Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 366

Punting with retail financial products beyond ASIC's watch

Despite the publicity in recent years about financial institutions selling unsuitable financial products to retail investors, the behaviour has not stopped. ASIC should take action to prevent sales of a number of investment products designated as ‘deferred purchase agreements’ (DPAs) by ‘large, reputable’ and other financial firms. Investment banks and financial advisers have offered such products with doubtful understanding by their clients.

Not suitable for retail investors

Notably, there appears to be no public information on the outcomes of past investments in such products. In some cases, they may well have been good. But the inability of a retail investor to assess the expected return and risk makes them unsuitable products.

What are they? To illustrate, imagine investing in a financial product where the final return in two years depends upon both the share prices of some US companies such as Amazon, Twitter, and Facebook (the ‘reference’ assets) at that time, and the paths the share prices have taken over those two years. The precise relationship between your payoff and the share price behaviour is very complex (as illustrated later), and you could lose a lot or gain a lot.

While explicit formulae are specified to determine the payoff, the likelihood of a retail investor or SMSF trustee (the target market for these products) being able to understand these sufficiently to accurately assess expected return, risk, and value for money is very low.

A finance specialist with the aid of good computing power could probably do it in a couple of days. But, realistically, the internal workings of these products are no clearer for the average investor than the workings of a poker machine!

To make things even more obscure, the contracts involved are classified as DPAs. This occurs because the value of the payoff in two years is settled by the financial product issuer delivering an equal value of shares in some specific company unrelated to the reference assets involved (such as Telstra). The DPA refers to the fact that the issuer has entered a contract for future delivery of some (uncertain) number of Telstra shares, for a payment by the investor at that time which is equal to the value of the investment’s payoff.

In most of these products, the issuer will agree to sell those Telstra shares on behalf of the investor, rather than deliver them, and provide the cash proceeds to the investor. Does something smell fishy? Why have this roundabout way of generating a cash outcome for the investor?

Designed like this for tax and ASIC reasons

The answer appears to lie in the bowels of tax legislation. The receipt involved in a DPA (of more than a one-year term) is treated as a capital item for tax purposes, meaning that profits or losses are treated as capital gains (taxed concessionally) or capital losses, rather than as normal income. Thus, if an investor on a 50% tax rate received $12,000 from an initial investment of $10,000, the tax on the $2,000 profit would be $500 (since only half of the capital gain is included in taxable income) rather than $1,000.

For those with suspicious minds, there may be another reason for structuring the investment product as a DPA. For some unknown reason, the product disclosure statement (PDS) of a DPA does not need to be lodged with ASIC!

Why are these products so hard to value? Consider an illustrative (simplified) typical structure.

First, over the two years there will be quarterly ‘memory call’ dates specified. On any call date, if certain conditions are met, the product may be terminated by the issuer by repaying the investor their principal plus a prespecified dividend amount. The product cannot be terminated at a call date if there is at least one share whose price has never been above its issue date value either at that, or an earlier, call date.

Second, if at any time the price of any single reference asset falls below 65% of its value at the product issue date a ‘kick-in’ event occurs. This triggers a specific formula being used for the final payoff, which also depends on the values of reference assets at that final date. A likely outcome is that the final return depends on the share price of the worst performing reference asset, such that a large loss could occur if that share price was less than its issue date price.

Third, if no ‘kick-in’ occurs, the final payoff will be the larger of some specified minimum positive return and the absolute return of the worst performing reference asset. If all reference assets have a positive return, it is likely that a call event will have occurred such that the product has been terminated earlier. But if one has a negative return, the formula is relevant, and the investor’s return will reflect the (absolute) return of the reference asset which has deviated most from its initial price (if that deviation is above the specified minimum).

Complicated? Certainly

The issuer can model these possible outcomes and determine how it might hedge its risk by derivative transactions in the reference assets (and the exchange rate if they are overseas stocks), and how setting of the various terms will affect its likely profit. But the chances of the retail investor being able to do likewise and determine whether the product offers fair value seem very unlikely. Nor, for that matter, are the financial/client advisers likely to have the technical skills needed to properly assess expected risk and return and product suitability for their client.

The introduction of Design and Distribution Obligations for financial product manufacturers and distributors to show product suitability for the target market has recently been deferred until 2021. Once they come into operation it seems unlikely that such complex products would meet those requirements and cease being offered. In the interim, there looks to be a good case for ASIC using its recently acquired Product Intervention Powers to stamp out such offerings.

 

Kevin Davis is Professor of Finance at University of Melbourne. In 2013, Professor Davis was appointed to the Commonwealth Government's Financial System Inquiry panel (The Murray Inquiry) which was "charged with examining how the financial system could be positioned to best meet Australia’s evolving needs and support Australia’s economic growth", and which presented its report to the federal Treasurer in November 2014 (www.fsi.gov.au)

This article contains general information only and does not take into account any person’s individual financial circumstances.

 

RELATED ARTICLES

Easy money: download Robinhood, buy stonks, bro down

banner

Most viewed in recent weeks

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

Three all-time best tables for every adviser and investor

It's a remarkable statistic. In any year since 1875, if you had invested in the Australian stock index, turned away and come back eight years later, your average return would be 120% with no negative periods.

The looming excess of housing and why prices will fall

Never stand between Australian households and an uncapped government programme with $3 billion in ‘free money’ to build or renovate their homes. But excess supply is coming with an absence of net migration.

Five stocks that have worked well in our portfolios

Picking macro trends is difficult. What may seem logical and compelling one minute may completely change a few months later. There are better rewards from focussing on identifying the best companies at good prices.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

Let's make this clear again ... franking credits are fair

Critics of franking credits are missing the main point. The taxable income of shareholders/taxpayers must also include the company tax previously paid to the ATO before the dividend was distributed. It is fair.

Latest Updates

Investment strategies

Joe Hockey on the big investment influences on Australia

Former Treasurer Joe Hockey became Australia's Ambassador to the US and he now runs an office in Washington, giving him a unique perspective on geopolitical issues. They have never been so important for investors.

Investment strategies

The tipping point for investing in decarbonisation

Throughout time, transformative technology has changed the course of human history, but it is easy to be lulled into believing new technology will also transform investment returns. Where's the tipping point?

Exchange traded products

The options to gain equity exposure with less risk

Equity investing pays off over long terms but comes with risks in the short term that many people cannot tolerate, especially retirees preserving capital. There are ways to invest in stocks with little downside.

Exchange traded products

8 ways LIC bonus options can benefit investors

Bonus options issued by Listed Investment Companies (LICs) deliver many advantages but there is a potential dilutionary impact if options are exercised well below the share price. This must be factored in.

Retirement

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

Investment strategies

Three demographic themes shaping investments for the future

Focussing on companies that will benefit from slow moving, long duration and highly predictable demographic trends can help investors predict future opportunities. Three main themes stand out.

Fixed interest

It's not high return/risk equities versus low return/risk bonds

High-yield bonds carry more risk than investment grade but they offer higher income returns. An allocation to high-yield bonds in a portfolio - alongside equities and other bonds – is worth considering.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.