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Priips set to redefine the way we look at risk

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Investment products falling under the EU’s Priips regulation are likely to have their risk downgraded, which could lead to poorer returns and put off investors, experts warn.

Last year, pressure mounted on European policymakers after the European Parliament voted to reject Priips standards on the grounds they were misleading for consumers, including the way product risk is calculated. This led to a year delay of the regulation’s introduction until 2018.

Money Marketing understands instruments such as structured products are likely to be re-rated to a lower risk level when Priips gets implemented. But experts say Priips is likely to add further burden to the way risk is calculated and will fail in its attempt to illustrate risk better.

By creating a level playing field among different types of products, it is argued Priips will also make them less competitive and “thrash” the investment opportunity out of some funds.

Priips regulation alone may not be enough to clarify risk-rating measurements and will inevitably need the FCA to step in and add further guidance, especially after Brexit.

‘Risk never encountered before’

The final draft rules on Priips’ regulatory technical standards, published in March 2016, require a summary risk indicator for products covering seven different classes.

The European Supervisory Auth-orities have identified market and credit risk as the major factors of risk and scenarios that need to be reflected in this indicator in the key information document, alongside liquidity risk. The standards, which are still to be finalised,  also contain a method for assigning each product to a risk indicator and also include an explanation of the risk,  with additional warnings for some Priips.

Wealth Management Association deputy chief executive John Barrass says Priips will expose a risk in products that consumers have never encountered before, and this has the potential to generate more problems in the future.

He says:“Part of Priips regulation is designed to mitigate risk or to deal with risk. Sometimes it helps to mitigate risk in the sense of reducing it but other times it just takes the risk away into somewhere else. The [risk] number you need to give on products is based on the estimation of the calculation of that risk. I would imagine the rating would go lower on all products as well as returns.”

In theory, Priips is set to level the playing field between life insurance products and investments covered by Mifid, but as independent regulatory consultant Richard Hobbs says, the risk re-rating could make Priips products less attractive for consumers and reduce supply.

He says: “If the product providers are redesigning the product to reduce the risk rating, then over the long run they’ll produce lower returns and make them less attractive to consumers. You do want a certain amount of risk in a product in order to get the return but what it needs to be is an investment risk, and not any other type of risk. Priips is not wrong but it thrashes all the volatility and investment opportunity out of the product in the long run.”

The Financial Inclusion Centre director Mick McAteer claims the activity involved in a fund, rather than finding a new measurement system of the risk, is what makes a product riskier. He says: “The most worrying thing is that the more speculative activities such as derivatives-type of activities the fund gets involved in will increase the risk. The risk rating should reflect that additional risk, but it is not clear that advisers or investors understand the risk of funds they are getting involved with.”

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Independent consultant Matthew Connell says what risk calculation ultimately needs to achieve is simply showing that higher projected returns will result in higher projected risk.

He says: “Having a risk rating doesn’t mean you’ll have lower risk products, the most important thing is to make sure that the story about taking high risk and getting higher returns and vice versa comes through in the end.”

Possible outcomes

Experts say the issue on measuring products’ risks is only the first part of a long journey to help customers understand risk.

Connell says when the regulatory standards are finalised, the industry will be left with something “not particularly misleading” but still not “user-friendly”. He says: “You’ll have a lot of risk scenarios but it will be such a wide range of projections, so it won’t be reliable and advisers and providers would need to do that themselves. It’s a difficult concept to put across, because you are putting across average returns versus volatility. The answer is design tools to see scenarios interactively and technology might help with models.”

As highlighted by the FCA in its study into the asset management industry, McAteer argues there is also the need for any “implicit promise” or guarantee of terms such as absolute funds, target funds or guaranteed funds to be backed by returns and assets.

Meanwhile, Apfa director general Chris Hannant claims even with Priips, advisers and providers will need to continue assess risks themselves.

He says: “One thing advisers must not do is rely on any providers’ risk rating. The FCA has been clear just because a provider has said something is in that risk category you cannot take that at face value so you must make your own assessment.

“The FCA needs to clarify this with Priips but currently the rule is you can rely on facts but not opinion. I’d be very doubtful if the FCA tells you to just take the Priips risk rating instead and not think about anything else.”

ConnellExpert view

Independent consultant Matthew Connell

The future for investments is so uncertain that whenever you make any projections you are always liable to be misleading . It is a case of being aware of how risk works and the extent to which you promote the projections.

The way we used to do things in the UK and Ireland is to make a guess at how equities might perform and then illustrate the outcome on that assumption and have a mid-point and show what returns might be if they were 2 per cent higher or lower, for instance.

The advantage of that is you present a reasonably sensible projection for the mid-point but also give a sense of how it might be volatile either way.

With Priips, the way it is done in the UK, the FCA would commission research and a third party would make a suggestion for the mid-point so it is done in a fairly technical way looking at the underlying economics of it. But at the European level there is not really an organisation that could do that because you are looking at a figure that would apply across all member states so there are many different currencies and inflation rates to consider from country to country.

Even if you look at a five or 10-year performance, you can get periods where a particular fund will perform very well and better than expected over a much longer period. So the problem with Priips at the end of last year was that you could have a situation where manufacturers were doing projections of 10 per cent for growth even when those manufacturers themselves were not really expecting more than 3 or 4 per cent in the long term. Obviously that represents a big misselling risk.

The EU came up with  a very pessimistic performance scenario to show the potential for a product to make a loss. But the more scenarios you have potentially the less helpful it is for customers, as they will indicate lots of different outcomes at that point it is worth asking if it is better to have a statement that describes how the investment might grow.

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Comments

There are 2 comments at the moment, we would love to hear your opinion too.

  1. And how exactly is this mess of potage going to add any value to the man on the Clapham omnibus?

  2. PRIIPs – nice idea but the execution is likely to be a disaster and as we all know trying to predict future investment returns is truly a mug’s game. The more paperwork we give to clients the less their understanding, not the greater. I’ve been an IFA for nearly 25 years and we have come a long way on risk/capacity for loss profiling – some of the latest tools are excellent in helping clients to understand the potential risk and reward of different investment strategies.

    It’s also vital that the context is explained to the client e.g. fixed interest was always seen to be low risk but currently? I think not!

    Financial planning is, as ever, a process and not an event.

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