Be Careful About Getting Lulled Into Structured Mess
June 12, 2011 (Chicago Tribune) It's like taking candy from a baby, with sweet words like "guaranteed," "protected" and "secure."
Starved for interest income, individuals are ready to devour just about anything their broker or financial adviser tells them is "guaranteed" or "protected" and will pay better interest than a CD or bond.
The trouble is many conservative investors are being lulled by such words when the terms actually mean just the opposite.
The risks are so great that the Securities and Exchange Commission issued an alert to individuals this month to beware of "reassuring names" attached to investments known as structured notes. You should see red flags waving if you see "principal protection," "capital guarantee," "absolute return" or "minimum return," because "they are not risk-free," said the SEC.
The word "structured," which your broker may never use, actually will tell you more than the comfy language. "Structured" typically means a product was created by a financial firm using derivatives, and the products are often so complex your broker won't understand how they work for or against you.
"Structured notes with principal protection contain risks that may surprise many investors and can have payout structures that are difficult to understand," said Lori Schock, director of the SEC's Office of Investor Education and Advocacy.
She noted that investors often have "the mistaken belief that these investments offer complete downside protection." So-called guarantees can be tied to how an underlying asset performs. It could be currencies, commodities or interest rates, for example.
But while the investor may imagine a broad guarantee, the actual guarantee might pertain to only 10 percent of your money, and the upside is often far less than it appears. For example, an investor is told he or she can receive a full gain if an underlying index rises 40 percent, but the investor may not realize that if it rises more, the gain is muted.
Further, the investor may have to hold the note for as long as 10 years, leaving little wiggle room if it performs badly or if the investor needs to use his or her money.
It's also critical to realize that a structured note is created by a firm that could have financial troubles of its own at some point. Think, for example, of Lehman Brothers, the once-mighty firm that collapsed in the financial crisis. If the firm behind your note fails, the SEC is warning, you could be left with nothing.
This is very different than a CD, which comes from a bank with Federal Deposit Insurance Corp. protection up to $250,000. And it's different than a U.S. Treasury bond, backed entirely by the U.S. government.
In a report issued recently by Demos, a think tank, author John Wasik estimated that banks and brokers sold more than $52 billion of structured products last year, and that individuals have lost at least $113 million in them. Top providers are Morgan Stanley, Bank of America, Barclays, JPMorgan and Goldman Sachs, the report said. The report called on regulators to do more to protect seniors, often easy targets because brokers and other advisers suggest the notes carry protection.
Among Demos' recommendations are that the SEC and Congress require:
FINRA also warned individuals that structured products are not risk-free and told financial firms they "must ensure that their promotional materials or communications to the public regarding these products are fair and balanced."
Individuals should never buy anything too complicated to understand, and they can safeguard themselves by asking advisers to show them in dollars and cents the worst-case and best-case scenarios for any product recommended. Expect to see the full calculation and know how it's done.