NASD Warns on Structured Products
If your advisory firm uses structured products (a.k.a. derivatives) in your non-institutional client accounts, you may want to heed the guidance issued in a recent NASD Notice to Members. The NASD issued the Notice after finding that broker-dealer firms are increasingly targeting structured products at retail investors. Many of those structured products are based on "blue-chip" and "household name" stocks that comprise the S&P 500 or the NASDAQ-100 indexes, said the NASD.
While the NASDís guidance, which was designed to help brokers fulfill their sales practice obligations to customers, is not binding on advisory firms that are not NASD members, it may be helpful to consider when using structured products in advisory accounts.
What is a structured product? Think of a structured product as a security whose value is tied to something else. The Notice defined structured products as "securities derived from or based on a single security, a basket of securities, an index, a commodity, a debt issuance and/or a foreign currency." Structured products come in a variety of flavors, explained the NASD: Some may offer principal protection, some may be listed on an exchange, and some may give the seller of the product a put option allowing it to sell the underlying reference security to the investor. But others may not.
Donít confuse the underlying security for the structured product. Just because a structured product is based on the S&P 500, it doesnít mean that the structured product is a blue chip investment. The NASD cautioned firms that they should not assume that if an investment in the "reference asset" is suitable for customers, then an investment in a structured product pertaining to such reference asset also must be suitable.
Treat Ďem as options, not debt. Donít be fooled by the fact that many structured products have a "note" component and pay interest: they arenít debt. "While structured products pay interest like debt securities, they often exhibit very different profit and loss potential," said the NASD. "The derivative component of structured products and the potential loss of the principal for many such products may make them unsuitable for investors seeking alternatives to debt securities,"
In fact, structured products smell a lot more like options, at least to the NASDís nose.
"The profit and loss potential of many structured products is more akin to an option contract," said the regulator, "particularly where the investor faces a loss of principal due to market movements in the reference security." In fact, suggested the NASD, "it may be an appropriate investor safeguard" to permit structured products to be purchased only in accounts approved for options trading, particularly where the investorís principal is at risk from market movements in the reference security. If a firm decides not to limit the purchase of those types of structured options, added the NASD, it "should develop other comparable procedures" so that structured products are only sold to customers for which the risk of principal is appropriate. Such firms "should be prepared to demonstrate the basis for allowing investors with accounts not approved for trading options to purchase structured products," said the NASD.
Comparison shop. The NASD warned firms about "reasonable basis suitability." Thatís a broker-dealerís obligation to make sure an investment is not a dog (i.e., the investment is suitable for at least some investors). An adviserís fiduciary duty of care gets you to the same place, and then some.
The NASDís advice in this regard: When determining whether a structured productís return is worth the risk, look at comparable structured products. If you line up products that have similar reference securities and similar volatility characteristics, but find that they offer materially different rates of return, itís a safe bet that the product with the lowest yield does not meet the reasonable basis suitability standard.
Or, put another way, that product with the materially lower yield might just be a dog.
In such instances, said the NASD, firms should use their "market expertise" to recognize that the lower yielding product "does not represent a reasonable rate of return given the attendant risks as compared to other similarly composed products or direct investments in the underlying components of such products with similar risk/reward attributes."