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FINRA has Citigroup Global Markets Inc. in Hot Water

Citigroup Global Markets Inc. is being fined $1.85 million for best execution and supervisory violations in non-convertible preferred securities transactions. They also ordered Citigroup to pay more than $638,000 in compensation, plus interest, to affected clients.

It was found that one of Citigroup’s trading desks employed a manual pricing methodology for non-convertible preferred securities that did not appropriately incorporate the National Best Bid and Offer (NBBO) for those securities. As securities trade on multiple exchanges, Citigroup missed the prospect of a better price for that security on an exchange other than its primary listing exchange. FINRA also found that Citigroup’s supervisory system and written supervisory dealings for best execution in non-convertible preferred securities were lacking. Finally, the firm failed to conduct supervisory reviews even though it had received several inquiry letters from FINRA staff.

“FINRA will continue to pursue firms that neglect their duty of best execution. Citigroup lacked the necessary systems and supervision to ensure that it provided customers with the executions they deserved and, as a result, customers were receiving inferior prices for more than three years,” says FINRA Executive Thomas Gira.

 

Expectations v. Reality of Unconstrained Bonds

Investors’ fears of rising interest rates of traditional bonds, have shown an influx in these “go anywhere” funds. With a focus on returns, many investors don’t understand the risk. In the category of a nontraditional bond fund, they hold a large percentage of the portfolios in high-yield bonds, which have huge potential for default. Some of the funds are full of derivatives, along with emerging-markets bonds and illiquid bank loans. Popular unconstrained bond funds suffered declines of 25% during the 2008 financial crisis.

The Complications of Structured Notes

A complicated investment to begin with, structured notes have grown more complex the last few years and are best to be avoided. They commonly claim to limit instability in a down market. A debt instrument whose return hinges on the price movements of other assets, such as, commodities and stocks. These notes aren’t backed by any collateral and often come with substantial fees. They are purchased through a bank or third party. A knowledgeable financial adviser doesn’t offer structured notes to their clients, because of their complexity and liquidity issues.

Leveraged and Inverse Exchange-Traded Funds are a Ticking Bomb!

Leveraged ETFs are designed to provide investors with a certain percentage return over the movement of a market over the span of a day. Inverse funds are supposed to move in the opposite direction of a specific index, to provide protection against declines.

The problem with these types of funds, is their use of borrowed money to magnify their bets also magnifies risk. The category has seen $2.8 billion in net inflows so far this year through mid-June, according to ETF.com, a research firm.

David Nadig, director of research at ETF.com says, “Many of these ETFs use “total return swaps”, a complicated financial agreement that allows a fund to take on leverage to boost returns. That adds a “counterparty” risk if the investment bank issuing the swap goes bust”.

Mr. Lee, Morningstar’s ETF analyst, says leveraged ETFs are aimed at day traders, who are constantly changing their portfolios and can take on more risk. “It’s not something you can buy and just forget about,” Mr. Lee says.

“If you want to make a strong bet on stocks, for example, you can invest in small stocks with a greater potential upside,” Mr. Lee says.

Nontraded Real-Estate Investments mean Risky Business

Nontraded REITs have been growing in popularity lately. Through June of this year, nontraded REITs have raised $8.8 billion. These real-estate investment trusts are similar to their public counterparts, which trade like stocks and allow investors to invest in an array of commercial properties.

The downside for investors is that they are hard to unload during a real-estate downturn. Fees are higher, as much as 11% in initial sales charges to pay the retail broker, the dealer and the back-end costs of putting the REIT together. Also, these investments have become a concern of the Financial Industry Regulatory Authority. The agency is warning that they are generally illiquid, their performance and value are difficult to understand, and their cost is too high. Disclosure is murkier than with publicly traded REITs as well.

Attorney Mark Maddox named to FINRA’s Arbitration Task Force

We are proud to share that Attorney Mark Maddox will be part of FINRA’s new arbitration task force. Click this link for details: http://www.finra.org/Newsroom/NewsReleases/2014/P554192

Know the risks of “Liquid-alternative funds” before you invest!

