on with options. It’s a psychological measure, and that’s where the media comes in. You cannot directly trade the VIX. Yet, the Chicago Board of Options Exchange (CBOE) created products whose values are based on the VIX index. The CBOE offers VIX futures and VIX options, both of which trade on liquid and regulated exchanges. Like the futures and options, I discussed in part 1 of this series, CBOE’s VIX products have the potential to be either risk-reducing or risk-enhancing. In the hands of experts who are working with clients who are honest about their risk tolerance, these products can potentially benefit both aggressive and many conservative clients.

Very few retail investors — anyone who isn’t a professional or who doesn’t work for a financial institution — deal in the specialized world of trading futures or options. That’s despite the fact that these tools can often tell us something about stocks! Those who do recognize the benefits of said products usually hire an advisor who has a specialty in them. This is for good reason. Learning the lingo isn’t difficult. But mastering the fine skills related to trading said products takes years of full-time work and mentorship. So, even financial professionals who have a high level of competency investing with more common products like stocks often decide not to take the plunge toward mastering these products. The doctor you want doing your eye surgery is not the doctor you want to see for you knee surgery or your pregnancy. Likewise, the financial professional you want to do your financial planning or to pick up the phone when you call is not going to be the same one who chains himself to a computer screen all day to trade. Professionals recognize that trading these kinds of products is high specialized. Consequently, professionals often form teams and partnerships to better serve their clients as well as keep from spreading themselves too thin in attempts to be jacks of all trades. Financial markets are more complicated than ever. Yet more firms are hawking “one-size fits all” approaches that nearly guarantee a huge number of investors will be behaving in exactly the same way at exactly the same time! Internet and TV marketers may promise shortcuts to expertise and money-making, but we live in an age of specialization. Beware financial snakeoil and diet pills.

Over the last few decades, we’ve seen a strengthening trend of some investors demanding they have more control over their own investing. Overall, this has been a very good thing. The concentration of power on Wall Street and a lack of alternatives wasn’t good for investors. There is a heads and a tails to every coin, though. The opening up of markets has allowed discount brokers and independent firms like WorthPointe to provide investors alternatives to those Wall Street products that always favored “the house.” Yet they have also exposed overconfident investors to risks an advisor may have shielded them from. New technologies have lowered the costs of investing in many real and meaningful ways. Yet it has inspired some firms to be more shrewd in how they “hide” their revenues to appear cheaper. The market of “do it yourselfers” (DIYs) has grown. With it, demand for financial entertainment television and websites has also grown. Many of these entertainers can make outrageous claims because technically, they aren’t advisors at all.

Follow the Money

Now, let’s take a second and consider the motivations of a financial infotainer on television. It becomes clear how his “guidance” isn’t free at all. The first thing you have to understand is how the financial entertainer/guru gets paid. Would you venture to guess that he’s working in the best interests of whomever is paying him? Do you pay him? No, you don’t. So he doesn’t work for you, he works for the network — sort of. How does the network determine how much to pay him? By the strength of his ratings. Why do ratings matter? Because advertisers will pay more to have their ads run when ratings are high. Higher ratings mean more profits for the network and for the guru. So, the incentive of the guru is to keep viewers tuning in so advertisers keep paying. Are advertisers a benevolent and charitable force of hundreds of millions of dollars? I don’t think so. Therefore, we must conclude that the show exists because of the advertisers and for the benefit of the advertisers. Who are the advertisers? We can sum up most of them in two words: Wall Street — the big banks, wirehouses, insurance companies and mutual fund companies. Following the money, we see the guru works for Wall Street. That’s who is putting the money in the bank account from which his check is written. Want to know who a person works for? Find out who pays them.

Fear Sells

The challenge for the financial infotainer, then, is to keep people tuning in. That’s no easy feat. Enter science! Studies have proven people would much rather avoid a pain/loss than get an equivalent gain. Combine that “loss aversion” with “recency bias” and you really have emotions getting in the way of good decision-making. Our emotions tell us if we invest $100, and it goes up to $110, and then down to $108, we lost $2. Of course, we know that feeling has no logical foot to stand on. It contradicts everything we know about statistics and the mathematics behind risk management. Yet our emotions tell us we are are still far more sad about “losing $2” than we are happy about gaining $8. (Our recency bias also makes us illogically focus too much attention on what happened most recently rather than the recent event in the context of history.) So, what’s the best tool to grab and sustain attention? Fear of loss. Fear is extremely motivating and engaging. It makes sense if you think about it for a moment. What if you tuned in and all the entertainer said was how wonderful everything was? Then on several more days, he talked about how easy investing is no matter if you watch his show or not. Would you keep tuning in? No, of course you wouldn’t. So fear must play a big role because even greed gets boring! We start thinking the rising tide that is carrying all boats is actually own superior expertise in navigating the ocean!

