16th April 2013
The new boss of the financial watchdog Martin Wheatley has just described some structured investment products as ‘almost spread bets on steroids’ as reported in financial adviser trade newspaper Money Marketing.
It certainly sounds as if Mr Wheatley thinks at least some products should not be available for most mainstream investors.
These are strong words which reflect a new hard hitting approach from what is now called the Financial Conduct Authority, the body that replaced the Financial Services Authority.
The organisation has been making much of its ability to ban products from the market but given that the FCA is only really getting up to speed should you be worried about the situation?
As is often the case with such debates, there has been a lot of inter-industry argument. For example, the Structured Products Association hit back at the comments on Citywire suggesting that structured products were following new rules already.
Yet could you be gambling when you think you are investing?
Well structured products have failed quite badly in the past in two ways. First they were often marketed as direct offer products around the turn of the Millennium or were oversold by some advisers and bank salespeople without due regard to the risks in either the marketing or the advice. These products were briefly referred to as precipice bonds, before the regulator settled on the name structured capital at risk products (SCARPs). More emphasis was placed on making sure people understood what they were getting in to though not all structures were SCARPs i.e. some would aim to return your capital for a particular return. The latter products proved very popular though some said the guarantees could prove very expensive.
The second round of failures came with the financial crisis when the counter-party i.e. the bank or institution that provided the derivative contract underwriting the contract was at risk of failure. The most famous failure was Lehmans and investors in related contracts lost money, though they usually had recourse to redress. There has been some argument about whether distributors and advisers should have anticipated this failure or not, but the focus came down, once again, to risk warnings and suitability of any advice.
But what about now? Well, we have to say that many people rather like these products and have benefited from their returns.
It is interesting that some advisers swear by them for some clients. Others avoid them at all costs. They can offer a degree of capital protection but some upside from markets. They can provide you with interesting ways to earn returns that might suit you. You might even have an adviser who will suggest that an element of a structured product as part of your portfolio.
In all cases, we suggest that you make yourself very aware of the risks. You shouldn’t put all your eggs in one basket. You should consider not just what the investment promises to do, but what sort of firm underwrites and provides the derivatives. How stable is it?
Mr Wheatley’s speech also talked about behavioural economics saying it could help consumers, but also, at times, could be used to get consumers to buy a product which they didn’t need or wasn’t appropriate. He said the FCA would be using behavioural economics in its work as well.
But it is the structure which he took from a real life example which is probably the most interesting part of the speech.
The full speech is here. But here is the key passage from Mr Wheatley which we have put in italics.
A perfect example has been some of the more exotic structured products offered by firms. Products that have often been mind-bogglingly complicated financial gambles – almost like spread bets on steroids.
One example I saw involved consumers tying up capital for between one and six years with their returns dependent on the share prices of three technology firms.
If, after one year, the share prices of all three are at, or higher than their initial price, the investor receives 12 per cent return and the product stops.
If, after two years, the share prices are at, or higher than 90 per cent of their initial price, the investor receives 24 per cent and the product stops.
If, after three years, the share prices are at, or higher than 80 per cent of their initial price, the product pays 36 per cent and so on and so on.
But if after six years the final price of any of the three shares is below 50 per cent of the initial price there will be a capital loss based on the performance of the worst performing company. So you could quickly lose a substantial chunk of your money. Is this product a good deal? Frankly, I’m not convinced.
This above is clearly an example of a kick out plan. Capital is at risk as the chief regulator points out and the link to tech stocks might raise an eyebrow or two given the recent share price travails of Apple. Yet you as an investor may not agree with Mr Wheatley and think that existing protections – the requirement for an adviser to check your risk or a direct offer service to highlight the risks are enough. Yet at Mindful Money we think this sort of product is probably cruising towards a ban.
Put simply the chief regulator thinks some types of products are unsuitable and are too complicated for all but a minority.
He also doesn’t believe that buyer beware works well enough nor that risk warnings are considered in detail nor products understood.
But before he gets around to banning things, a development which may be good for the broad range of investors, we suggest that in your own individual case, you prove him wrong by making sure you do understand.