• Investments: New Class

    By Jim Heitman, Instructor, Kaplan Professional and Continuing Education
    Published October 2014

    In the early 1990s, it was not at all uncommon to turn to your favorite music station and, after hearing some unfamiliar tunes, learn that they had changed their format to alternative rock. At about the same time, financial advisers began introducing their wealthy clients to alternative investments, now generally referred to as alts. These included, among other products, hedge funds, private equity, and new, highly sophisticated financial derivatives. 

    One thing that all of these alternative investments had in common was that they were quite difficult to understand, for both the investor and the person recommending the investment. While investing can be complex, standard investments are fairly easy to comprehend. Even neophyte investors understand that stocks have more risk but hold out the chance of superior returns, while bonds generally have less risk with correspondingly lower returns. The dream of investors is the miracle of high returns without the bad stuff (negative returns). 

    In an effort to give investors exactly what they want (a nice profit while minimizing negative results), the investment marketplace has created an impressive array of products that try to mimic the upside of equity investments (like stocks and real estate), while still providing some protection on the downside. Over the years, these cobbled together creations have become increasingly complex and unpredictable. For some time, securities industry regulators, and more recently the public, have realized that these alternative investments more closely resemble Frankenstein’s monster than a miracle.   

    As early as 2003, the Financial Industry Regulatory Authority (FINRA) cautioned the securities industry to uphold its obligation to thoroughly vet investments it planned to offer the public (a process called due diligence). Even as FINRA published more and more advisories on specific products, the industry continued to create and sell ever more complex investments to the public. The financial crises of 2008 revealed the weaknesses in many of these investment structures and proved to be an unpleasant surprise for investors, brokers, and regulators. FINRA concluded the industry needed a more comprehensive approach to the sale of these investments to the public.

    In January 2012, FINRA released Regulatory Notice 12-03: Heightened Supervision of Complex Products. Notice 12-03 provides the most comprehensive guidance to date on the approval and sale of complex investments. The Notice effectively created a new classification for investments, the “Complex Product.”

    FINRA regulatory notices regularly include background material to provide context for rules being introduced. Notice 12-03 is more than 20 percent background. The background section reminds the reader of a large number of existing rules regarding different products, as well as regulatory activity, both here (the SEC) and in several other countries on the issue.

    The breadth of investment notices covered in the background material reminds the industry that nothing here should be new; everything in the notice has been stated before, just not as clearly or comprehensively. At certain points, the tone sounds like an exasperated parent explaining that the prohibition against locking your little brother in the hall closet applies to all closets, trunks, suitcases, and other confined spaces wherever they may be. You can almost hear the regulators sigh as they say, “Do I really need to explain this?”

    One of the most important points in the regulatory notice is something that is not in it: a definition of what makes an investment product complex. Before launching into a discussion of what characteristics may make a product “complex,” FINRA states:  

    “Although this Notice provides guidance about the characteristics of many complex products, it does not define a ‘complex product’ or provide an exhaustive list of features that might render a product ‘complex.’ Moreover, some relatively simple products may also present significant risks to investors that warrant heightened scrutiny or supervision.”

    The Notice continues with a list of characteristics and includes specific examples of products with those characteristics. However, at the end of this list, FINRA writes, “The list above is not exhaustive.” It is clear that FINRA is not interested in issuing guidance just to have the industry develop products that are just different enough to avoid the category. FINRA does provide a general principal in identifying a complex product: 

    “Any product with multiple features that affect its investment returns differently under various scenarios is potentially complex. This is particularly true if it would be unreasonable to expect an average retail investor to discern the existence of these features and to understand the basic manner in which these features interact to produce an investment return.”

    Put simply, if an investment has multiple moving parts that would make it difficult for the average investor to understand how it works, it may be considered “complex.” FINRA gives us eight examples of investments that would be considered “complex” under the Notice and identifies those characteristics that cause complexity. 

