I have never seen a regulatory breakdown like the one currently gripping Europe and the UK. The Financial Conduct Authority (FCA) is making rules on the run, and the normally reserved investment industry is baying for blood after new disclosure rules came into effect on 3 January. The problem is that a key component of the new rules is proving to be fundamentally flawed.
In January the EU’s packaged retail and insurance-based products (Priips) regulation began. The key investor information documents (KIDs) are the issue. A KID is intended to disclose the potential volatility for that product. But, because the rules require five years of performance data, the information provided in some cases – possibly many cases – is either misleading, or extremely misleading.
I do not understand how this was allowed to happen. The regulation has been on the table for some time. Several times over the past few years we at FinaMetrica have talked about the flaws in the calculation and the effect it will have on investors’ expectations.
We cannot have been the only ones.
No-one knows exactly what to do. The only thing certain is that these new rules damage investment suitability and credibility, instead of making things better.
Misleading and meaningless
The grumblings in the media began in early January and quickly grew. The matter became so critical that the FCA took the unprecedented step of admitting that KIDs might mislead clients.
It said: ‘Where a Priip manufacturer is concerned that performance scenarios in their KID are too optimistic, such that they may mislead investors, we are comfortable with them providing explanatory materials to put the calculation in context and to set out their concerns for investors to consider.
‘Where firms selling or advising on Priips have concerns that the performance scenarios in a particular KID may mislead their clients, they should consider how to address this, for example by providing additional explanation as part of their communications with clients.’
This is, to say the least, astounding.
The regulator is publicly admitting that the regulation it mandates and enforces produces misleading or meaningless results – and sanctioning product manufacturers using their own ‘workarounds’.
Senior industry figures are calling for FCA heads to roll, along with a few more heads in Europe for good measure.
To recap, these are the two core issues:
- Five years of performance data required in a KID is, in most cases, not enough. In some limited cases it is far too much. For products like short-term options, a five-year extrapolated figure is just meaningless. For long-term investment products, five years of performance data simply is not enough to properly frame an investor’s expectations.
- The labels used to describe investments do not have agreed and accepted definitions or understandings.
The FCA is saying that if the KID data is insufficient, extended performance data and commentary can be provided: what the FCA is calling ‘additional explanation’.
But that leaves us as much in the dark as ever.
We do not even know what content is required or acceptable in these additional explanations. Nonetheless, for now, the market appears to be stuck with these flawed rules.
Broadly, advisers must know the client’s circumstances and goals. Specifically, to really ‘know’ the client, they must know their:
- Risk required: the amount of investment risk needed to achieve the goal within the timeframe.
- Risk tolerance: the amount of risk they are comfortable with during market volatility.
- Risk capacity: the amount of financial loss that can be sustained without compromising goals.
One of the best professional protections comes from having a client’s properly informed consent to their plan and the risks in their plan. That is clearly not possible when risk descriptions are so patently flawed.
Paul Resnik is director of FinaMetrica.