Wall Street is aggressively selling so-called structured notes as a “safe” way to earn increased returns without increased risk. The appeal of such a pitch is obvious in these times of low interest rates and stomach-churning stock market volatility. Structured notes are gaining in popularity. Retail sales of structured notes increased by 46% in 2010 to a record $49.4 billion, according to Bloomberg, and are expected to be up again sharply in 2011. But beware, says Fortune magazine contributor Janice Revell (“Beware of Wall Street’s latest ‘safe’ investment,” CNNMoney), there is increased risk and the increased returns are illusory.
The disconnect between the sales pitch and reality is so great that both the Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission have issued alerts warning potential investors about the cons of structured notes.
Structured notes are customized investments that essentially combine a zero-coupon bond with derivatives. Sellers claim that investors receive upside exposure to a risk asset such as stocks, commodities, or currencies (the “reference asset”), while keeping the relative safety of a bond held to maturity. But that is not quite right.
Most structured notes limit your upside to a level that can be drastically less than the market’s actual gains. In one example cited by FINRA, if the reference asset rises up to 40% over the life of the note, the investor gets the full 40%, but if the reference asset rises 41% or more, the return is slashed to 10%.
In addition, in many cases, the issuer can “call” the structured notes, thereby forcing investors to redeem them before the return gets too high. Any gains are subject to ordinary income tax rates, which can exceed 30%, rather than long-term capital gains rate of 15%.
The supposed downside protection can also disappear. Many notes only offer partial principal protection. If the market falls by more than the protected amount, the investor bears the loss. If the investor needs the money and has to cash out before maturity, the protection is canceled, and the investor will probably lose money, as there may be no secondary market for the notes. If the issuer goes bankrupt, as Lehman Brothers did, investors will be treated as an unsecured creditor and recover little, if anything, as holders of Lehman Brothers 100% Principal Protected Notes sold by UBS found out.
Fees are high, often at least 3% of the investment.
“I’ve never seen a cheap retail structured note,” Kent Smetters, a professor of risk management at the University of Pennsylvania’s Wharton School, was quoted as saying.
Perhaps the greatest downside is that selling firms have a poor record of telling investors and their own brokers the truth about the structured products they sell. Investors naturally rely on their brokers, as they are encourages to do, and their brokers rely on the sales slicks provided by management, and thus have no real understanding of the structured products they are selling. It is a recipe for disaster. FINRA issues “investor alerts” because its member firms refuse to explain the true risks of these investments. Maybe FINRA should impose a serious consequence for such misconduct instead of enabling it to continue by posting “alerts” that most investors never see.
Page Perry is an Atlanta-based law firm with over 125 years collective experience representing investors in securities-related litigation and arbitration. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 45 occasions. Page Perry’s attorneys have extensive experience in representing investors in cases involving principal protected notes, reverse convertibles and other structured products. For further information, please contact us.