Risks of Structured Products Subject of SEC’s, FINRA’s Warning

Jack Humphrey, Regulatory journalist
June 03, 2011 /

The Securities and Exchange Commission’s Office of Investor Education and Advocacy and the Financial Industry Regulatory Authority (FINRA) have sought to educate investors about the risks associated with structured products and the way these complex financial products work.

Structured Notes with Principal Protection: Note the Terms of Your Investment was issued by the SEC and FINRA on the back of the risky retail market for these structured products that have grown in the past couple of years, notwithstanding their reassuring names.

“The recent bear market has left many investors worried more about securing the return of their investment dollars than about the return on their investments. Financial product providers have responded by marketing new types of mutual funds that pledge to guarantee, for a set period of time, that the capital you invest in the mutual fund will be kept safe for a price,” FINRA said in a statement.

It also includes a list of questions investors should ask before investing in these products.

The SEC explained that structured products with principal protection typically combine a zero-coupon bond – which pays no interest until the bond matures — with an option or other derivative product whose payoff is linked to an underlying asset, index or benchmark, which vary from commonly cited market benchmarks to currencies, commodities, and spreads between interest rates.

A certain change in the value of the underlying asset is available to an investor through an entitlement given to it to participate in a return linked to that change.

However, the SEC said investors must learn that the “upside exposure” to the underlying asset, index, or benchmark can be limited or capped, depending on the structure of the notes.

According to the SEC,investors who hold these products until maturity will typically get back at least some of their investment, even if the underlying asset, index or benchmark declines.

But the levels of protection for these products vary, with some guaranteeing as low as 10 percent. Moreover, any guarantee is only as good as the financial strength of the company that makes that promise.

“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.

“This alert is a ‘must read’ for investors considering these products, especially those with the mistaken belief that these investments offer complete downside protection.”

FINRA Senior Vice President for Investor Education John Gannon added that the potentially higher yields offered by structured products with principal protection do become “enticing” to investors with the current low interest rate environment.

“But retail investors should realize that chasing a higher yield by investing in these products could mean winding up with an expensive, risky, complex and illiquid investment,” he said.

Structured notes with principal protection can have complicated pay-out structures, making it hard to accurately assess their risk and potential for growth, FINRA and SEC advised investors.

Investors who consider these structured products were further told that they could tie up their principal for upwards of a decade, and possibly gain no profit from their in initial investment.


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