The Financial Industry Regulatory Authority (FINRA) has a message for investors considering lesser-understood investments as an alternative to traditional fixed-income and equity investments: caveat emptor.
Investments such as structured products, high-yield bonds and floating-rate loan funds hold the promise of high returns. And they may seem welcome alternatives at a time when the stock market is volatile and fixed-income investments are paying paltry yields. But they should be approached with caution, FINRA advises.
"Investors should never make an investing decision solely by looking at an investment's return, whether past or projected,” Gerri Walsh, FINRA's vice president for investor education, said in an investor alert issued Monday. “Higher returns come with higher risk.”
FINRA's alert was prompted by significant recent inflows into riskier investments. High-yield bond funds had $75 billion in new sales in 2010. Floating-rate fund inflows grew from $15 billion in 2008 to $60 billion in April 2011, and sales of structured products increased from $33 billion in 2009 to $54 billion in 2010.
FINRA's alert, titled, “The Grass Isn't Always Greener -- Chasing Return in a Challenging Investment Environment," explains the benefits and risks of these products and includes a checklist of questions investors should ask before investing.
David D’Amico, president of Braver Wealth Management, in Needham, Mass., said it’s not surprising that some are turning from stocks and mainstream fixed-income vehicles.
“Investors are frustrated with the inability to generate any meaningful dependable income from their investments,” he said, “and are certainly chasing yield in this low interest rate environment.”
The problem with high-yield bond funds, floating-rate debt, structured notes and leveraged exchange-traded funds is that they are often misunderstood by investors, D’Amico said. It can be particularly difficult to determine the underlying holdings of structured notes and leveraged ETFs, he added.
“Knowing what you own is an essential element to successful investing,” he said, “and these asset classes, often by definition alone, are usually a black hole to many investors hoping for improved returns.”
High-yield bonds are bonds with lower credit ratings, higher risk of default and consequently a more attractive interest rate to compensate the investor for the additional risk. Floating-rate loan funds invest in loans extended by financial institutions to entities of below investment-grade credit quality.
Structured retail products are typically unsecured debt with payoffs linked to a variety of underlying assets. And leveraged products, including leveraged ETFs and mutual funds, seek to deliver multiples of a specified benchmark by increasing exposure to the benchmark through the use of derivatives.
A better bet than these exotic investments are dividend income stocks and higher-rated corporate bonds, D’Amico argued. Dividend income stocks currently sport high yields -- in the 4% to 5% range on average -- along with strong balance sheets, improving earnings, strong cash flow and relatively low valuations, he said
D’Amico likes higher rated corporate bonds, which he says are benefiting from the same business and balance sheet strength.
