Five investment advisory and dually registered firms settled with the SEC today over charges that representatives invested client money in unsuitable exchange-traded products linked to market volatility and designed for short-term investments. Representatives at the firms advised investors to invest in these products for longer periods, sometimes as a hedge in anticipation of falling markets, with clients suffering millions in losses as a result. In addition, the supervising firms failed to oversee and monitor the transactions in a way that would have prevented the misuse of these investments.
The actions, which were filed against American Portfolios Financial Services/American Portfolios Advisors, Benjamin F. Edwards & Company, Royal Alliance Associates, Securities America Advisors and Summit Financial Group, are the first to come from investigations at the Exchange-Traded Products Initiative in the Commission’s Enforcement Division. The initiative uses trading data and quantitative analysis to root out misuse of these kinds of investments by financial advisory firms. The charged firms will be returning more than $3 million to harmed investors.
"It is important for firms to put the appropriate protections in place to ensure complex products are properly evaluated and understood by their representatives. Failing to do so puts investors at risk," Stephanie Avakian, director of the Division of Enforcement, said. "We take these failures seriously, and we will continue to look for sales that expose customers to unsuitable investments."
Starting in early 2016, representatives at these firms started pushing retail investors to consider exchange-traded products linked to the S&P 500 VIX Short-Term Futures Index, which tracks the market’s expected volatility as opposed to the price level of the S&P 500, according to the complaints. In early 2016, some investment advisory representatives at Summit Financial were expecting increased volatility, and even a market decline, in the year to come, and suggested the volatility-linked products as a hedge for clients.
Many of the complaints focus on these firms' use of the Barclays iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX), which is meant to match short-term movements in the volatility of the S&P 500, and is most often used by active traders moving in and out of short-term positions. The rolling costs of the underlying options contracts make them unsuitable for longer-term holdings.
However, representatives at these firms were advising clients to invest in these products for a long-term time horizon, which posed a greater risk for reduced returns, according to the complaints. In the case of the volatility-linked products touted by representatives at American Portfolios, it was “not reasonable” to hold the product for an extended period of time, even as a hedge against a market downturn, the commission said. The value of the product tied to the index could begin to break down even in the course of a single day, and the long-term value of this product was zero, according to the complaint. The SEC argued that if an investor held such products as long-term investments, it was likely clients could lose their entire investment. These sales continued at the firms from 2016 through April 2020, according to the SEC.
“Investors using volatility related exchange-traded products incur a higher likelihood of loss of capital the longer the product is held,” said Todd Rosenbluth, head of ETF and mutual fund research at CFRA Research. “These securities are best used for short-term tactical purposes but unfortunately some people fail to understand the risks and own them for the longer term.”
According to the commission, the offering documents for each of these products specified that they were more suitable for short-term investments, with diminishing returns the longer they were held. But representatives at the firms didn’t understand the products, the SEC said, urging investors to hold them for months, and even for years, in some cases.
Additionally, the firms themselves also failed to put into place policies and procedures about the suitability of recommending volatility-linked products, according to the complaints. In the case of Securities America, the firm did not have any written policies or procedures specifically focused on volatility-linked exchange-traded products, even when the firm knew representatives were investing in those products for retail clients and holding them for longer periods. Additionally, procedures at the firm that did apply (including judging recommendations based upon clients’ risk tolerance) were not implemented, which “subjected retail advisory clients to significant risk” and led to sizable losses.
While none of the firms had to admit or deny the charges, all of them agreed to cease and desist from any future violations, and also agreed to a censure and to pay disgorgement and prejudgment interest. In addition, American Portfolios and Benjamin Edwards will both pay a civil penalty totaling $650,000 each, with Securities America and Summit Financial each agreeing to a $600,000 civil penalty, and Royal Alliance agreeing to pay a penalty of $500,000.