Eight products on FINRA examiners’ watch lists in 2015

January 30, 2015

The Financial Industry Regulatory Authority’s 2015 exam priorities letter named eight products that it plans to monitor for risks to investors.

FINRA said shoddy disclosure about the products has made investors vulnerable to major losses when conditions in the market change. 

“While firms have improved new-product review processes, the sales of novel products and services remain a regulatory flashpoint,” FINRA said.

J. Bradley Bennett, executive vice president of enforcement at FINRA, recently said brokers should learn how their products perform and the risks they pose to investors.

Here is a quick rundown of the products that are on FINRA’s watchlist:

Variable annuities: Variable annuities offer investment features that are similar to mutual funds. While variable annuities can make good investments, FINRA is concerned that some are too complex for investors to understand.

FINRA wants firms to tighten up the sales practices around the products. It will look at how brokers are paid when they sell the products and the suitability of the recommendations that brokers make.

Alternative mutual funds: These products are marketed as a way for investors to invest in a mutual funds using hedge fund-like strategies.

Although alternative mutual funds claim to reduce volatility and produce higher returns, there are different variations of the products. FINRA wants firms to be clear in explaining to clients how the products work and how they react to negative market conditions.

Sales of alternative mutual funds have grown from $50 billion at the end of 2008 to an estimated $300 billion by November 2014.

Non-traded Real Estate Investment Trusts (REITs): A REIT can be a corporation, trust or association that owns or manages income-producing property. Some REITS trade on exchanges and others do not. In the 2013 exam priorities letter, FINRA cited the poor liquidity in non-traded REITs and the difficulty of valuing them.

FINRA wants firms to know the risks when their brokers recommend non traded REITs to their clients. It wants firms to conduct regular background checks on REITs that their brokers recommend or stop selling the products. For more on REITs, see Regulatory Notice 15-02.

Exchange Traded Products that track alternatively Weighted Indices: Exchange traded products are tied to stocks, commodities, and indices. Investors in these products get a return linked to a market index like the Standard & Poor’s 500 index.

In recent years, demand has grown for exchange traded products that use alternative weighting strategies. FINRA is concerned that firms are emphasizing the superior returns in these products over products that track traditional indices. It is also worried that the stocks that make up alternative indices may be too thinly traded.

Structured retail products: These are unsecured debt instruments with payoffs that are linked to their underlying assets. They attract investors because they can offer higher returns but they are also thinly traded, incur high costs, and have market risk.

FINRA has warned about structured products in various investor alerts. Bennett has said brokers should understand structured products, know how they perform and understand the risks. FINRA expects wholesalers have detailed know-your-product policies. It has asked the firms to ensure that their distributors have adequate controls in place.

Floating rate bank loan funds: These funds typically invest in floating rate bank loans. Although they are mainly used by institutional investors, they can affect retail investors that are exposed to them through mutual funds. FINRA is worried that the funds investing in the loans could face liquidity challenges if a large number of a fund’s investors try to make redemption requests at the same time.

Securities-backed line of credit: These revolving loans allow investors to borrow money from banks using the securities that they hold as collateral in their brokerage accounts. FINRA wants firms to have procedures in place that allows them to interact with the lender so that it can monitor the customer’s account. It also wants firms to keep adequate records and to make sure that their customers are promptly informed when the value of their collateral falls.

Interest rate-sensitive fixed income securities: In its 2014 exam priorities letter, FINRA warned about the risk to investors that hold interest rate sensitive products. FINRA’s position on the products is the same in 2015. It wants firms to discuss the impact of rate changes on the price of the products when they communicate with their clients. In the coming year, examiners will focus on concentrated positions in interest rate sensitive products such as high yield bonds and mortgage backed securities. FINRA will also examine the training that firms have in place to educate their brokers about the products.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)

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