Structured CDs Are Not For Everyone, Or Maybe Anyone, And Almost Certainly Not You

The Wall Street Journal does a good job of explaining why investors should steer clear of "Structured CDs" and anyone who tries to foist them on customers. The truth is, they're unlike traditional CDs that savers and investors have relied on for years. They're riskier, more complicated, and as often as not perform worse than regular CDs:

Of the 325 Barclays CDs reviewed by the Journal, 239 had announced at least one annual return payment. More than half of those returns were lower than an investor would have earned from an average five-year conventional CD. Of the 118 structured CDs that were issued at least three years ago, only one-quarter posted returns better than those of an average five-year conventional CD. And roughly one-quarter produced no returns at all as of June 2016.

On the other hand, if you're looking to pay high fees to get a product that you won't understand, comes with a 200 page prospectus filled with calculus and legalese, and that will likely earn less than a plain vanilla CD, then by all means, go with a structured product.

Investor Should Beware Of Back-Tested Results In Marketing Materials

The New York Times provides an example of why investors should not trust strategies that are advertised as successful based on hypothetical returns in prior periods. The example comes from Spruce Alpha, a hedge fund run by Spruce Investment Advisors, which specializes in managing money for the wealthy and institutional investors like the Hamlin School, a private all-girls school in San Francisco, family offices, corporations and pension plans. Spruce "pitched large returns in periods of market turbulence" and emphasized in its marketing materials that the strategy would have generated "outsize[d] hypothetical performance going back as far as 2006." Despite this, Spruce Alpha lost nearly half its money during the market turbulence in August 2008 by heavily relying on exchange-traded funds (E.T.F.s). While it's not clear yet exactly what caused the losses:

The back-tested results for the Spruce Alpha fund may not have taken into account how markets and investors would react given the kind of circumstances that took place in August. The hypothetical results could have underestimated the fact that some E.T.F.s are used as trading instruments that big money managers move quickly in and out of in times of extreme market volatility.

Back tested results are easily manipulated to make an untested investment strategy seem better and less risky than it actually is:

Back-tested results in hedge fund marketing materials have long drawn scorn from some in the hedge fund world. The results are typically recreated with the benefit of hindsight, making it easier for a fund to post hypothetical good results.

Norman Kilarjian, a partner with Aksia, a hedge fund advisory firm to institutional investors, said individual investors should not put great credence into back-tested results in hedge fund marketing material because the results are derived assuming optimum trading conditions.

“I’ve never seen a back-test that didn’t look fantastic, but investors are often falling for it,” he said, not commenting on any specific hedge fund.

There are two takeaways from this. First, regulators should take a hard look at how funds and advisors are using back tested results to sell their strategies to investors. Second, investors should take such hindsight analysis with many grains of salt.

SEC Proposes To Expand Discovery In Administrative Hearings

In response to criticism from banks and investment advisors, the SEC has proposed several rule changes to how it conducts administrative hearings. The proposed changes will do three things. First, they will extend the time between the initiation of the proceeding and the hearing, giving respondents more time to prepare their case. Second, they will allow respondents to take depositions. Third, they will require the parties to use electronic service for the filings of papers.

“The proposed amendments seek to modernize rules of practice for administrative proceedings, including provisions for additional time and prescribed discovery for the parties,” SEC Chairman Mary Jo White said in a statement.

It is interesting, if not particularly surprising, that the SEC has moved so quickly to respond to industry concerns regarding the limited discovery available in these proceedings. Attorneys representing claimants in FINRA arbitrations against banks have complained for years without any success about the limited discovery (including lack of depositions) in those proceedings.

The SEC's proposed rule changes are available here and the SEC's press release discussing those changes are available here.

Credit Suisse To Settle With Regulators Over Dark Pools

Credit Suisse is reportedly about to pay $80 million to the SEC and state regulators to settle claims arising out of their management of "dark pools." Dark pools are private exchanges for trading securities where large investors can undertake block trades. Because there is no transparency relating to the trades taking place in dark pools, they are susceptible to conflicts of interests by the operators of the dark pools and to predatory practices by high frequency traders.

This is not the first such settlement with and is unlikely to be the last:

The deal will be the second time in a few weeks that the SEC has set a record payout in a dark pool case. Last month, Investment Technology Group Inc. said it would pay $20.3 million for operating a proprietary trading desk that used knowledge of customers’ requests to trade for its own benefit, among other infractions. In January, UBS Group AG paid $14.4 million for lack of disclosures about how its dark pool operated.

