Advice is Key

January 27, 2016

Back in 2008/09, the market for structured products was under intense scrutiny by regulators after the collapse of Lehman Brothers left some investors high and dry.

The findings of review into the suitability of advice on these structured products (the UK FCA’s Structured Products: Thematic Review of Product Development and Governance) found several main failings, importantly: a failure to consider the suitability of the products from a risk perspective, and an over-concentration of clients’ assets into structured products. 

In 2016 it is easy to look back and say that these failings are not unique to structured products;but they are not! Instead, a lack of coherent investment philosophy and process, coupled with a culture of brokering product as opposed to offering a genuine advice service led to these failings, and they apply to many other investment products. So much so that the US has recently passed a law governing financial advice given to retail investors incorporate ‘fiduciary responsibility’.  

Advisors need to work with their clients to define an investor need to access to their money in an emergency, for  example. Easily liquidated assets available for sale on a secondary market should be used if investors demand liquidity in a structured product. Th elevel of capital guarantee and most importantly, how that guarantee is provided also needs to be openly discussed. The key to correct due diligence and research of the market for structured products is no different from any other investment solution; it is about asking the right broad-based ‘enhanced suitability’ questions.

It is crucial to be able to assess both risk and capacity for loss and apply this to the selection of the correct structured product. There must be a logical link between the investment selected for the client and the agreed risk profile and documented capacity for loss. It should be noted that many firms are still getting this wrong, as the FCA review of suitability in wealth management firms has found (Wealth management firms and private banks: suitability of investment portfolios). When assessing structured products against the risk profile and capacity for loss, there are many considerations. Once simple mnemonic  firms apply is CLEAR:

Counterparty – who is making what promises and how likely they are to keep them?

Length – is the term appropriate for the client’s planning needs and tax circumstances?

Exposure – what is the client actually exposed to and does this meet their capacity for loss?

Access – where can the product be held (inside an tax-efficient insurance policy or through brokerage account) and is this appropriate?

Risk – does it match the investor’s profile?

These screening criteria are more difficult to apply to the most complex structured products. Therefore, simplicity is key. Look for easily accessible underlyings, like major indexes and ETFs.  Look for simple structures such as auto calls (with low barriers) and credit linked notes. One simple rule of thumb can be used for all advice, if it is too complicated to explain to a friend in 30 seconds, don’t use it.

Of course, a strong advice process needs to be backed by competent advisers and there is no substitute for structured product education. AdvancEquities is happy to work with advisors demonstrating that they understand the above process, thereby protecting both advisers and their clients from unsuitable advice.