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 is necessary.