As I discussed in the first part of this series, the financial entertainers have given the VIX nicknames like “the fear gauge” and “the fear index.” Of course they are attracted to the VIX! It provides some great material for grabbing people’s attention. It’s as easy as suggesting “other people are afraid, so why aren’t you? Stay tuned!” It should come as no shock then, that the VIX has become much more widely known over recent years. Entertainers in the financial media have mentioned it much more often. Why wouldn’t they? DIYs usually went pro in something else. They are often successful people who spent years honing their skills in something other than investing. Naturally, they are drawn to a shortcut. Who wouldn’t rather kick back and watch television after a long day at work rather than pore over long and detailed financial texts —  especially those written in a specialized language? Who wants to stumble through the complicated math mandatory for a trader?

All that talk about the VIX to DIYs translated to a growing number of them becoming interested in trading the VIX. However, these DIYs are often unequipped to deal with professional tools like futures, which are tools requiring years of study and apprenticeship to master. Therefore, they again need a shortcut to access all things VIX. This demand opened the door for firms like Credit Suisse Group AG and others to introduce VIX-related products. Said products looked a lot friendlier to DIYers. Yet they were based on professional-level tools. That’s kind of like putting gasoline into a pink bottle and handing it to your infant. The packaging now looks friendly, but the contents are still dangerous to someone who doesn’t know how to use them properly! Gasoline is not bad. Gasoline enables us to do a lot of things very efficiently. Still, if you don’t understand how it works, it can hurt you. Perhaps a pro could get away with carrying gasoline in a baby bottle. I sure wouldn’t want to try — and I’m no petroleum professional. I would never want to handle gasoline in a baby bottle, but if investors demand gasoline in baby bottles, the market will surely sell them.

The “baby bottles” in question have often been exchange traded notes (ETNs). On the surface, ETNs look the same as the often friendly exchange traded funds (ETFs) many investors have embraced. The ETNs trade easily — just like stocks and ETFs. Now take a moment and think about the profile of a speculative DIYer looking for a shortcut to trading the “fear index” without having to put in the time to trade it like a professional. Do you think he read the prospectus? Would it matter if he tried? If you’ve been reading my blog for a while, you know that what’s “inside” the ETN is not the same as what’s inside the typical ETF.

Most ETFs are invested in a basket of stocks or other securities that have similar characteristics. For example, you could buy an ETF that invests only in U.S. government treasury bonds that mature in 1 – 3 years. You could buy an ETF that invests only in large-cap (read: big companies) European stocks. An ETF is a fund that holds assets, so it stands alone from the company that created the fund. What happens if the ETF issuer went out of business? You’d either see your fund continue as usual under a new name, or you’d get your money back for the investments that were in the fund. An ETN, on the other hand, doesn’t stand alone from the issuing company. ETNs are unsecured debt obligations of the issuing company. They don’t necessarily own the investments from which they derive their value. That’s not inherently a bad thing, but it should at least scream, “proceed with caution.” It means you’ve got more homework to do on an ETN than you do on an ETF, all other things being equal. For more on ETNs versus ETFs, be sure to see this prior blog post.

To be clear, there is nothing inherently wrong or evil with how ETNs are structured. It can be a problem if investors don’t take the time to understand the differences in their structure versus that of an ETF. In fact, certain specialty ETFs could be subject to some of the same risks as the ETNs if they are using the same strategy as the ETN. An ETF with the same strategy as a similar ETN would be exposed to the same strategy risks, but not the same structural risks. How complicated is it? Think of it this way… Let’s start with the assumption that you have a basic understanding of stocks but very little understanding of futures. You are probably 90% of the way toward understanding a typical ETF that invests in stocks. If you have a basic understanding of ETFs, you are 10% of the way toward understanding exotic/leveraged/or inverse ETFs that invest in securities you don’t understand. You are probably only 5% toward understanding an ETN with the same strategy. In summary, the structural risk of the ETN versus the ETF is important. But the biggest risk is that you don’t understand the underlying investments in futures. If you don’t understand futures, you will not understand the mechanisms that may help or hinder the product from doing what it has set out to do. If you lose money, you are likely to blame the product, since you didn’t understand that the product behaved the way it should have. If you don’t truly understand the rules of the game that you asserted you understood when you signed up to play the game, whose fault is it when you lose at said game?

