David Wright questions whether AS IC’s “swim between the flags” approach to investment risk will really work
Going to the beach on hot, summer days is a great Australian pastime. A quick observation of those beach-goers taking a dip in the ocean demonstrates that the vast majority of swimmers swim between the surf- lifesaving flags. This is particularly true in choppy conditions. The reason for this is that most people feel safer, or less at risk, with the knowledge that the swimming area between the flags is carefully monitored and patrolled by experienced lifesaving guards who can come to the rescue of anyone who gets into trouble in the surf.
And so it is with great interest, from a research house perspective, that we read that the Australian Securities and Investments Commission (ASIC) is contemplating a system of categorising investments as those “between the flags” and those “outside the flags”. To be fair, this is a new initiative that is well intentioned, in order to protect investors’ interests, and it is not yet fully defined; but the concept and initial categorisations published so far raise a number of concerning issues.
Some recent comments from ASIC’s deputy chairman, Jeremy Cooper, defined the categories “between the flags” and “outside the flags” as follows: “At its simplest, swimming between the flags is investing in a diversified way between bank deposits, your super, blue-chip shares, vanilla managed funds (and other investments with relatively low risks) or with independent, professional advice. ‘Outside the flags’ is investing in more complex, illiquid, undiversified investments or leveraged products, all the way to outright scams. “For the ‘flags’ message to be truly successful, advisers need to use it as well. Margin lending by retail investors is nearly always outside the flags, but how many financial advisers explain this to their clients in such simple and clear terms? We also want clients to remember to ask advisers whether their advice is ‘between the flags’.
“What else do we think is outside the flags? Here are a few examples:
- Complexity – if you don’t understand it, then it’s outside the flags;
- Gearing – direct gearing is outside the flags, as are investments with high internal leverage or other ‘financial engineering’;
- ‘Maturity transformation’ products that are not prudentially regulated – for example, debentures and mortgage trusts;
- Lack of diversification – unless all your money is in the bank, putting all your eggs in the one basket is outside the flags;
- Tax-driven schemes;
- Hot tips, fads, stock picking and nearly all forms of forecasting – for example, ‘this investment is really going to outperform…’ ”
While I’m sure (and I certainly hope!) that these categorisations are to be further refined, they are currently too broad to be of much use at all. Having been involved in researching a broad range of investment products over the past nearly 20 years, there is a multitude of issues that needs to be considered when identifying the risks inherent in an investment. To list a few, these include: Historical returns and volatility, liquidity, transparency, term of the investment, financial stability of the manager or product provider, quality of investment personnel, quality of management personnel, quality of investment process, security selection, portfolio construction, risk management, counter-party risk, structure of the investment, fees and expenses, investor suitability and after-tax returns. With all due respect, it’s very difficult to see how ASIC would have the resources and necessary skills and experience to effectively categorise investment products so as to minimise the chances of loss.
It’s too easy to say, “it’s a standard Australian equities large companies fund, so it fits between the flags”. Over the many years I’ve been involved in research I’ve seen plenty of standard Australian equities large companies funds that I wouldn’t invest “two bob” in, because they’ve been absolute rubbish. These managers have had a range of issues including unstable, poorly capitalised business structures; inexperienced management or investment personnel; lack of a well-defined investment process; poor portfolio construction, monitoring and maintenance; no risk management measures or constraints; little or no systems and office infrastructure; tiny levels of funds under management; expensive fee structures; or all of the above! The majority of these managers are thankfully no longer with us. It’s disturbing to think that these kinds of funds could be categorised as “between the flags” when a well managed, highly diversified mortgage fund backed by one of the big four Australian banks would be “outside the flags”, due just to the illiquidity of its underlying assets.
Similarly, term deposit holders in some of the failed financial institutions of the past (Pyramid, for example) may not agree that term deposits are “between the flags”. After all, the Government bank deposit guarantee is not going to be in place forever. is, what happens when a product categorised as “between the flags” inevitably fails? Do the investors blame ASIC for misleading them? Investors assume that government authorities are acting in their interests – in much the same way some (wrongly) assume that a product ruling from the Australian Taxation Office (ATO) endorses the commerciality or viability of a tax-effective managed investment scheme – and they can take too much comfort from their guidance. If investors feel that a “between the flags” categorisation from ASIC offers some sort of protection, then this whole process could actually discourage them from doing their own research on an investment and trying to understand it.
It’s easy to criticise the initiative, but there’s no doubt it is well intentioned and an attempt to take action following a raft of high-profile corporate and investment product collapses that have resulted in investors losing substantial sums of money. Zenith agrees with Cooper’s statement: “There are many dimensions to poor financial outcomes for retail investors, including lack of access to quality advice, poor product design, poor investor behaviour and low literacy levels (both financial and general literacy), conflicts of interest and poor disclosure.” Zenith believes ASIC’s campaign (and advertising budget) would be better directed at some of the other issues highlighted by Cooper, including low investor literacy levels, access to quality advice, the quality of investment advice, conflicts of interest, poor disclosure and poor product design.
Collectively through ASIC, the ASX, the ATO and other government and industry bodies, solid progress is being made in areas such as conflicts of interest, via a review of remuneration practices of financial advisers, research houses and credit rating agencies. Progress has also been made on disclosure; but unfortunately a 120-page product disclosure statement (PDS) or statement of advice (SoA) does not translate into quality and transparent disclosure. In fact, this volume of information intimidates the average investor and makes it less likely they will read or understand the information. This process is ongoing, so let’s hope it results in shorter documents written in plain English that the layperson can understand. Not such good progress has been made in some of the other areas, such as financial literacy, quality of investment advice and product design.
It’s still amazing to think that of all the esoteric subjects now offered in secondary schools, there is still little, if any, education provided on the basic and essential life skill of managing your own money. Most people still have very little idea of some basic money management techniques, such as budgeting, let alone any understanding of how the sharemarket and other investment markets operate. While it’s true that some investors who have received professional financial advice have still lost money, there is a far greater percentage of direct investors who lack the financial literacy to understand what they are investing in who have lost even more money. From a quality of financial advice perspective, it’s still disturbing that the level of education required to provide financial advice to investors is laughably low. If the industry is ever to be taken seriously and held in the same regard as other professions, we need to dramatically lift the level of education required to provide financial advice.
While this won’t guarantee investors receive quality advice – and there is no substitute for financial planning experience – it will assist in “weeding out” poorly qualified, shonky operators. Product design is an area where ASIC could potentially make rapid inroads. One of the fundamental changes here would be seeking to match product structures with the underlying liquidity of the investment. That is, product structures should be designed to discourage inappropriate use of products. As an example, mortgage funds were never appropriate as a cash management facility.
If the product structure discouraged this kind of use through an exit fee over a three-year period and/or access to only part of an investor’s investment on a year-by-year basis, then this would help ensure (but not guarantee) that products are used in a more appropriate way for suitable investors. As ASIC already authorises the release of PDSs for investment products, a greater focus on the appropriateness of the structure of the offer should not be overly difficult, once established for different product types. Perhaps these measures are a more appropriate and effective use of ASIC’s budget and resources in protecting investors. After all, if the flags on the beach are placed in the wrong position or too far apart and the number of lifeguards is limited, it’s unlikely everyone “between the flags” will be saved.