By David Meyer
They're complex. Difficult to explain. Expensive. Risky. And are often
over-sold and accompanied by promises that go unfulfilled.
They are called
structured products and they have increasingly become the target of frequent warnings from
the Financial Industry Regulatory Authority (FINRA) and other industry
watchdogs, who are cautioning investors about the limitations and potential
problems of these complex products.
While not well known or understood by many investors, structured products
are based on financial engineering and comprise a $45-billion-a-year industry.
The end result is an array of exotic
derivatives based on complex options strategies whose payoffs often depend on a very
specific set of market, index and/or price-related circumstances in order
to produce any profits for investors.
These products often are based on underlying price moves in stocks, mortgages,
commodities, foreign currencies, equity indices, or interest-rate spreads.
Investors are often attracted to these products because they are sold
with some "guarantee" feature or promises of great gains, but
in reality, they are designed to have limited upside potential.
Unfortunately, too many investors have discovered these limitations long
after they have purchased the products.
Structured products are offered by some of the largest names in the brokerage
and banking industries—such as Credit Suisse, UBS, Morgan Stanley,
Smith Barney—and go under the names of "structured notes,"
"principal-protected notes," "reverse convertibles,"
"exchange-traded notes" (ETNs), or "convertible notes."
Many structured products can trace their origins to ETNs that were introduced
in the U.S. in 2006, when the Securities and Exchange Commission (SEC)
permitted Barclays to sell two simple securities. This opened the floodgates
to many new ETNs. Soon, there were about 200 ETN-type securities that
relied on leverage, short-selling, and other complex options strategies.
In many cases, these products, which were originally designed for very
large institutional portfolios, are being sold to individuals without
adequate explanations about the products' illiquidity, fees, and lock-up periods.
Worse, these products are often sold by brokers and financial planners
who have not been properly trained in the key facets of these complex
products, including factors that drive their prices and volatility, according
to an examination of FINRA and SEC enforcement documents.
Consider these specific examples of the limitations of structured products
and their associated compliance problems:
- FINRA warned investors in July 2012 that an ETN's indicative price,
which is calculated by the issuer, could differ, "sometimes significantly,"
from the market value. FINRA issued that notice after Credit Suisse Group
stopped selling shares in an ETN tied to the Chicago Board Options Exchange
Volatility Index, or VIX. That note (ticker symbol: TVIX) traded at a
premium of as much as 89% before losing more than 50% of its value over
a two-day period in March 2012.
- In April 2011, FINRA fined UBS $2.5 million for unsupervised sales practices
regarding its structured products. This was after UBS sold $1 billion
in structured products.
- Investors bought Lehman Brothers–issued structured products created
by UBS, but they later discovered that their principal in these principal-protected
structured products was not protected at all.
- Convertible notes sold by brokerages such as Merrill Lynch, Morgan Stanley,
and Smith Barney were bought as a way to earn income, but overnight they
were "converted" into depreciated stocks, causing significant
losses to investors.
What to avoid
While FINRA and other watchdogs continue to issue warning letters and other
cautionary notices, individual investors should be skeptical of any exotic,
complex investment products that has a "guaranteed" feature
or that they don't really understand.
Here are steps investors need to take when considering structured products:
- Know who is issuing and managing the investment and ask your broker to
fully explain all the details.
- Examine the accompanying structured-product prospectus to determine the
design of the investment and what market and price factors affect its
pay-out conditions. Find out the specific upside potential and whether
the product has ever delivered on its promises. Demand documentation.
Understanding the fees, expenses and lock-up periods is also critical.
- Finally, if you cannot comfortably explain to your family and neighbors
how this product works and what its limitations are, it is not for you.
Have you lost money on structured products?
If you have suffered losses by buying structured products you didn't
understand, you may have legal recourse. The team of investment fraud
attorneys at Meyer Wilson has won verdicts, arbitration awards, and settlements
of hundreds of millions of dollars for investors across the country. All
of the firm's cases are handled on a contingency fee and no retainer