The answer seems pretty straightforward at first glance, but it’s complicated. We know from psychology that people tend hear what they want to hear, or at least hear something that is different than what was said. We pick out details that confirm what we want to believe, at the same time ignoring or discrediting information that challenges what we want to believe (confirmation bias.) Our minds look for shortcuts, called “heuristics,” to cut corners in our thinking processes. (For more, check out the book Thinking, Fast and Slow by Daniel Kahneman.) The point is that our minds play tricks on us, and that’s why we have contracts, prospectuses, and other written agreements. It’s also why contracts for what seem like a basic services are so long. Every time someone disputes something that seemed clear to 99.9% of other people, the contract gets a little longer and more intricate to close any potential loophole. Yet every time the contract gets longer and more intricate, it gets harder to understand.

The overwhelming majority of people who ask me to review their annuity contract get upset or even angry with me when I have to explain that their contract says something different than what they “know” it says. I use annuities as an example because they are some of the most complicated and misunderstood products available, yet they are somewhat strangely quite common. While there are unscrupulous salesmen who seek to deceive, my personal experience gives me hope that is not the norm. I’ve sat in on annuity meetings in which we were given what I felt was an honest presentation. Obviously the broker didn’t read the prospectus to us word for word, yet that’s what a 100% full disclosure would’ve required. Nobody wants that, though. We want the right level/amount of information. Not too much, not too little — just right. But “just right” is different for everyone, and every broker is an imperfect human who is trying to hit a moving target every time he sits down with someone new.

Even the words people use to describe themselves aren’t consistent across a sample of people. I talk to people who tell me they are conservative, but I see them investing aggressively, and vice versa. I talk to people who are extremely conservative, but have aggressive expectations, and vice versa. I talk to people who assure me they know a tremendous amount about investing, but my observations contradict that. Likewise, I talk to people who are extremely modest about their knowledge who I would consider far above average! My point is that communication isn’t just difficult, it’s extremely time-consuming, and time has a cost. We have time constraints, attention constraints and sometimes inaccurate perceptions of ourselves. All of us!

After such a meeting, I have found the client heard something materially different than I heard. My suggestion, of course, was to go to the contract to synchronize our understanding. The conversation then goes something like this… I assert that the salesmen said X. I back it up by showing the contract also says X. The other party asserts the salesman said Y. So he concludes either I must be misunderstanding the contract, or the salesman lied about the product. I’ve been through this not only with clients, but with family. It’s a difficult conversation.

What lesson have I learned?

That I’m a financial professional with certain distinct specializations. I know something about financial planning, but I am not a CFP like many of my partners at WorthPointe. I know something about accounting, but I’m no CPA. I know a lot about certain types of contracts, but if the contract is not in my niche, I know to call for help. As an expert in certain things, I catch things people without said expertise don’t catch. In other areas, I miss things an expert would catch. That’s the catch-22 with the products I’ve been discussing that give DIYs more control and power. These products in a sense put DIYs in competition with pros rather than putting pros on their side. It’s also the catch-22 with any type of investing. If you want something different than the unfavorable certainty of the typical thing that has been watered down to the point where it could fit anyone, you are going to have to accept some degree of uncertainty. This is why so many people may go to their independently owned local favorite restaurant when they are in their home city, but when they get hungry on a road trip, they will look for the next exit that has some familiar chain restaurant like Chili’s or T.G.I. Fridays. It’s also why these types of familiar establishments locate themselves near exits. They know out-of-towners are less likely to take a risk on a potentially incredible local restaurant that is unknown to them, instead settling for the adequacy of the familiar.

Some ETNs have “blown up,” causing some to argue that they should never have been available to retail investors in the first place. I understand that argument, and I empathize with it. Yet some people want more powerful products and solutions. If a firm like Credit Suisse created a product and disclosed how it would operate, and a customer falsely claimed to understand said product, who is to blame? Do we blame the pro who created the product or solution? Do we blame the person who falsely claimed to understand the product, or perhaps didn’t even bother to read the prospectus or disclosures? It would be easy to blame regulators if they didn’t catch a material error in the disclosures of these products, but so far, it doesn’t appear like that has been the case. Do we blame regulators for allowing firms to create products that were accurately described to customers? Logically, they should have a right to the products. Logically, we know we shouldn’t be surprised if something labeled “highly flammable” ends up catching fire. But it doesn’t feel good when there are losers, even if we decide the loser can only blame himself. Does this discussion sound familiar? It should. This topic is one example of a philosophical debate that is happening all the time in our country. In conclusion, I abstain from making an argument about whether these products should even exist, let alone be available to retail traders. I will, however, point out that from what I can tell, the products behaved how I expected them to behave based on their investment strategy as well as what was disclosed by the companies.

Due to its role in the February 5 volatility shock, one ETN is getting the most media attention right now. Said ETN is the VelocityShares Daily Inverse VIX Short-Term ETN (symbol: XIV), issued by Credit Suisse. In the next part of this series, I’ll take a closer look at XIV. I’ll discuss how its “explosion” caused the illusion of collateral damage in some areas, as well as how it caused actual collateral damage in other areas.