Liquid-alternative funds are increasing rapidly in popularity, with investors pouring $40 billion into them in 2013, according to Morningstar. This year through June, they have taken in $14.6 billion.

“Liquid alternative” mutual funds typically service hedge-fund-like strategies but don’t come with the same limitations. There isn’t a high investment minimum, for instance, and the funds aren’t as challenging to exit as traditional hedge funds.

Fund companies are offering investors a chance to capture at least some of the upside of stock returns in good markets while offering protection in down markets and diversifying portfolios.

Doubters say the strategies often are too complicated for the typical investor to understand, and many are too new to have a proven track record. They also come with high fees: an average of 1.9% of total assets, or $190 per a $10,000 investment, compared with 1.2% for a usual actively managed stock mutual fund and 0.6% for a stock index fund, according to Morningstar.

“They have some ugly baggage and warts they carry,” says Mark Balasa of Balasa Dinverno Foltz in Itasca, Ill., a wealth-management firm with $2.8 billion in assets under management. “Advisers are challenged to understand what they do, let alone investors.”

FINRA Fines Merrill Lynch $8 Million & Millions Repaid to Retirement Accounts and Charities

FINRA announced last month that they fined Merrill Lynch, Pierce, Fenner & Smith, Inc. $8 million for failing to waive mutual fund sales charges for certain charities and retirement accounts. Merrill Lynch was ordered to pay $24.4 million in restitution to affected customers, in addition to $64.8 million the firm has already repaid to disadvantaged investors.

Brad Bennett, FINRA’s Executive Vice President and Chief of Enforcement, said, “Merrill Lynch failed to offer available waivers to customers, including small business retirement accounts and charitable organizations. FINRA’s commitment to investor protection is highlighted by the significant restitution component of this settlement, which reinforces that investors must be able to trust that their brokerage firm will offer the lowest-cost share classes available to them. When firms fail to do so, we will take appropriate action.”

Merrill Lynch’s written supervisory procedures provided little information on the waivers. Even after the firm learned that it was not providing sales charge waivers to eligible accounts, Merrill Lynch relied on its financial advisors to waive the charges, but failed to adequately supervise the sale of these products or properly train or notify its financial advisors about lower-cost alternatives.

Investors can obtain more information about, and the disciplinary record of, any FINRA-registered broker or brokerage firm by using FINRA’s BrokerCheck. Investors can access BrokerCheck at www.finra.org/brokercheck or by calling (800) 289-9999.

Alternative Mutual Funds under SEC Review

The increase of alternative mutual fund investments caught the eye of the U.S. Securities and Exchange Commission. The SEC will be launching investigations on fund companies targeting funds’ leverage, liquidity and other concerns.

Director of the SEC’s Division of Investment Management, Norm Champ, says, “The series of examinations, which will likely begin this summer or fall and will also gauge funds’ compliance with securities industry laws and regulations.”

Champ originally made the remarks at a seminar for lawyers in New York last week and it includes many details about the imminent investigations, which are available at 1.usa.gov/1ssp3IS

In January, the SEC issued a risk alert directing investment advisers to be cautious when they conduct due diligence, or research, alternative investments.

Does your advisor know enough about alternative investments?

You may want to take caution when discussing alternative investments with your financial representative. In a survey by Natixis Global Asset Management, they found that only 31% of advisors said they feel they understand alternative investments “very well,” with 53% of advisors saying alternatives are “often too complex to explain.” And yet, 89% of advisors put at least some of their clients’ money in these alternative investments.

Determining whether an alternative is accomplishing its goal is difficult, Wall Street Journal investigating columnist Jason Zweig states, but he suggests that consumers ask advisors what benchmarks they will use to evaluate each investment that is recommended. This has two key benefits for consumers:

  • It will tease out how well the advisor understands the alternative investments being recommended.
  • It will make sure that the advisor doesn’t change the benchmark later.

Regarding this advice, it’s important to know under what circumstances the investment will do well or poorly under. The benefit of identifying the right benchmark is that it helps make sure that the advisor really knows the role of the investment in their clients’ portfolios.


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