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Complex Investments that Even Financial Advisors Don't Understand

Posted by Jack Duval

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Feb 11, 2014 8:41:38 AM

This blog post continues our expert analysis of complex investments.

The difficulties in understanding investments for even highly intelligent and educated investors discussed in yesterday's blog post are not limited to retail customers.  Investments have become so complex that even industry insiders frequently don’t understand them either.

Exchange Traded Funds

An example of this exists with leveraged and inverse Exchange Traded Funds (“ETFs”).  The first ETF was introduced in 1990 and was based on the S&P 500 Stock Index.[1]  ETFs have had exponential growth in popularity over the years, with assets of roughly $1 billion in 1995 growing to $66 billion in 2000, $608 billion in 2007, and $1,048 billion in 2011.[2]  Furthermore, as of September 30, 2012, there were 3,297 different ETFs globally.[3]

The phenomenal asset growth of ETFs has been partially driven by their broad adoption by Registered Representatives and Investmernt Advisors (hereafter collectively referred to as "advisors").  This growth can be attributed to many factors, not least of which was the simplicity of the first generation of ETFs as  investment vehicles.  The first group of ETFs were relatively easy for industry professionals to understand.

However, when leveraged and inverse ETFs were introduced, the new products were generally misunderstood by advisors and subsequently misused in investor portfolios, resulting in many unnecessary losses and eventual litigation.

In response to the widespread misuse of leveraged and inverse ETFs, the Financial Industry Regulatory Authority, Inc. (“FINRA”) issued Regulatory Notice (“RN”) 09-31 in June 2009.  This RN stated:

… (these products) are highly complex financial instruments that are typically designed to achieve their stated objectives on a daily basis.  Due to the effects of compounding, their performance over longer periods of time can differ significantly from their stated daily objective.  Therefore, inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.[4]

Many advisors who were familiar with unleveraged, long-only, ETFs had bought and held the leveraged and inverse ETFs, under the mistaken belief that they were essentially the same as the traditional versions.  This assumption was wrong.  Whereas the traditional ETFs were appropriate for a buy and hold strategy, the leveraged and inverse ETFs were not meant to be held for longer than one day. 

They had not understood what they were selling and thousands of customers were damaged because of it.  For more in-depth coverage, see our white paper Leveraged and Inverse ETF:  Trojan Horses for Long-Term Investors.

Collateralized Mortgage Obligations ("CMOs")

As we have discussed here, brokers have been suing their own firms after having sold complex products that they didn't understand. Indeed, The New York Times recently reported, a Wedbush Securities broker sued his former employer over CMOs he sold to his clients.

On Sept. 25, Michael Farah, a former broker at Wedbush Securities, won a $4.3 million arbitration award from his former employer — including $1.4 million in punitive damages. Arbitrators for the Financial Industry Regulatory Authority, the industry-financed group that oversees such claims, took up his case in a nine-day proceeding.

Mr. Farah said in his statement of claim that he was “unaware of the true state of facts” about the ill-fated collateralized mortgage obligations, the mortgage-backed securities that are pooled and grouped by risk. He recommended such products after his firm endorsed them, but said that his business was hurt after his clients lost money on them. “A broker has the right to rely on what he’s told about an investment by the firm,” said his lawyer, Phil M. Aidikoff. Wedbush didn’t respond to requests for comment.  (Emphasis added)

Both ETFs and CMOs are investments commonly sold to retail customers.  If licensed industry professionals don't understand them, how can the customer understand them?

___________

The Accelerant roster of securities experts with complex investment backgrounds includes:

Steve Pomerantz, Ph.D.Tom Boczar, Esq., CFATom Brakke, CFAGerry Guild, CFA, and John Duval, Sr.

You can find the complete roster here.

Notes

[1]                 ETP Landscape Global Handbook 2012; Blackrock; 2012, 4; available at http://www.indexfunds.com.cn/userfiles/file/1358232962976.pdf; accessed July 26, 2013. 

[2]                 Visual Guide to ETFs; David J. Abner; Bloomberg Financial; Kindle Edition, 262.

[3]                 Id. at 534.

[4]                 FINRA Regulatory Notice 09-31, available at http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p118952.pdf, accessed June 3, 2013.

 

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