Most people don't even know what complex securities are, much less invest in them. If you are in that category, you may be in a better position than those that do.
Complex securities are often sold rather than purchased, meaning that the sales pitch can make a profound difference in whether the product is bought or not. For readers presented with this “opportunity,” there often is more to the story than is initially apparent. This article covers some of the most common complex securities for which the Securities and Exchange Commission has issued an investor alert. This, in itself, should give a potential buyer pause.
Most people don’t even know what complex securities are, much less invest in them. If you are in that category, you may be in a better position than those that do. The reason? Each is opaque, intricate, and often carries potentially hidden risk. This means these products have to be considered very carefully if an enthusiastic salesperson comes your way. The below are particularly high risk.
Equity-indexed annuities: A combination of a fixed and a variable annuity. It appears that an investor could have the best of both worlds—a guaranteed minimum return (fixed annuity) with some potential for a higher return (variable annuity).
Leveraged and inverse exchange-traded funds: A leveraged exchange-traded fund is a financial derivative that uses debt to enhance the return of an underlying index. Derivations are stocks, bonds, commodities, currencies, interest rates, and market indexes characterized by high leverage. So, if the index goes up, the return is higher than the index because it is leveraged due to debt.
An inverse exchange-traded fund also uses derivatives, but to profit from a drop in its underlying index. So, if the market drops, the return would be greater than a short, which does not use leverage. “Short selling” is betting that a security will decline in value.
While the return can be large for these 2 specialized exchange-traded funds, the loss can also be substantial. For example,
Reverse convertible bond: This is a bond that contains an embedded derivative that allows the issuer to force the bondholder to relinquish it prior to the bond's maturity. The hitch is that the bond can be for existing debt or shares of an underlying company that need not be related in any way to the issuer's business (from Investopedia). For this, the investor may receive a rich yield of up to 15-20% yield.
Alternative mutual funds: These are hedged mutual funds. They use leverage, derivatives and short selling in an attempt to outperform the market. Leverage is a way to enhance gains or losses using debt. As a reminder, derivatives are stocks, bonds, commodities, currencies, interest rates and market indexes characterized by high leverage. Short selling is betting that a security will decline in value.
Clearly, these methods are not those used by traditional long mutual funds that invest in public equites and bonds in a buy and hold strategy.
Structured note: A structured note is so complicated that it is hard to explain, much less understand. Essentially, it is a hybrid that combines income from ordinary securities, such as a bond, plus a derivative, such as an option. The upside to an investor is that structured notes theoretically can further diversify a portfolio by adding a variant asset class.