Structured Products Pose Major Risks for Investors

 

Danger lies ahead for investors in structured products. Structured products were once used only by institutions and sophisticated investors that had the education, training and experience needed to fully understand these complex and opaque alternative investments.  Over the past several years, however, structured products have been sold to individual investors, who do not understand the risks and costs involved.

Structured products are hybrid securities packaged by investment banks that are based on derivatives, such as options, indexes, commodities or swaps.  The rationale for the derivatives is hedging risk and bolstering returns.  Some even claim to offer principal protection.  If structured products were so great, however, sellers would be buying, not selling.

What is often overlooked by advisers and investors is that structured products are overly costly, illiquid, not transparent in the way they are priced and operate, and are subject to credit risk, which means the promises and guarantees are only as good as the issuer who made them.  If the issuer goes bankrupt, as Lehman Brothers did, the guaranty of principal protection is no longer operative, as investors in Lehman-issued structured notes discovered. See What Every Investor Should Know About Structured Products.

Financial advisers cannot explain the risks and costs because, for the most part, they do not have the education, training and experience to fully understand the products themselves (“Advisers Gain Access to Complex Structured Products,” by Daisy Maxey, Wall Street Journal).  Sales are often driven by high commissions and fees that make them profitable for sellers.

$49.38 billion of structured products were sold in the U.S. in 2012 and $56 billion in 2011 according to StructuredRetailProducts.com.  There were 10,784 structured product offerings in 2012 compared with 9,679 in 2011.

Despite the problems, unexplained risks, and evident unsuitability, banks are increasingly pushing structured products to a wider client base by partnering with other banks and large brokerages.  Goldman Sachs, for example, is reportedly partnering with an online global alternative-investment exchange called CAIS to market its structured products to independent and registered investment advisers.  CAIS allows advisers to trade private alternative investments.

Another type of structured product, reverse convertible securities, are composed of short-term instruments linked to a “reference asset,” often a stock or basket of stocks with an embedded put option.  They pay higher yields but come with higher risk, including the very real risk of loss of principal.  If the reference asset trades below a certain level at maturity, the put options allows the issuer to “put” the reference asset to the investor instead of repaying principal.  In this way, conservative, income-oriented investors can get stuck in a deal in which they overpaid for a declining stock. See What Every Investor Should Know About Reverse Convertibles.

Investors should be aware that structured products have drawn regulatory scrutiny, and the Financial Industry Regulatory Authority is said to be looking into broker sales practices involving structured products.

Page Perry is an Atlanta-based law firm with over 150 years of collective experience maintaining integrity in the investment markets and protecting investor rights.