The Riskiest Financial Products for the Average Investor
The United States Securities and Exchange Commission (SEC) has launched a new public investor watchdog to look out for the interests of mom and pop investors around the country.
The new SEC Office of the Investor Advocate has recently published a list of the most complex financial instruments and industry practices which put average investors at risk in the past year. The report focuses on the year 2014 and is one of two reports the office is expected to publish every year.
Their list includes the industry practice of reverse churning. While most traders and investors are aware of the practice of churning employed by some brokers to bolster their commissions by recommending excessive trading in the account of their client, reverse churning refers to the placement of brokerage accounts into fee-based structures to generate income from traders who either trade less frequently or not at all. The practice has been condemned by the SEC.
The office has said that new rules and infrastructure are not needed to tackle the unethical practice of reverse churning. Rather, they say that improved enforcement actions going forward should be adequate to deter it.
The complexities involved in variable annuities was also mentioned as an issue for investors. The products are basically insurance contracts where the insurance company promises a set amount at the end of the accumulation phase or invests money within the product. The primary concern was the complex fee structures involved in such annuities offered to investors.
As opposed to a public stock offering like Alibaba, private placements, where companies place a set amount of shares with high net worth individuals privately, have also been a cause for concern for retail investors due to the lack of information and access mom and pop investors would have in these deals. The office has described the practice as “illiquid” and “lacking transparency.”
Binary options were also highlighted by the report from the SEC’s Office of the Investor Advocate. While investors are familiar with plain vanilla options which tend to have a broad spectrum of payoffs, a binary option has either one of two possible outcomes – either the investor is paid a set amount of an underlying asset at the expiration of the option or is paid nothing.
Another financial product which has proved bedeviling for investors is an unlisted Real Estate Investment Trust or REIT. A REIT basically invests in real estate and is traded on an exchange as a normal stock. But when the REITs are unlisted the costs for regular investors is increased substantially, which was the primary concern for the office and the shares are not as liquid.
The SEC Office of the Investor Advocate was set up to uncover the potential risks faced by investors and attempt to change the system to protect them. It was set up under a directive by the Dodd-Frank Wall Street reform law from the year 2010.
They are expected to publish two reports annually which point out how new rules are affecting investors, what can be done to improve communication of problems between investors and the SEC, and how rules must be modified to better protect them.