As financial advisers turn to complex products to help their clients navigate volatile markets and rising interest rates, regulators are scrutinizing the investments more closely than ever.
Advisers recommend complicated investments — such as inverse or leveraged exchange-traded funds, private securities, nontraded real estate investment trust, structured products, interval funds and some types of options, among others — to generate higher returns and provide downside protection.
Regulators are worried that neither investors nor advisers understand the risks they’re taking. The potential for harm is exacerbated because investors can access many complex products in a do-it-yourself manner in online accounts.
The dangers of complex products were recently illustrated when Blackstone’s $69 billion real estate fund for wealthy investors hit its redemption limit.
“Complex products tend to come with higher commissions and lower liquidity and they’re harder to understand. That’s really the reason for our concern,” said Andrew Hartnett, Iowa’s top securities regulator. “We want investors to get good, conflict-free advice that they understand.”
Hartnett is president of the North American Securities Administrators Association, which is reviewing its policy toward nontraded REITs. It also is probing whether Regulation Best Interest, the broker standard of conduct, is improving how brokers deal with complex products.
Other regulators also are taking a close look at difficult-to-explain investments. The Financial Industry Regulatory Authority Inc. earlier this year asked for public input on the oversight of complex products and options. The Securities and Exchange Commission is considering a rule regarding complex ETFs. In the last fiscal year, it conducted several major enforcement cases targeting complex products.
“As the products become funkier, they're harder to understand.”
Brynn Rail, partner, Ropes & Gray
Regulatory activity is spiking as complicated investments are becoming ubiquitous.
“A lot of these products that a few years ago were offered only to the most sophisticated clients have for a number of years been making their way into accounts of less sophisticated clients,” said Bill Reilly, associate director of Oyster Consulting and a former Florida securities regulator.
As they proliferate, complex products are becoming more intricate, which adds to their risk because they could move the opposite way of the market and produce counterintuitive payouts. Used the wrong way, they could amplify losses rather than protect against them.
“Brokers really need to understand the products that they are selling,” said Brynn Rail, a partner at Ropes & Gray. “As the products become funkier, they’re harder to understand.”
That puts increasing pressure on compliance staff to keep track of how the investments are sold and to whom. The risk-reward trade-off has to align with an investor’s risk appetite and objectives.
“When they find something close to the line, they have to dig into it,” Rail said.
The SEC’s complex product cases show that the regulator is zeroing in on firms’ policies and procedures that illuminate that risk and ensure that their reps and customers grasp it, said Dabney O’Riordan, a partner at Quinn Emanuel Urquhart & Sullivan.
“When the SEC or Finra examines them and asks them what [they] have been doing to educate [their] representatives about these products that they’re selling, they better be able to point to something,” said O’Riordan, who led the SEC Enforcement Division’s asset management unit for six years.
A good first move for brokers and investment advisers is to step back.
“Advisers should ask themselves: Is there a safer, cheaper product that could help their client achieve similar objectives without the increased risk, uncertainty and complexity?” said Carlo di Florio, global advisory leader at ACA Group and a former SEC and Finra official. “If there is, they should consider whether that may be a better alternative.”
“Complexity is the enemy. You need to have something simple and easy to understand.”
Charles Sachs, CIO, Kaufman Rossin Wealth
That’s what Paul Peeler, an adviser at Integrated Financial Group, is doing.
“I have gravitated toward using investments that can be explained in four sentences or less,” Peeler said. “More often, I lean toward the most simple and less costly way to meet client needs.”
Charles Sachs, chief investment officer at Kaufman Rossin Wealth, also keeps it straightforward.
“Complexity is the enemy,” Sachs said. “You need to have something simple and easy to understand.”
When a customer works with an adviser, there’s a built-in layer of protection that is supposed to be enhanced with Reg BI. The rule requires brokers to consider reasonably available alternatives that may be less risky and less expensive when making recommendations to retail clients.
It’s not clear the extent to which brokerages and registered representatives are adhering to Reg BI when it comes to complex products. The NASAA study so far suggests brokers are still making recommendations that are not in the best interests of their clients. Financial industry groups dispute the organization’s methodology in coming to that conclusion.
But brokers and investment advisers aren’t always the gatekeepers between investors and complex products and options. Investors can help themselves through online brokers, which is stoking regulators’ concerns.
Micah Hauptman, director of investor protection at the Consumer Federation of America, has been following social media sites such as YouTube, TikTok and Reddit. He’s found that there’s a lot of heated chatter about making money on complicated investments but little evidence that anyone is getting good advice.
“The way they’re talking about them suggests they don’t understand how these products work,” Hauptman said.
Brokers can’t just leave investors on their own, even in self-directed accounts.
“There should be heightened obligations for brokers to ensure that trading in these products is appropriate for their clients,” Hauptman said. “It’s appropriate that B-Ds provide a minimal layer of review.”
The financial industry is leery of the direction regulators might go in beefing up oversight of complex products, especially because there’s no agreement on what they are. Generally, a complex product combines an underlying traditional asset, such as a stock or index, with other products or strategies, such as derivatives, options or futures contracts, to produce an investment that often is uncorrelated to the market and produces counterintuitive payouts.
“The underlying concern that we have is that regulators need to be very clear about what they’re trying to accomplish and very clear in their definition,” Ken Bentsen Jr., CEO of the Securities Industry and Financial Markets Association, said at a Dec. 1 event. “Some of these proposals have been overly broad, in our view, [in] how they define a complex product that captures a lot of more traditional products.”
An SEC spokesperson declined to comment on its next steps. A Finra spokesperson said the regulator continues to review the more than 16,000 comments that have come in for a request whose deadline was May 9. It has not made a decision on whether to propose a rule.
Hartnett said NASAA is parsing comment letters on its nontraded REIT proposal. It’s unclear whether the group will propose a model rule. He stressed the goal is not to eradicate the investments.
“We’re not trying to say these are illegitimate products,” Hartnett said.
Finra is likely to take a measured approach.
“You can expect to see Finra be very thoughtful in reviewing those comments and coming back with potential rule proposals that are very tailored to address the risk that is new and different from what the existing rules already address,” di Florio said.
The word “complex” presents a challenge not just for advisers but also for regulators.
“It’s a very complex area to deal with in rule-making,” Bentsen said.
In the meantime, advisers should be able to show they have a handle on complex products if they put them in their clients’ portfolios.
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