Equity-linked notes – a type of structured product – are securities issued by brokerage firms and traded in the secondary markets like shares of common stock. These investments offer part of the upside from owning stocks but limit nominal losses if held until maturity. Once sold only to sophisticated investors, structured products are increasingly being sold to unsophisticated retail investors. Equity-linked notes are difficult to evaluate and monitor, have high hidden costs and are illiquid. They are therefore virtually never suitable for unsophisticated investors.

Published in The Journal of Index Investing, Winter 2012, Vol. 3, No. 3, pp. 35-48.

Exchange-traded products (ETPs) linked to futures contracts on the CBOE S&P 500 Volatility Index (VIX) have grown in volume and assets under management in recent years, in part because of their perceived potential to hedge against stock market losses.

In this paper we study whether VIX-related ETPs can effectively hedge a portfolio of stocks. We find that while the VIX increases when large stock market losses occur, ETPs which track short term VIX futures indices are not effective hedges for stock portfolios because of the negative roll yield accumulated by such futures-based ETPs. ETPs which track medium term VIX futures indices suffer less from negative roll yield and thus appear somewhat better hedges for stock portfolios. Our findings cast doubt on the potential diversification benefit from holding ETPs linked to VIX futures contracts.

We also study the effectiveness of VIX ETPs in hedging Leveraged ETFs (LETFs) in which rebalancing effects lead to significant losses for buy-and-hold investors during periods of high volatility. We find that VIX futures ETPs are usually not effective hedges for LETFs.

Auction Rate Securities (ARS) were marketed by broker-dealers to investors, including individuals, corporations and charitable foundations as liquid, short-term, cash-equivalent investments similar to traditional commercial paper. ARS’s liquidity and similarity to short-term investments were entirely dependent on the presence of sufficient orders to buy outstanding ARS at periodic auctions in which they were bought and sold subject to a contractual ceiling on the interest rate the issuer would have to pay. If the demand for an ARS was too low to clear the market, broker dealers sponsoring the auction could place bids just below the maximum interest rate to clear the auction. The lower the public demand for an issue, the larger the quantity broker dealers had to buy to avoid a failed auction.

Participating broker dealers had better information than public investors about the creditworthiness of the ARS issuers and were the only parties with information about the broker dealers’ holdings and inclination to abandon their support of the auctions. This severe asymmetry of information made public investors in ARS vulnerable to the brokerage firms’ strategic behavior. In this paper, we explain what auction rate securities were, how they evolved, how their auctions worked, and why their flaws caused them to become illiquid securities.