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Know Your Market, No Matter How “Complex”


In January, the Financial Industry Regulatory Authority released Regulatory Notice 12-03 regarding heightened supervision of “complex products.” 

The notice didn’t try to define what complex products are. Rather, it said the term includes “any product with multiple features that affect its investment returns differently under various scenarios.” Products fitting that description include structured notes, inverse or leveraged exchange-traded funds and asset-backed securities.

According to FINRA, if a product has similar features of complexity, such as embedded derivative-like features or a structure that “produces different performance expectations according to price movements of other financial products or indices, then firms should err on the side of applying their procedures for enhanced oversight to the product.”

That means having procedures and operations in place to educate your sales and marketing people about these products, before they go out into the market.

Under FINRA’s suitability rule, a firm or registered representative must perform a reasonable suitability determination before recommending a transaction or investment strategy to retail investors.

“A reasonable basis suitability determination is necessary to ensure that a transaction or investment strategy is suitable for at least some investors (as opposed to the customer-specific suitability determination, which is made on an investor-by-investor basis),” according to the notice.

In general, the notice said what constitutes reasonable diligence will vary depending on the complexity of and risks associated with the investment strategy, and the familiarity of the firm or the registered representative with the investment strategy. Registered reps should have an understanding of the product’s performance in a range of normal and “extreme market actions” and the lack of this understanding when making recommendations could violate the suitability rule.

The notice warned that firms should have formal written procedures to ensure that their registered representatives do not recommend a complex product to a retail investor before it has been thoroughly vetted. “Those procedures should ensure that the right questions are answered before a complex product is recommended to retail investors.”

So what are firms to do?

The Investment Company Institute is cautionary because of the nature of alternatives, where they come from, and the potential for “culture shock” for hedge fund managers facing regulation for the first time.

As a result, it recommends firms “review all potential issues— even those we have assigned to the roll out phase—as early in the process as possible, in order to assess and communicate their consequences; to involve a multi-disciplinary team and an open dialogue among all constituents; and to build enough time and resources into the process to allow for education of all concerned, including the regulators.”

Know your market.