High Yield: FINRA Cautions Investors Against Excessive Risk Taking

Attorney Advising Disclaimer

FINRA chairman and chief executive Richard Ketchum is worried about risk—specifically, that investors might be incurring too much of it.

Referring to aculture not satisfied by low-yield income options, Ketchum voices concern that in their zeal to chase after high yield and return levels, some investors are opening themselves up to unnecessary and potentially dangerous risk.

For instance, Ketchum points out that complex, alternative investments may often advertise high rates of return, but often carry heightened underlying risks. Many of these risky investments are found in structured products, the financial alchemy of blending stock options and debt securities.

In January, the industry saw just how risky and devastating one of these products can be.

When one specific complex structured bond instrument known as a reverse convertible or "revcon" was sold in 2012, it was tied to Apple stock (AAPL). At the time, Apple stock was valued at over $700 per share. Marketed as a safe and secure investment, the reverse convertible consisted of a promissory note issued by an unrelated company and a stock option based on Apple stock. The product was designed to be purchased like a bond, the promissory note would pay interest to the investor, but if Apple stock fell below a certain price, instead of receiving a return of principal, at the time of the reverse convertible's maturity the investor would have Apple stock put to him at a greatly depressed price.

Unfortunately, Apple shares fell by over $250 to just $439.88 by January 25, resulting in significant losses to investors in the Apple-tied revcon.

Exchange traded funds (ETFs) are another complex product that has historically been the periodic source of headache and financial trouble.

ETF range from simple baskets of stocks to the more esoteric versions. Some versions are so archane because they are tied to performance of a stock, index or benchmark, or sometimes the opposite performance of the same, are often leveraged to provide two or three times the result of the underlying index, and have their prices reset daily. As a result, an average investor ends up playing with dynamite, often holding the product for far longer than the one day limit recommeded by the issues.

Because of the ETF's complexity, the products may be improperly sold to unsuitable investors or sold by firms or brokers who fail to fully understand the products before marketing them to customers.

Massachusetts last year filed suit against LPL Financial for improper and unsuitable sales of non-traded real estate investment trusts (REITs), generating $1.8 million in commission, due to the bulk of sales. For instance, state regulators found that 569 of 597, or nearly 50% of firm transactions violated investor prospectus requirements. 77 additionally violated state concentration requirements.

The most egregious—yet most appetizing—of the advertised fast money investments are the high-yield investment programs (HYIPs), which FINRA notes "are hazardous to your investment portfolio."

In its Investor Alert, FINRA cautions that because HYIPs are unregistered investments created and sold by unlicensed individuals, they are highly likely to be associated with fraud with FINRA concluding that "virtually every HYIP we have seen bears hallmarks of fraud."

Though while HYIPs are gobbled up by investors in an extreme case of high yield thirst, Ketchum advises conducting due diligence before taking on a complex, alternative or high risk investment vehicle:

Ask your broker about costs and benefits, liquidity risks, volatility and the worst-case scenarios. Ask your broker whether he or she read the prospectus, or private placement memoranda (PPMs), and do not be afraid to ask for the documents the brokerage firm used to determine the investment was reasonably suitable to be sold. Lastly, do not be afraid to ask how much commission the broker will earn on the transaction.

Asking the tough questions, the questions good brokers want to hear and bad brokers hate to answer, can reveal more about the risk of a product than any sales pitch will provde.

News: Chasing yield usually means chasing trouble (The Financial Times)