Urged by regulators to improve their practices with regard to complex financial products, brokerage firms and mutual fund companies must listen.
The
Financial Industry Regulatory Authority Inc. has found that brokers often can't explain the sophisticated products they are selling to clients, meaning the brokers don't have a clear understanding of how they work and what role they can play in a portfolio.
That's unacceptable and could lead to another scandal that would damage the reputation not only of the firms pushing such products, but that of a brokerage industry that's just now recovering from the subprime mortgage disaster.
In addition, brokers who sell products they do not fully understand cannot meet the suitability test, that is, assuring that the products they sell to investors are suitable for those investors. If you don't understand the product, how can you know that it fits your clients' needs and fits within their portfolios?
LACK OF KNOWLEDGE
State regulators have noticed the lack of broker knowledge of complex products as well, which suggests it's a widespread problem.
The Securities and Exchange Commission also is paying attention to the surging use of alternative strategies in the portfolios of less sophisticated investors.
SEC officials are concerned that the disclosures given to investors might not accurately represent the strategies used in the mutual funds being sold. Incomplete or obsolete disclosures not only expose investors to a mismatch between investment strategy and desired risk profile, but also exposes advisers to failing the suitability test.
Alternative investment funds are mutual funds or exchange-traded funds designed to give less sophisticated individual in-vestors access to investment strategies outside of the typical long stock, bond and cash portfolios and sometimes involve the use of derivatives. They typically are designed with low correlation to the broader markets and are used to provide greater diversification.
Alternative mutual funds are one of the fastest-growing segments of the investment markets and at the end of September, more than 400 such funds held assets of $282 billion, thus triggering regulators' concerns that investors might not understand what they are investing in, and that the strategies they think they are buying may not be the strategies actually used.
Brokers and mutual fund companies must heed the gentle warnings being given to them by Finra and the SEC. Failure to heed these nudges toward improvement could lead to additional regulation in the future, and additional regulation is the last thing the financial services industry should want after Dodd-Frank.
Brokerage firms must step up their training to ensure that all brokers selling alternative funds fully understand the products, where they fit on the spectrum of investments, and how they work within different client portfolios.
They should be aware that Finra's proposed Comprehensive Automated Risk Data System, known as CARDS, which almost certainly will be implemented in some form in the near future despite industry resistance, likely will provide the regulator with evidence of where alternatives funds are being sold inappropriately.
Likewise, mutual fund and other companies sponsoring such funds must further refine their disclosures of the strategies used by the various funds, and they must continually update those disclosures whenever a fund modifies its strategy.
The time to implement these changes is now, not after some scandal has pushed the regulators to mandate such actions.
