September 29, 2013 6:36 am

Chasing yield usually means chasing trouble

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Warning signs: Finra is concerned about excessive risk-taking

In today’s nearly zero-yield environment, investors who seek predictable income find it a problem meeting their goals. The Financial Industry Regulatory Authority (Finra) is concerned that some are turning to complex or alternative investments and taking risks they either do not understand or cannot afford.

These products present clear hazards for investors and require regulators to monitor market conditions and the sales practices of financial professionals.

A product might be considered complex if the average retail investor has a hard time understanding how its features will interact under different market conditions and how that interaction may affect potential risk and return. Complex products can include a security or investment strategy with novel, complicated or intricate derivative-like features or embedded leverage.

If investors do not fully understand the leverage and other risk and reward features of options, they should stop right there. A good general rule is never invest in products you do not understand.

Many investors have turned to structured products. Unlike corporate or government bonds, they typically involve unsecured debt and feature payouts linked underlying assets such as a narrow or proprietary index or some other obscure benchmark. These may be marketed to retail customers based on attractive initial yields, or a promise of some level of principal protection.

While some are fairly straightforward, others are often complex and have cash flow characteristics and risk-adjusted rates of return that are uncertain or hard to estimate. These products generally do not have an active secondary market, so investors must be willing to assume considerable liquidity risk.

Finra monitors the marketplace and has resources that provide early warnings to the public and the companies we regulate of the risks associated with complex or alternative investments.

Take inverse exchange traded funds (ETFs): these seek to deliver the opposite of the performance of the index or benchmark they track and are often marketed as a way to profit from, or at least hedge exposure to, downward moving markets. As early as June 2009, Finra notified securities companies that inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.

Just last year, we provided guidance to companies about the supervision of complex products in general, identifying characteristics that may render a product “complex” for purposes of determining whether it should be subject to heightened supervisory and compliance procedures. The notice provides examples of heightened procedures that may be appropriate. Similarly, investors seeking exposure to alternative investments might seek out alternative mutual funds. Finra recently warned investors considering such funds to make sure they fully understood the unique characteristics and risks of these investments.

Alternative funds might invest in assets such as global real estate, commodities, leveraged loans, start-up companies and unlisted securities that offer exposure beyond stocks, bonds and cash. These funds may employ complex strategies, including hedging and leveraging through derivatives and short selling that make it harder for some investors to understand the strategies and risks involved.

Alternative funds might make sense as a small part of an investor’s overall portfolio. They can offer protections that other vehicles for gaining exposure to alternatives such as hedge funds do not. Nevertheless, investors need to understand fully the alternative fund’s investment structure and strategy risk factors.

If your financial professional recommends you invest in these, or other, complex investments, ask a series of questions before you hand over your money, including:

● What are the direct and imputed costs? Complex investments can have embedded costs that might be difficult to discern and have significant impact on your ability to weigh the risks and rewards of the investment.

● What are the liquidity risks? Is there a secondary market for the investment in case you have to sell?

● What is the worst-case scenario? Do not just accept your adviser’s assumptions and recognise that your own worst assumptions may be too optimistic. Investors considering a structured product tied to an asset would do well to ask: what is the greatest volatility of the underlying asset in the past 50 years?

The key takeaway for investors is that reaching for a higher return almost always involves taking on more risk.

Investors must look beyond the number next to the percentage sign and realise, if they do not fully understand the risks and costs they are taking on, that chasing yield usually means chasing trouble.

Richard Ketchum is chairman and chief executive of the Financial Industry Regulatory Authority (Finra)

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