News Analysis date published New: 
Thursday, September 13, 2012 - 08:30
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Thursday, September 20, 2012 - 11:49
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Thursday, September 13, 2012 - 08:30

Avoid This Investment at All Costs

Thursday, September 13, 2012 8:30 AM

Wall Street is infamous for investment scams and shady deals.

The market got a big taste of that in 2008, after Bernie Madoff was busted for running a $50 billion Ponzi scheme. Soon after, fellow billionaire financier Alan Sanford was also convicted of defrauding investors and is currently serving 110 years for running a Ponzi scheme of his own.

But it's not just blatantly illegal behavior on the Street that poses a threat to investors. There is a big difference between illegal and unethical, and there are plenty of legal but shady strategies Wall Street uses to fleece unsuspecting investors.

Take the Facebook Inc. (Nasdaq: FB) IPO for example. Most analysts had the stock rated as a "buy" going into the IPO.

That fueled liquidity from individual investors, generating waves of enthusiasm. But six months down the line, long after the insiders have cashed out with big gains, Facebook shares are down 50% and individual investors are sitting on big losses. The same thing happened with Groupon Inc. (Nasdaq: GRPN) and Zynga Inc. (Nasdaq: ZNGA), with prices crashing lower post-IPO in spite of glowing reviews from analysts. The only people who made any money on those stocks were privileged insiders with priority access.

Was that illegal? Of course not. But it definitely casts a shadow of doubt about whose priorities are being served in the hierarchy of the banking structure.

Since the financial crisis of 2008, this fundamentally flawed relationship between Wall Street and its customers has increasingly come to surface. Earlier this year, an outgoing executive at leading investment bank Goldman Sachs (NYSE: GS) leaked a memo leak calling its retail clients "muppets" and mocking them as an easy source of liquidity and fees.

I'm not saying all of this to scare you away from investing in the stock market. On the contrary, despite these scandals, the stock market stands out as one of the single greatest avenues of wealth creation in the history of civilization. But as you can see, in the ruthless world of Wall Street, it pays to stay informed. That is why I want to send out a warning shot on what I consider to be the most dangerous financial instrument in the market.

Anyone who owns shares of this investment needs to sell immediately. If you don't, then you're almost guaranteed to lose all your money.

In fact, its own prospectus acknowledges that its share price will eventually decline to $0. And that's exactly what has been playing out on the chart this year, with shares down an eye-popping 94%.

The instrument in question is the VelocityShares Daily 2X ST ETN (Nasdaq: TVIX), an exchange-traded-fund (ETF) that returns twice the daily performance of the S&P 500 VIX short-term futures contract, which is a key measure of stock market volatility. But while this ETF may appear like an attractive hedge against volatility at first glance, the reality is turning out to be much different. In spite of the VIX falling just 28% on the year, TVIX is down 94%, a sharp underperformance that speaks of serious tracking errors, regardless of its double leverage.

But the reality is that this is exactly how this product was designed.

There are two main reasons for the sharp underperformance and why VelocityShares is systematically exposed to downward pressure.

The first is due to something called volatility decay. Like many other leveraged instruments, TVIX is designed only to accurately track daily moves and resets its leverage at the end of every session. In a bull market, those compounding returns can lead to big gains. But in a bear market, they can be devastating, as losses are amplified on top of each other. Daily losses compounding over and over again in a bear market is a quick path to insolvency.

The second factor applying systematic downward pressure on TVIX is its exposure to "contango," a market condition in which futures contracts trade above the expected spot price of contract maturity. These futures contracts have a fairly short life, usually from one to three months. But if the market has bullish expectations, then those new front-month contracts will trade at a premium to expiring months, forcing fund managers to pay a premium and essentially increase their cost basis. Those higher levels of trading activity required to stay current with front-month futures contracts also leads to higher trading volumes and fees, something that shows up in TVIX's expense ratio of 1.7%, well above the category average of 1.1%.

Action to Take --> This fund should be banned from the market. Although shares still trade, there is a class action lawsuit over sharp losses from earlier in the year.

Avoid using this leveraged ETF if you are looking to hedge your portfolio or speculate. There are many other instruments that are much more effective to help protect your portfolio from weakness.

Michael Vodicka does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.