SEC: Calling Leveraged Fixed Income Products Safe Is Fraud

Citigroup has agreed to pay $180 million to settle SEC charges related to its ASTA and MAT municipal bond funds. The advisers called the investments safe while hiding from clients the significant risks involved, according to the SEC.

Citigroup pitched the investment as a “better version of a bond” and instructed some clients to sell their unleveraged fixed-income portfolios in order to buy into the investment, according to the SEC. Internally, the private bank rated the funds as having “significant risk to principal,” while not sharing that assessment with the majority of investors and sales people, the SEC said.

Leveraging even safe investments always increases their risk and the failure to adequately inform investors of those risks and to guard against them can expose investors to significant losses and advisors to legal liability.

Settlement Of Claims Against Employers For High Fee Funds in 401(k)s

Boeing is the most recent company that employees have held to account for mismanaging its 401(K) plan. Employers offering such retirement plans have a legal obligation to ensure that its employees are not hit with excessive management fees:

If a company does right by its workers, it finds low-cost, well diversified, smart investment choices, many experts say. But Schlichter says some companies offer workers mutual funds with fees that are way too high. Sometimes, he says, the companies get kickbacks for that.

By offering high cost options in its 401(k), a company can cost its employees hundreds of thousands of dollars over the life of the investments. For example, a fee that is only one percent higher will cost employees 28% in returns over a 35-year work career. What does this mean for you?

[G]enerally, if you're paying less than 0.5 percent in fees total for your investments, you're doing well. But if you're paying more than 1 percent, you're losing a lot of money over time.

Is your company's 401(k) costing you more than it should?

Muni Bond Funds Loaded With Unrated Bonds A "Red Flag"

Municipal bond funds are often thought to be safe investments, but be careful, especially with funds stuffed full of unrated bonds:

Nuveen Investments LLC's High Yield Municipal Bond Fund has 46.9% in non-rated bonds. Waddell & Reed's Municipal High Income Fund and the firm's Ivy Municipal High Income Fund have 44.9% and 39.15%, respectively, in non-rated bonds. OppenheimerFunds' Rochester National Municipal Fund has 43% in non-rated bonds, and its Oppenheimer AMT-Free Municipals Fund has 38%.

“I would say that anything with more than 20% in non-rated bonds requires absolute confidence in the management team,” said Eric Jacobson, director of fixed-income research at Morningstar. “Anything above 40% is a red flag.”

So, what's the problem with having so much of a fund's assets tied up in unrated bonds?:

Non-rated bonds tend to be small in size and thinly traded. The average size of these issuers is $21 million, according to Municipal Market Advisers. Given the continuing headline risk in the municipal bond market, funds with such large allocations to non-rated bonds risk having to meet massive redemptions and getting stuck with having to sell these less liquid, non-rated bonds at lower prices, Mr. Jacobson said.

Another trouble with these bonds is that since they tend to be thinly traded, it can often be difficult to price them, experts said. This is a risk with all municipal bonds but even more so for non-rated bonds, said Matt Fabian, managing director at MMA.

“When you have uncertainty about what the bonds are worth and managers reporting the value on the bonds, you need to make sure they aren't exaggerating the value of the bonds,” Mr. Fabian said.

According to Investment News, here are the top-10 muni funds with the highest percentage of unrated bonds:

Invesco High Income Municipal A: 64.3%
Invesco Van Kampen High Yld Municipal A: 61.3%
Nuveen High Yield Municipal Bond A: 46.9%
Waddell & Reed Muni Hi-Inc A: 44.9%
Oppenheimer Rochester National Muni A: 43.0%
Pioneer High Income Municipal A: 41.1%
Lord Abbett High Yield Municipal Bond A: 40.2%
Ivy Municipal High Income I: 39.2%
Oppenheimer AMT-Free Municipals A: 38.0%
Federated Municipal High Yield Adv F: 35.3%

It is important to note that most if not all of these funds are high yield funds. Oppenheimer's California Municipal Bond Fund, which purported to be a more conservative, capital preservation bond fund, had over 60% of its assets invested in unrated bonds as of December 31, 2008, according to Lipper.

That's one big reason that when the financial crisis hit in 2008, Oppenheimer's California Municipal Bond Fund lost over 46% of its NAV while the average loss among funds in the same Lipper Classification only lost 11% over the same time period.

At the very least, Oppenheimer should have disclosed the enormous risks that it was taking with investors' money.