Structured products still should be avoided by yield chasers

August 1, 2011

Regulators have finally gotten the message that structured products can be hazardous to your wealth .

Structured products are notes that promise a high yield and are linked to derivatives sold by a bank or broker. After I wrote a column based on a study I conducted for The Nation Institute on May 17 exposing the dangers of these vehicles, the SEC and industry regulator FINRA issued two warnings.

The SEC followed up with a sweeps probe of brokers selling these products and released the results July 27. The agency found evidence of unsuitable recommendations, omission of material facts and “questionable sales practices.”

Why are regulators finally telling you to stay away from retail structured products? They carry embedded risks and high costs that brokers and banks are not clearly disclosing to you. Since the sales commissions on these notes are high, many brokers are aggressively selling them.

The Georgia Secretary of State, for example, is probing the sale of reverse convertible notes, which are bets tied to underlying stocks. The state has subpoenaed UBS AG, Morgan Stanley and Ameriprise seeking information on product sales and customers. The companies have denied wrongdoing.

Watchdogs have reason to be concerned as structured products are now finding their way into variable annuities. The pitch is beguiling: Do you want market gains with downside protection? Sounds pretty sweet, doesn’t it?

A structured product will pair an options contract linked to a securities index or zero-coupon bond. Of course, it’s rarely disclosed in plain language how those options are priced or how much the note will cost you. While at first blush it sounds like a good deal, when you add up the commissions and internal costs, it’s usually a dubious investment in which you’re stuck for a few years. And you could lose principal, so nothing is guaranteed.

The one exception to structured notes is a structured certificate of deposit that is also linked to market indexes, but carries FDIC deposit insurance. In these products, your return of principal is guaranteed while your market exposure is limited.

Chasing yield has drawn investors into a number of other risky products. In its most recent investor warning, FINRA also cautioned against risky leveraged exchange-traded funds, high-yield and floating-rate bonds.

“With yields on many fixed-income investments at historically low levels and a volatile stock market, investors may be tempted to chase returns,” the regulator warned.

With yield-chasing often comes a blind eye towards risk. Every higher-yielding vehicle will expose you to greater market and credit risk and it may not be worth it. You may be dazzled by the high yields without reading the fine print. That’s why more than $54 billion in structured notes were sold last year and some $75 billion poured into high-yield bonds.

Here are some guidelines to keep in mind when considering these products:

Higher credit risk
Since high-yield or “junk” bonds carry lower ratings, they are much more likely to default. Don’t buy single bonds and find a large, responsibly managed mutual fund such as the Vanguard High-Yield Bond fund.

Higher volatility
Floating-rate funds, for example, invest in short-term bank loans. They can offer higher yield in rising-rate environments, but may move the other way when rates fall.

Leveraged returns
Some ETFs borrow money to enhance returns. You could lose money if your bet goes sour.

With all high-yield products, you always need to ask about total costs. How much are the commissions? What are the annual management expenses? What does it cost to buy options within the note? What are the other embedded expenses? Not everything is disclosed in a term sheet or prospectus.

There also may be conflicts of interest between the broker and the bank. Their compensation could be higher for selling you select notes, which many not be in your best interest.

Since disclosure and explanation of how these products achieve their returns is poor, you should consider vetting them through fiduciaries such as registered investment advisers or certified financial planners. And if you don’t understand how the product works — even after your financial adviser explains it — that’s the best reason to avoid it.

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