Financial advisers risk being sued if they wrongly allocate hybrid securities to the defensive bucket of a client’s portfolio, according to Russell Investments.
Scott Fletcher, Russell’s director of client investment strategies in Australasia, says that in the quest for income and yield in a low-rate environment, many advisers are putting their clients into hybrids.
“The scary thing we’re seeing is how they’re used,” he says. “If you’re grouping a hybrid into a defensive bucket you’re really misallocating the risk your putting into your portfolio.”
Russell says that if a client suffers serious losses on hybrids, a financial adviser could suffer significant business damage from disgruntled clients.
But they also expose themselves to legal action if they don’t have a proper understanding of risk, and allocate hybrids to the conservative bucket.
Many advisers are taking a renewed look at hybrids, and planners are “absolutely” putting them in defensive side of portfolio as a yield asset, Fletcher says. “What we’re seeing is there’s a reasonable amount of instances where hybrids are used as a term deposit replacement.”
“But it’s actually an equity-like strategy,” he adds.
Fletcher says when asked where they would allocate a hybrid security, most people say they would put them into a portfolio as a yield asset. But when asked where they would place an option on a bank stock, they would put it in the growth part of the portfolio.
“They’re actually the same thing,” he says. “The pay-off profile of a hybrid is effectively like writing a special type of option on a bank stock.”
“You need to understand the nature of risk you’re getting when you get into a hybrid security. It’s actually more equity like in terms of downside risk.”
The devil is in the detail
Fletcher says hybrids have both downside and “hidden” risks.
He says most people believe the chances of a bank converting hybrids into shares is very low. But he notes that conversion could also be triggered by regulators.
Basel III Tier 1 Capital rules have required a higher level of reserving from banks. “Hybrids can be caught up in that and converted into Tier 1 capital,” Fletcher says. “It could be a regulator or APRA saying you [a bank] need to increase capital. One of the most liquid ways [of increasing capital] is converting a hybrid.”
Fletcher says when it comes to hybrids the “devil is in the detail”. Yet many people don’t’ read right through the product disclosure statement (PDS) which could reveal “hidden things”.
He says that banks, for example, could have a cap on the maximum number of shares they convert. “It’s not going to be one for one,” he says, adding that conversion usually occurs at a time when bank stocks will be falling and investors could lose half, three-quarters or even more of their capital.
“There is a significant risk of capital loss on conversion,” Fletcher says. “Because that risk exists it’s not a term deposit or a bond fund. It behaves like an equity when markets fall, and when markets rise it behaves more like a bond.”
If an adviser replaces a term deposit with all hybrids for a client who is a conservative investor, such as a retiree; they are significantly underestimating the risks in that portfolio, Fletcher says. “There are potentially problems and risks for advisers from a business point of view.”
“In this sort of environment you just need to be smart in the way you construct growth and defensive allocations,” he says, adding that advisers shouldn’t allocate based on the name of an instrument. “You need to allocate by its risk characteristics. If something has more of an equity-like risk, it needs to go into the growth side of the portfolio.”
