European Union financial watchdogs are warning investors about the risks of buying complex financial products.
The European Securities and Markets Authority (ESMA) says investors are offered a confusing array of opportunities that are not always marketed in a straightforward way by advisers and financial firms.
ESMA suggests investors should:
- Seek professional advice if they do not understand the key features or risks involved with an investment product
- Understand that promises of ‘high’, ‘guaranteed’, ‘hedged’ or ‘absolute’ returns often mean the product is expensive or risky
- Make sure they know how long their money is tied up and what the penalties for early withdrawal might be
- Add up the total costs of the investment and how the charges impact on the yield
Difficult to understand
Complex investments are described by ESMA as difficult for ordinary investors to understand as they were designed for professional or retail investors.
Products considered include:
- Derivatives – which are financial products that are valued according to other underlying financial assets, currencies or indices.
- Products that are hard to value
- Fixed term investments with early withdrawal penalties
- Products with complicated formulas to calculate investment returns
- Guarantees or other safeguards that come with conditions that can render them worthless
“These products can provide good returns, but risks and disadvantages are also involved for investors,” says ESMA.
“Our warning is that inexperienced investors may overlook these risks and disadvantages because they are not always clear or easy to understand.
Liquidity risks
“Investors should understand the key features of their investments, and if they don’t, find someone who can explain them or turn down the opportunity.”
ESMA also warns that many complex investments come with liquidity risks, like bonds, certificates, Contracts for differences (CFD), credit-linked notes, structured products and warrants.
“A liquidity risk is the chance that the investment will be difficult to sell if you need to get out before the end of the term for some reason,” says ESMA. “If it’s not liquid, it’s likely any sale will involve a hefty discount on the buying price. Investors either lose some money, or in some cases, cannot sell at all and are stuck with a cash flow problem.”
The authority also warns that investors should not buy complex investments from providers or advisers that are not authorised by regulators in the country where they live.
“If the firm or adviser is not authorised, it’s likely that investor protection rules do not apply and you may not be able to apply for compensation or make any official complaints.”
