The Plundering of Investors is Endless

Here is how to avoid becoming a victim of the securities industry.

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How is this for a New Year’s resolution: I will not be a victim of the securities industry in 2012?

I know it seems like a modest goal, but millions of Americans don’t attain it every year. Here’s an example of a slick practice with the potential for devastating consequences:

On December 15, 2011, the Financial Industry Regulatory Authority (FINRA) announced that it fined Wells Fargo Investments $2 million relating to unsuitable sales of reverse convertible securities to 21 customers, most of whom were over 80 years old. FINRA found that Wells Fargo failed to review these transactions to determine if they were suitable, among other transgressions.

The registered representative involved in these trades, Alfred Chi Chen (who is no longer with Wells Fargo) is the subject of a separate FINRA complaint. Chen is alleged to have not only sold unsuitable reverse convertibles, but also to have made “unauthorized trades in several customer accounts, including accounts of deceased customers.” If true, this is a new level of depravity.

[See The 10 Best Places to Retire in 2012.]

Of the 172 accounts handled by Chen which had reverse convertibles in them, 148 had concentrations greater than 50 percent of their total account holdings. Some 49 of these accounts had concentrations greater than 90 percent.

Reverse convertibles are structured products, which is the first red flag. They typically consist of a high-yield, short-term note that is often linked to the performance of a single stock or a basket of stocks. Investors are lured by the high yield and are blinded to the risks, which are rarely disclosed or understood. Owners of these notes don’t benefit from the appreciation of the underlying asset.

The issuer of these notes hopes the price of the underlying asset will fall. If it does, it can return your principal by paying you in depreciated stock. If the asset retains its value, you will receive the higher yield and the return of your principal in cash at the end of the term of the investment (typically three months to one year).

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Contrary to what many investors believe, reverse convertibles are not a free lunch. In exchange for a higher coupon rate, you will receive an investment tied to the performance of a more volatile underlying asset. More volatility equates to more risk. While the typical fixed income investment involves an assessment of the creditworthiness of the issuer and interest rate risk which will vary based on the duration of the bond, reverse convertibles have the additional risk that the underlying asset will fall in price. If the price falls precipitously, you could end up with a fraction of your principal, or none at all.

Reverse convertibles make sense for relatively few investors, so why are they so aggressively sold? You guessed it. Fees. According to FINRA, typical fees range from less than 1 percent to 8 percent or more. The exact amount of the fee is rarely disclosed to the investor. Without this information, it is difficult to assess the risk of inverse convertibles.

[See 12 Retirement Resolutions for 2012.]

Reverse convertibles are one of many ways investors are victimized by the securities industry. Its ability to structure products that appear to offer high returns with little risk is boundless. Here’s a simple way to protect yourself and make your New Year’s resolution a reality: Confine your investments to a globally diversified portfolio of low management fee index funds in an asset allocation suitable for you. I show you exactly how to do this, without using any retail broker, in The Smartest Portfolio You’ll Ever Own.

Dan Solin is a senior vice president of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, was released in September, 2011.

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.