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Are Regulators Misleading Investors?


If you have had someone tell you that a fund they are proposing or recommending has low risk as defined by the Regulator (the risk categories of 1-7, also referred to as the ESMA risk ratings), treat that information as currently presented with a large pinch of salt. The European regulators are assessing the risks in funds is an entirely misleading way. This article is aimed at explaining the problem.

Many investment commentators as well as many in the media have tended to argue that the major issue facing private investors is whether they should use passive funds (i.e. tracker funds like ETFs) or actively-managed funds. While it's a sound debate, at GillenMarkets we do not agree that it is the main issue for private investors.

It is a well-researched fact that retail investors invest most when markets have already advanced sharply, and they divest in droves when the news of the day is grim, and markets are declining. In other words, they miss most of the returns not because of which fund-type they are in, but because they invest when they are confident and divest when they are fearful. It is this lack of emotional control during difficult market conditions that is the chief enemy of the private investor.

Understanding the actual risks that can lead to a permanent loss of your capital can help to overcome this natural tendency to buy high and sell low.

Global Markets - iStock PhotoThe three major risks in companies are the business, financial and valuation risks. If you can mitigate these risks you will be a successful investor, and everyone can succeed at investing with a little knowledge or education.

Business risks include the risks that a company will be earnings less in 5-10 years than it is today. To mitigate the business risks, we can own many different businesses, and this is more easily achieved through fund structures.

Financial risks include the use of too much debt either by the company or by the investor herself. Financial risks can also be largely mitigated by diversifying widely using fund structures and by the private investor avoiding the use of personal debt.

Valuation risks are the hardest to mitigate as even owning shares through a fund structure does not overcome the fact that an entire market can be overvalued. For example, investing a lump-sum in the US S&P 500 Index in late 1999, when developed stock markets were arguably the most overvalued ever, led to losses on both a five and ten-year view, and has delivered a return of 4.5% compound per annum over the 18 years since, which is just half the historical long-term average.

Of course, investing through good market conditions and bad can greatly assist an investor to mitigate the poor returns that always follow overvalued markets, but not everyone has that flexibility.

When investment risk is understood in this way it becomes clearer that volatility in markets is rarely actual risk, but mostly just noise. As an example, Kerry Group's share price declined 41 per cent from peak to trough during the Global Financial Crisis (GFC). Yet, business risks at Kerry were no higher at the end of the GFC than at the beginning, the company was never overborrowed and its shares were not particularly expensive prior to the crisis. The volatility in Kerry's shares back then was not the sign of rising risk at the Kerry Group. It was just noise and a damn good investment opportunity if you had any cash!

Yet, and most disappointingly, regulators in Europe would have you believe that this volatility in companies (and funds) represents the real risk. And the European Securities and Markets Authority (ESMA) has actually gone so far as to insist that retail funds be rated for risk according to how volatile their share or unit prices have been over the previous five years. So, in the eyes of European regulators, Kerry at €13.20 a share in late-2008 was a riskier investment proposition than Kerry at €22.50 a share 18 months' earlier because of this volatility.

Life is easier for regulators, of course, if they have Einstein's formula for risk, that single formula which allows them to compare the risk in one fund with another. To use volatility as the proxy for risk solves the problem for them as to how to compare the risk in one fund with another. The uncomfortable truth, however, is that the entire basis of their argument is flawed and this method of assessing risk has been discredited for decades.

Recently, the Association of Investment Companies (AIC) in the UK has gone so far as to remove the Key Investor Information Documents (KIIDs) recently introduced by European regulators for inclusion by investment trusts - which use volatility as the measure of risk - from its website stating that they are 'misleading'. The same argument can be made about Key Information Documents (KIDs) which are required for UCITs regulated funds in Europe and PRIIPS which are required for packaged retail and insurance-based investment products.

What's the hapless investment adviser to do? One the one hand, she is forced by regulators to ensure that her clients have seen these new Documents/Factsheets before investing while on the other hand she has a duty to inform the client that these same documents contain seriously misleading information.

Perhaps the Irish Regulator would speak up for common sense in future European regulatory meetings that they attend and request that the EMSA risk ratings in general be withdrawn and that the KIIDs, KIDs and PRIIPs be revamped. The issue of judging risk is subjective, cannot be reduced to a single formula based on volatility and is the responsibility of the investment adviser and not the Regulator!

The Regulator is the chief problem. By allowing so called 'advisors' to earn upfront commissions on investment products that they recommend the Regulator continues to encourage the development of a network of sellers rather than impartial advisers across the Irish financial services industry. Ban upfront commissions on investment products and you will get advisers who act impartially. If they are impartial and properly trained they can assess the risk in one fund versus another through knowledge and experience and the problem of assessing risk in funds sorts itself out. It's about the incentive!


Rory Gillen
Founder, GillenMarkets
11th June 2018