    • Asset backed securities, particularly those that are composed of a pool (or pools) of debt, like mortgages, credit cards, and other consumer debt. Also mentioned are securities that represent interest in future royalty payments. Mortgage Backed Securities (GNMA, FNMA, FHLMC certificates) and Collateralized Mortgage and Debt Obligations are clear examples due to the difficulty in gaging the creditworthiness of the underlying borrowers and the impact of pre-payment risk. Unlisted REITs are also mentioned in this section because of the lack of liquidity and difficulty in valuing the investment for the average investor.  
    • Investments that include an embedded derivative component that may be difficult to understand, including exchange traded notes, “Steepener” Notes, Reverse Convertible Notes, and investments that have “knock-in” or “knock-out” provisions. 
    • Products with contingencies in gains or losses, particularly those that require multiple events like the simultaneous occurrence of conditions across different asset classes. Range Accrual Notes with multiple reference assets are identified as an example here. 
    • Structured Notes with “worst-of” features that tie performance to the worst performing reference index in a specified group. 
    • Investments whose returns are tied to an index or market that may not be well understood by the average investor. The example noted in the notice are investments based on the CBOE Volatility Index (VIX). Most investors do not understand the concept of volatility or how the VIX functions. 
    • Investments that feature principal protection that is conditional or partial like a Principal Protected Note. Even though the name says Principal Protected, few average investors will grasp that the protection can be reduced or even completely voided in certain circumstances. 
    • Inverse and Leveraged ETFs are noted as complex based on their tendency to perform in unexpected ways when held for extended periods. These investments have a daily “reset” feature that can lead to unexpected (and disappointing) returns when held for extended periods. It is unlikely that the average investor will have a firm understanding of the impact of the Volatility Loss Effect. 
    • Structured Notes with complex limits or formulas for the calculation of investor’s returns. Cap rates and Participation rates are mentioned elsewhere in the Notice, so it seems likely that at some point in the future, FINRA may classify Index Annuities that use cap and participation rates as “complex.” 

    FINRA closes the Notice by recommending that firms “err on the side of caution” when deciding if they should apply the higher expectations recommended in the Notice. As FINRA is a regulator, the guidelines laid out in Notice 12-03 apply to member firms and representatives, but there are some things the investor can learn from the Notice as well. Let’s take a look at all three.

    The Notice is aimed squarely at brokerage firms (also known as broker/dealers) that sell or offer to sell these investment products. As mentioned above, the Notice strongly cautions firms that they have an obligation to perform a reasonable due diligence investigation into a product before it allows its representatives to sell the investment to its customers. One of those determinations is that the investment be suitable for at least some of its customers. Before a firm includes a complex product on the approved list, it should answer a number of questions, including:

    • What are the investments objectives, and does the structure of the investment make it likely it will meet those objectives? 
    • Which customer is the investment appropriate for, and which customer should not be sold this investment? 
    • What are the risks? How will the investment perform in normal and extreme markets? 
    • How liquid is the investment? 
    • Does the product’s complexity impair understanding and transparency? 
    • Could less complex products achieve the same ends? 

    FINRA makes it clear that a brokerage firm and its representatives must understand how an investment works, and whom it will work for, before they place it on the approved list. A firm is said to have a “special relationship” with its customers and should take the necessary care before approving a product.

    In addition, FINRA suggests that its member firms establish an approval process for those customer accounts that seek to purchase complex products, similar to that used for derivative investments, such as options. Product-specific training should be put into place for representatives before they are allowed to recommend a complex product to the firm’s customers.

    FINRA also has a number of guidelines for the representative. Most of the recommendations are reminders to apply standard suitability expectations to the recommendation, but there are a few higher expectations for complex products. The first is that a rep should possess a “sophisticated understanding” of the investment. The representative needs to be able to explain the investment and its associated risks in a way that fortifies the customer’s understanding of the investment. A deeper and thorough understanding of the product’s investment characteristics would likely include how the payoff is structured and how the investment will perform in a variety of market environments.

    Representatives are cautioned that they may not rely on the product’s presence on the firm’s approved list, or account approval for complex products, to determine suitability. Suitability determinations need to be made on a case-by-case basis considering each customer’s objectives, circumstances, and sophistication. Representatives must take special care in recommending complex products to the average customer.

    Though FINRA notices are aimed at the securities industry (the SEC produces alerts aimed at investors), there is much for the investors to glean from Notice 12-03. First, no investment is without risk. If an investment appears to have no downside, something is missing. Furthermore, “complex” is an understatement for some investment products; arcane is a more colorful and accurate description. Investors should ask questions and try to develop an accurate and thorough understanding of what they can reasonably expect, as well as what can cause the investment to perform badly. No investment is perfect.

    Why has FINRA gone so far as to effectively create a new classification of securities for regulatory purposes?

    Complex investments are viewed by FINRA to fit the specific needs of certain sophisticated investors. Through the Notice, FINRA put member firms and their representatives “on notice.” The industry must take great care in recommending complex investments to all its customers, and particularly the average investor. It’s too easy to communicate a simple story and leave out the details needed to fully understand the rewards, as well as the risks, associated with complex investments. There are no magic tricks, sure things, or miracles in investing. Make sure you fully understand all the characteristics of a “complex product” before offering it to your customers.


    Jim Heitman is an instructor at Kaplan University School of Professional and Continuing Education. The views expressed in this article are solely those of the author and do not represent the view of Kaplan University.

    The contents of this article are presented for informational purposes only. Always check with a professional regarding any questions you may have regarding financial services.

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