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Clients Get Burned When Brokers Sugarcoat Investment Risk

April 15, 2020 Blog
  • Brokerages sold retail investors billions of dollars of complex and risky volatility linked investments.
  • Volatility investments have been hit hard in the recent market turmoil.
  • Investors’ nest eggs have suffered huge losses.

Mom and pop retail investors need to examine the sales pitches many brokers made to them for high-yield investments and supposedly super safe, don’t worry about it, complex investment strategies.

In the decade since the 2008 credit crisis, brokers have sold such products as safe and low-risk, touting them as comparable to government bonds. In fact, they are the exact opposite.

For example, retail investors who were sold UBS ETRACS exchange-traded notes (ETNs) and the Yield Enhancement Strategy (YES) have suffered catastrophic losses. These products were pitched as, you guessed it, low-risk.

In mid-March, ETRACS were suddenly redeemed at rock bottom prices pursuant to a provision in the notes leaving investors holding the bag. The YES strategy, which this blog has written about in the past, has delivered 35% losses to investors.

Many brokerages have also sold their yield chasing clients billions of dollars of complex “volatility linked structured notes” and “trigger autocallable optimization securities” which are linked to the performance of underlying assets such as oil ETFs. If the underlying assets hit a preset level, investors are stuck with steep losses.

For example, Credit Suisse’s oil ETN VelocityShares Daily 3x Inverse Crude exchange-traded notes, or DWTIF, a once-popular product that amassed more than $1 billion in assets at its peak announced this month that  “as a result, the closing indicative value will be $0, which means current holders and future buyers won’t receive a payout at maturity, if the ETN is called or if they attempt to redeem.”

There is more, of course. “Because the Closing Indicative Value of the ETNs will be $0 on April 2, 2020, and on all future days, investors who buy the ETNs at any time at any price above $0 will likely suffer a complete loss of their investment,” according to Credit Suisse.

And the malaise is spreading overseas. South Korea’s $84 billion market for complex structured products is coming under strain as global stocks and commodities tumble, threatening to saddle securities firms with losses and worsen volatility in everything from local corporate bonds to offshore derivatives, according to a report last month by Bloomberg News.

Packaged by Korean and global financial firms and sold primarily to individual investors, the products are designed to deliver bond-like coupons with exposure to the upside in things like equities and crude oil.

But as markets sink around the world, it’s becoming increasingly complicated and expensive for the firms that stand behind the products to hedge their risks. Some are facing margin calls on their offshore derivatives positions and scrambling to sell assets — including Korean corporate bonds — to meet their obligations, according to Lee Hyo Seob, a research fellow at the Korea Capital Market Institute.

Securities industry rules, enforced by the Securities and Exchange Commission and the Financial Industry Regulatory Authority Inc., require that brokerages and investment advisors must make fair and balanced disclosures to clients. They also must refrain from discussing or implying any potential benefits without a clear and prominent discussion of the downside risk or other limitations.

For the past ten years, too many brokers have sugarcoated their investment pitches without disclosing the specific risks. As the COVID-19 crisis worsens, more investors will get burned.