SEC Warns That Retail Investors May Not Understand the Risks of Complex Investments

shutterstock_26269225On April 14, 2015, Luis Aguilar, Commissioner to the Securities and Exchange Commission (“SEC”), gave a speech before the North American Securities Administrators Association (“NASAA”), stating that the SEC is looking closely at sales practices with respect complex securities. “Complex securities” refers to securities that include complex features such as imbedded derivatives. Complex securities include, but are not limited to equity-indexed annuities, leveraged and inverse-leveraged exchange traded funds, reverse convertibles, alternative mutual funds, exchange traded products, and structured notes.

The speech cited a 2012 SEC study on investor financial literacy that found that retail investors, and particularly the elderly and minorities, lack basic financial literacy skills. When you combine a general lack of financial literacy with an investment product landscape that increasingly focuses on increasing the complexity of product offerings investors are more reliant on their advisers than ever.

Accordingly these investment products can be very opaque and complex for retail investors to fully appreciate the risks involved. It was also noted that in this environment yield-starved investors become easy prey for fraudulent schemes in complex securities.

Even more troubling is that complex securities have been increasingly marketed to retail investors in recent years. For instance, the total asset growth of ETPs rose to more than $2 trillion in March 2015 while retail investors hold an estimated 50% of ETP assets. In addition, alternative mutual funds, that is mutual funds that invest in complex securities, grew from about $76 billion in assets at the end of 2009 to over $311 billion in assets at the end of 2014 with the growth stemming from retail investment.

Another area the SEC noted significant concerns was in the area of structured notes. Structured notes contain characteristics of both bonds and derivatives, complex pay-off structure, and opaque pricing features that may not be easily understood or appropriate for mom-and-pop investors. Structured notes have become a $45 billion market where an estimated 99% of all purchasers of these products are retail investors.

Structured notes are typically issued by large financial institutions and offer returns that are linked to the performance of a reference asset or index. Basic notes typically have a fixed maturity that includes a bond component and an embedded derivative but what isn’t always made clear are the risks of these debt look-alikes. The risks of these products include the products’ complex payoff structures, market risk on the reference asset or index, high fees, a lack of a liquid secondary market, opaque pricing, credit risk, and complicated payoff structures. The combination of these facts make it extremely difficult to assess value, risk, and potential for growth of these products. Basically an investor would need complex computer model simulations to understand how these products would react under various market conditions.

The SEC cited a wide variety of structured notes that contain these types of risks such as principal protected notes, reverse convertible notes, enhanced participation or leveraged notes, and hybrid notes that combine multiple characteristics.

The SEC also cited issues with these investments through the last financial crisis an example of risks retail investors do not understand. When Lehman Brothers filed bankruptcy the firm had sold unsecured debt called “principal protected notes” that became worthless when the firm collapsed and investors lost billions of dollars as a result. While the securities were sold as “principal protected” they were really not “protected” by anything other than the creditworthiness of Lehman Brothers. The SEC stated these products have been referred to as “Trojan horses” that can destroy people’s life savings.

Investors who have suffered losses may be able recover their losses through securities arbitration. The attorneys at Gana LLP are experienced in representing investors in cases of unsuitable investments. Our consultations are free of charge and the firm is only compensated if you recover.