Many investors buying financial products or seeking advice, may feel that they are entering into shark infested waters. They may be right. In the UK alone, about 20,000 new jobs were created to deal with the complaints over mis-sold payment protection insurance, according to employment group Manpower.
Between March and September 2012, the UK's Financial Services Authority, (FSA) used a research firm to send mystery shoppers, armed with tape recorders to pose as investors with a cash some of about £40,000 to invest for five years.
Like the UK, Irish investors are protected by regulation. Sellers of financial products must explain clearly the product they are selling, and give details of cooling off periods, the right to cancel and penalty charges for early redemption. Irish courts have recently dealt with instances where customers were sold unsuitable products, in breach of these rules and lost heavily.
All banks and financial intermediaries regularly assure regulators that they have procedures in place to protect the consumer. The good news is that, generally, the FSA was happy with 75 per cent of those it visited. On the downside, that means there is a one in four chance that some of us will be given misleading advice and this alone makes the report* worth reading.
Financial advisers are motivated to sell the highest quantity of financial products they can and focus on those that pay the highest commission. To keep costs down, the financial adviser will try to automate processes so that the expense of training and hiring experienced financial advisers is kept low.
A small minority treat regulation as a box ticking exercise, with savvy players finding ways of simultaneously complying with the regulation but giving customers whatever advice is necessary to maximise commission.
Suppose a customer has received €130,000 from an inheritance and has credit card debts of €10,000 and a sub-prime loan of €30,000. An ethical financial adviser might advise him to clear the credit card and sub-prime debts and invest the remaining €90,000. Very few investments would deliver returns that exceed the interest charged by credit card companies.
The FSA however found that some advisers either didn't want to know or ignored the loans – the commission on a €130,000 investment is, of course, higher than on €90,000.
The FSA is also concerned with how customers are classified according to risk. It suits the commission hungry adviser if customers are willing to take on a lot of risk. The adviser can then sell him a highly leveraged structured product, one that is complex and opaque and therefore conceals the high commission that the adviser receives.
If the customer claims that he or she is risk adverse, the adviser is confined to recommending simple products like bonds or straightforward bank accounts where the commission is both transparent and low.
One adviser, for instance, told a customer that his ability to achieve high returns was constrained by the system and was asked to pretend that he had good investment knowledge so that he could avail of higher yielding products.
Reluctant
The time horizon is a third area of concern. An initial transaction charge of say 5 per cent spread over 20 years works out at 0.25 per cent a year – relatively insignificant.
However, if the customer intends to cash in the investment after one year, the yearly transaction charge jumps 20 fold. Many customers, according to the FSA, are persuaded to set long-term horizons even if it is obvious that they have no intention to hold on to such investments beyond say three years.
Some advisors were reluctant to reveal precisely how their commission was charged. The FSA found that 87 per cent were honest. However, one adviser said: “You don’t pay me a penny and you don't pay the bank a penny for this.”
This is misleading since the adviser as intermediary is given commission by the company which originates the investment product which, in turn, is passed on to the investor.
Occasionally, investment advisers are tempted to make false promises to the customers who do not have a lot of investment knowledge. Typically, the adviser will focus on the returns that could be achieved and not reveal too much about the risks the investor may be taking to achieve those returns.
Deceptive
A customer who doesn't understand the risks in unlikely to make the correct decision. The FSA observed: "We saw a number of cases where advisers emphasised the potential returns from the investment product without mentioning the potential for losses."
The FSA also revealed a defaulters’ list. Household names that boast of being heavily regulated with strong controls and procedures are often in the dock. The principal flaw is that they sell complicated structured products to investors who don’t understand them.
Even names are sometimes deceptive. In one case the FSA remarked: “The Balanced Fund was risk-rated ‘balanced’ when it should have been ‘adventurous’.”
Cormac Butler is the author of
Accounting for Financial Instruments
and has led training seminars for bank regulators and investors on financial risk. He has traded equities and options
