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Defective Securities Products
As we have learned in the last market cycle, some securities products (such asleveraged ETFs, CDOs, REITS, TICs CMOs, and MBSs) should never have been recommended or sold to most investors.
These products are generally designed for sophisticated investors whose investment strategies are significantly more complicated than that simply buy and hold strategy of the average investor. Such products are designed to address specific needs for large, sophisticated investment managers, day traders and other financial professionals. However, these products are very complex and typically have hidden risks. This means that products like these should rarely, if ever, be sold to average investors with more conservative needs or goals. Examples of such products are:
- Leveraged ETFs
These products are designed to trade like stocks but at multiples of their target index. In other words, a Triple-Leveraged ETF that follows the S&P 500 would be designed to return three times the return on an investment in the S&P 500 index itself, but also incur three times the loss if the S&P 500 went down. These products are designed to be day-traded, not held long term. Because of the way the products are structured and readjusted, long term investments in these products will only return a loss in the long-term.
These are too often sold without proper risk disclosures as ways to recoup losses or magnify gains. Unfortunately, these investments tend to neither, and instead just amplify losses.
- Non-Traded Private Placements
These are highly illiquid, oftentimes very speculative investments. This category includes Real Estate Investment Trusts (REITs) and Oil and Natural Gas Limited Partnerships. Once the investment is made, it can be very difficult for the investor to cash out of the investment without paying a large penalty or incurring a substantial loss.
Sold as safe, high income-generating investments, these appeal to conservative retirees who are living on a fixed income. However, the inherent risks and inability to freely sell are often hidden from investors until it is too late.
- Commodity Futures
For a knowledgeable, sophisticated investor, speculating on commodity prices can be a way to make substantial profits. However, for the average investor, making an informed decision can be nearly impossible. Commodities are a very unique category of investments. Even investors who have significant experience in stocks and bonds can be overwhelmed by the commodities market. The average, unsophisticated investor should not venture into these products.
Investors may believe that they are being safe by buying goods. However, what they are actually doing is speculating on the price of that good at some point in the future, which can be very risky.
- Tenant in Common Investments
Touted for the tax benefits and steady income stream they offer, TICs have become a booming industry. However, investors may not appreciate the risks that stem from them. The investor also has little control over the way the property is managed. These are long term, illiquid securities that cannot be easily sold and can lose much of their value.
Brokers may only highlight the benefits of a TIC without properly advising a client of the risks. Such investors can find themselves holding a losing investment that they are unable to sell.
- Collateralized Debt Obligations, Collateralized Mortgage Obligations, and Mortgage-Backed Securities
CDOs, CMOs, and MBSs are largely credited with causing the problems that led to the Great Recession of 2008. These investments were sold as safe, creditworthy products, despite being just the opposite. Companies bundle bad loans together with some good loans, and through creative accounting, were able to obtain good credit ratings for them. They then sold pieces of these “bundles” to investors, who eventually realized huge losses when the bad loans were defaulted on.
Like the other products on this list, these too were sold by brokers who minimized the risks and left their clients “holding the bag” when the investments failed.
We deal with product failure issues in mutual funds, preferred securities, notes bonds, annuities, hedge funds, private placements, REITs, TICs, CDOs, CMOs, MBSs, and other structured products. FINRA has stringent rules relating to how these products are sold:
- FINRA Issues New Investor Alert: Private Placements—Evaluate the Risks Before Placing Them in Your Portfolio
- Advertising New Products
- Selling New Products
- Understanding Structured Products
- Selling Reverse Convertible Notes
- FINRA Notice to Members Recommending Best Practices for Reviewing New Products
- Investor.gov / Investing Basics: What are Hedge Funds?
- Overconcentration of Structured Products in Retired Couple’s account