Understand Your Investments

This concept ought to be one of the very first rules investors (along with brokers and advisors) should commit to memory.

There was an article in the Wall Street Journal today (June 21, 2016) discussing how the “SEC Readies A Case Against…” a brokerage firm over Notes that lost 95% of their value.

In reading the article (subscription required) we learned these structured notes were created in 2010.  The notes offering raising approximately $150 million. These structured notes almost immediately began losing value. The brokers who sold the structured notes to their individual clients cried “foul” along with likely claims of product failure.

The firm issuing the notes, claims the notes performed as expected. The notes, originally offered in 2010 at $10/unit had a redemption value last fall (November 2015) of 50 cents. That seems shocking, doesn’t it? Why would folks invest in something which will ultimately expire worthless (or near-worthless)? The company claims these notes were created as a hedge.

If individuals invest in a hedge (for example, options – different from notes), the “hedge” is there for protection. Eventually the hedge then goes away. I do not mean any disrespect to anyone — but hedges can be complicated and often misunderstood.   If an investor (or broker, or advisor) cannot explain an investment to a fourth-grader, it’s too complicated.Understand Your Investments

Sometimes a hedge can be positioned or described as insurance against a potential drop in the price of another item in your portfolio. For example, if you own shares of stock which have appreciated in price, one way to hedge your investment (a potential way to protect your investment), is to purchase puts against the holding. If the stock drops, your hedge is there to help protect the gain you have built in the investment. However, if the original investment continues to hold it’s value, the puts (your insurance against a drop) will ultimately expire worthless. Like auto insurance, the premium paid (the cost of the hedge) gives coverage for a specified period of time, then expires.

Hedges, structured notes, equity-linked products can be complicated tools. Personally, I can’t help but think many of the retail brokers who offered this particular structured note to clients may not have fully understand them.  It’s important to know what could go wrong, or how these notes would (or could) behave. If the brokers do not fully understand an investment, how can they pass these opportunities along to investors?

In the comments section below the article, several posters shared the same feelings. Some even wondered if the quantitative analysts (“the quants”) who created the product had any real-world knowledge of how these notes may behave.

The main take-aways:

1. Understand Your Investments! If you cannot explain to a fourth-grader where your money in invested, you might want to reconsider where that money is parked.
2. While some in the industry object to a fiduciary standard, this case may wind up being a good example.   My opinion, all brokers and advisors should exercise great care to understand how specific investments work (and what could go wrong).  But all parties involved must also be certain they understand where the funds are invested, and what to expect from them.

Here’s a link to the article, but keep in mind a subscription is required:

Now Go Talk About It!