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The FSA has failed to grasp the problem of low-risk products

Stuart Fowler

Barclays’ £7.7m FSA fine is a punishment for weaknesses in its sales process. I expect these had more to do with the way it frames questions about risk tolerance and interprets the answers than its assessment of risk in the products it then matches customers to. But it is still striking that at least one of the two funds at the centre of the customer complaints is one that has regularly sat well inside the return range of the lower-risk IMA sector called cautious managed. Striking but not surprising.

The peculiar feature of packaged products created at the low end of the risk spectrum is that the downside risk relative to cash is much harder to esti-mate accurately than in equity funds, yet has far greater impact.

However “cautious”, there is an unavoidable quantum change between cash and low-risk product structures. That is a big issue when cash returns are really unsatisfactory, as now, but customers’ tolerance to risk is low.

Managing the quantum change safely so that advisers can be sure customers will have sufficient composure to weather disappointments relative to risk-free savings may require even more education and expla-nation than the same discussions about location on the risk spectrum higher up, where it is all about different levels of exposure to equity risks.

Measuring the distribution of past returns within the cautious managed category (using Lipper data) and trimming the top and bottom deciles to try to avoid capturing atypical and miscat-egorised funds, we find a fairly stable range from top and bottom of about 7 per cent a year both before 2008 and after 2009.

Relative to cash, this is incon-veniently wide. But it is perfectly natural once you move from cash to a wide range of instru-ments by duration and credit risk and a wide range of (albeit small) equity exposures.

At this end of the risk spectrum, many of the incremental return sources take on the nature of insurance, gathering premium income for bearing the risk of occasional losses. So there will always be some exposure to a lowprobability but high-impact event such as the explosion of the distribution in cautious managed fund returns from 7 per cent to 20 per cent in 2008 after the banking crisis.

For most investors, the answer is to split exposure between genuine risk-free assets and equities – bets on or off the table but nothing in between.

If inflation is an issue for their risk-free assets, they will normally be able to protect against both capital market and inflation risks by holding index-linked National Savings certificates or index-linked gilts. Both are also more tax-efficient than low-risk packaged products.

The industry discourages this portfolio separation because it finds it difficult to attach a fee to the risk-free portion. There is therefore a strong financial incentive for manufacturers to keep creating “low-risk” products and advisers (whether taking commission or, after the RDR, charging asset-based fees) to keep allocating to them. I do not believe the FSA has quite grasped the nature of this problem.

Stuart Fowler is director of No Monkey Business


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There are 9 comments at the moment, we would love to hear your opinion too.

  1. The FSA have failed to grasp the problem.
    Any problem.

  2. The FSA never seem to grasp the nature of any problems!!!!

  3. Why is it no one seems to grasp the FSA IS THE PROBLEM !!

    A £1/2 Billion a year problem or £500,000,0000.

  4. Yet another person making sweeping statements, suggesting that products are being created to enable advisers to receive commission, or obtaining asset based fees. Any adviser doing his job properly will advise his clients about NS& I indexed linked certificates, but are there any currently available – No!

  5. Guess what Mr Fowler, many of us humble advisers realise that there is no risk free lunch out there – and many of us are wise enough to also realise that if a client can genuinely accept no risk of loss that they are better off being left in savings based products as opposed to investment products of any sort.

    I happily walk away from such clients as I realise that any loss (even on a miniscule 10% of their capital) will in all probability involve a conversation with the compliance department at some time or worse still the ombudsman, who isn’t reknown for taking an appreciative view of an holistic ‘whole of portfolio’ approach when considering investment complaints.

    Your tone is pretty patronising though and you obviously see yourself as a cut above us riff-raff advisers seeking to make a tawdry living from the giving of investment advice.

  6. The mistake the banks made is that they did not differentiate between SAVERS and INVESTORS. Two completely different sets of people. Anyone who invests a saver is an idiot.

  7. This article is downright debasing to most Advisors.

    Low risk investments can be those such as With Profits, low outward volatility and no sense of the effects of inflation if bonuses are not being added regularly. They can also be the off the shelf structured/protected products sold over Bank counters to the public with no advice Alternatively it may be the Icelandic Banks or the Post Office invested with safe as houses Bank Of Ireland. All carry a form of risk.

    NS&I index linkers are so valuable the govt don’t let them out to Joe Blogs any more. Was the Author aware of this?

  8. The banks exploit this very well with the fixed term capital guaranteed onshore life assurance investment bonds that they flog by the boatload.

    Don’t want to risk losing any capital, Mrs Client? But you do understand that to get better returns than cash, you have to take the medium to long term view? How long is that? Well, how does five years sound? Okay? Well, I just happen to have here……

    It may have heavy charges, it may be tax in-efficient, it may not be remotely flexible, it may invest in just one cheesy new managed fund with no track record, it’ll almost certainly deliver returns only a point or two better than cash and the upfront commission’s a decidedly hefty 7%, you’ll never receive any sort of mid-term review (in fact, you and I are unlikely ever to meet again) and I really don’t want to bore you with all sorts of techno-talk about stuff like portfolio construction and the difference between volatility and risk.

    So let’s keep it simple, you’ll have nothing you can complain about and that’ll make sure the FSA stays nicely where it belongs, namely off our backs and on those of all those perennially troublesome IFA’s.

    Ain’t life great when you have a simple business model?

  9. Keydata was a regulatory failure, therefore the bill for this failure should end up a Canary Wharf?

    Unfit persons were authorised and deemed fit and proper, by an unfit regulator

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