Time to think, talk and walk like an investment industry

At the end of October, the UK’s regulator, the Financial Services Authority (the FSA), published the findings of its thematic and wider implications review of the structured products industry.

Triggered by the collapse of Lehman Brothers, the FSA has focused on the needs of investors, with an ‘up close and personal’ review of structured product providers and their financial promotions, financial advisers and their advice, and general treating customers fairly issues. The output was substantive and detailed.

The FSA rarely receives recognition from those it regulates but it deserves some for its review of the structured products industry, through which it has demonstrated detailed working knowledge of the industry, providers, product features and the advisory process.

Specific issues

It is beyond any doubt that the regulator has invested significant time and resource in its review, which has focused on specific issues relevant to ensuring investor’s interests are protected.

The result is explicit guidance to structured product providers’ regarding their marketing materials and general approach, and equally clear direction to advisers regarding the expectations upon them, relating to their use of structured investments.

It is not rocket science. Providers must present investors (and advisers) with information that ensures they understand what they are investing in and the risks, specifically detailing counterparty risk, any market risk, liquidity risk and compensation scheme rules, in language that the target audience can understand. The FSA has also focused on the systems and controls that it expects firms to operate, both pre and post sales.

The guidance to advisers is also fundamental, in respect of the standard of advice that it expects them to meet. As well as needing to understand structured products, advisers must be able to demonstrate solid portfolio planning principles when advising clients, including assessing client circumstances, needs and risk tolerances, and ensuring appropriate consideration of product features and risks such that solutions are suitable, taking into account ‘basic’ portfolio planning points such as diversification and tax.

The FSA review involved visiting 11 advice firms, of varying size and position in the market, and scrutinising 157 client files. Generally, it should be noted that some of the advice issues detailed by the FSA, in its review of structured products, are not issues that are exclusively to do with structured products.

In terms of detail, although the FSA found the advice in 73 of 157 cases, from 11 firms, to be unsuitable, this was often for reasons not specific to structured products. For instance, 67 cases related to exposing the customer to inappropriate risk, primarily placing customers who did not want any risk to capital in something other than deposits and/or not diversifying portfolios. Ten cases related to a failure with regard to tax and one case even detailed a suitability report covering an entirely different product from the one invested in.

The fact is that some or even many of the examples of bad advice would have surfaced – and should indeed be brought to the fore – whether it had been a structured product review or a review of any type of investment or investment advice per se. The FSA found client’s individual circumstances were not properly considered, that individual risk tolerances or investment time-scales were not taken into account; that portfolios were not properly diversified. These failings would equally have applied if mutual funds, bond funds, hedge funds or any other type of investment product had been under review.

In this respect, at least, structured products are suffering from advisory issues that are generic and far wider financial services industry issues. But, the opportunity is now presented for the structured product industry to respond positively, and to demonstrate its value and its integrity.

Notwithstanding the fact that it was the demise of Lehman Brothers which sparked the review, it should also be noted that it was not the issue of ‘counterparty default’, which is a ‘performance issue’, as per the performance of an equity, that has been the focus of the FSA’s review and output. Rather the review has driven at the heart of the consequences of imprecise targeting of products and product literature that fails to detail investment and counterparty risks for investors properly, advice, and other factors such as internal processes and controls, in provider and adviser firms.

However, with specific regard to counterparty risk, the review has made it clear that due diligence considerations of counterparties must be robust, and should include factors other than just credit ratings, such as credit default swap levels and further fundamentals.

Credit ratings

Notably, the FSA supports using credit ratings as a key indicator in assessing credit risk in the post-Lehman world, specifically suggesting that weaker rated counterparties (it specifies a ‘B’ rating as an example) may only be considered by advisers to be appropriate for investors who identify themselves as higher risk. And we certainly note that the only providers to have suggested that credit rating agencies are discredited are those suffering with the worst credit ratings.

It is clearly incumbent upon the structured products industry and leading providers to advance the working knowledge of structured investments among advisers – and to ensure that the future growth of the industry is based upon client-centric, research-backed investment integrity and appropriate use of best of breed structured investment solutions.

Professional advisers must also recognise that the appropriate response to the review, from their perspective, is to ensure adequate working knowledge of structured investments going forward – not least as the FSA’s Retail Distribution Review, in pointing towards the shape of advice post 2012, states that advisers must understand structured products and how to use them in balanced portfolios, if they wish to continue calling themselves independent advisers.

The simple fact is that ‘intelligent structured investments’, founded on research backed investment thinking, that demonstrate investment integrity, that are developed in close consultation and collaboration with wealth managers and investment advisers, increase the range of investment options and add value for investors. They are not alchemy – they do not make investment risk disappear. But intelligent structured investments can remove, reduce or at least define market risk and change the risk/return profile of market or asset class exposure.

This opens up significant investment opportunities. Most notably, exposure to high growth investment markets and asset classes, which might otherwise be considered out of the reach of many investors, can be accessed by a far wider audience.

It is now time for the industry to stop ‘talking products’ and to think, talk and walk like an investment industry that has a proven role and place in portfolio planning. The responsibility is a collective one, however, for both providers and advisers. This view is no doubt as valid across Europe, and indeed globally, as it is in the UK.

Chris Taylor is CEO of Blue Sky Asset Management