Securities regulators have expressed concern that individual investors have been pouring billions of dollars into complex and risky alternative investment products in search of higher yields. These products include certain types of mutual funds, hedge funds, private placements, and other risky investments. Not all investors understand the risks of these investments and, if the past is any indication of what may be happening now, stockbrokers may misrepresent the risks or nature of the investments. In short, these investments may not be suitable for many of the investors who buy them. A common form of stockbroker misconduct is the misrepresentation of the risk of an investment.
To make matters worse, in July of this year the SEC decided to allow risky hedge funds to advertise to the general public. Advertising will increase the visibility of such investments and likely expose more unwitting investors to the massive risk of many hedge funds.
The strategies employed in alternative investments can include betting against stocks, or shorting them, using derivatives or leverage, which increases risk, and buying unusual assets such as privately issued junk bonds. According to Morningstar, a total of $59 billion poured into alternative mutual funds this year through July 2013, compared to a total of $25.6 billion in all of 2012.
These investments often have far higher annual expenses and commissions that more traditional stock and bond investments, which take a larger bite out of the investors' principal. So, in addition to the higher risk of loss associated with the investments, investors in these products have to achieve greater returns just to overcome the higher costs.
As we have previously blogged, the Financial Industry Regulatory Authority fined a group of brokerage firms last year for selling billions of dollars of leveraged - and therefore risky - exchange-traded funds improperly, in some cases to conservative investors who were seeking stable investments. In addition to FINRA's regulatory action, Massachusetts securities regulators recently censured and ordered restitution from brokerage firms LPL Financial Holdings Inc. and Ameriprise Financial Inc. for selling risky, nontraded real-estate investment trusts to dozens of unqualified investors. Not surprisingly, those alternative investment sales had commission rates as high as 7%.