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

Super changes, the Budget and 2021 versus 2022

Josh Frydenberg's third budget contained changes to superannuation and other rules but their effective date is expected to be 1 July 2022. Take care not to confuse them with changes due on 1 July 2021.

Noel's share winners and loser plus budget reality check

Among the share success stories is a poor personal experience as Telstra's service needs improving. Plus why the new budget announcements on downsizing and buying a home don't deserve the super hype.

Grantham interview on the coming day of reckoning

Jeremy Grantham has seen it all before, with bubbles every 15 years or so. The higher you go, the longer and greater the fall. You can have a high-priced asset or a high-yielding asset, but not both at the same time.

Whoyagonnacall? 10 unspoken risks buying off-the-plan

All new apartment buildings have defects, and inexperienced owners assume someone else will fix them. But developers and builders will not volunteer to spend time and money unless someone fights them. Part 1

BHP v Rio v Fortescue: it's all about the iron ore price

Don’t look at an earnings forecast or a DCF valuation or a broker target price for a mining company. Share price forecasts are only as good as the commodity price assumptions they are based on, and they are a guess.

Should investors brace for uncomfortably high inflation?

The global recession came quickly and deeply but it has given way to a strong rebound. What are the lessons for investors, how should a portfolio change and what role will inflation play?

Latest Updates

Shares

Five stock recoveries not hanging on COVID predictions

The focus on predicting the recovery from the pandemic is the wrong emphasis. Better to identify great companies benefitting from market changes over a three- to five-year horizon with or without COVID.

Exchange traded products

Peak to peak, which LIC managers performed during COVID?

A comprehensive review of dozens of LICs shows how they performed in the crucial 'peak to peak' of COVID. This 14 months tested the mettle and strategies of a sector often under fire, with many strong results.

Property

Blink and you missed a seismic shift in these stocks

Blink and it happened. If announcements in this sector were made by a producer of iron ore, gas, copper or some new tech, the news would have been splashed across the front pages. Have we witnessed a major change?

Worries over the planned proxy rule changes in Australia

We do not agree with Treasury’s suggestion that institutional investors are overly influenced by the research provided by proxy advisors. Here's how active ownership works to serve the client's best interests.

Economy

How to invest as inflation fears fade

There are many reasons why the worries about inflation are overstated and investors should protect their portfolios against falling inflation rather than rising. The economy is completely different to the 1970s.

Economy

A tale of the inflation genie, the Fed and the RBA

The inflation genie is still in the bottle. While wage growth remains low and the US Fed maintains current settings, we should expect the RBA's accommodatory approach to continue.

Strategy

Not so plastic fantastic: solving the single-use pandemic

At least 8 million tonnes of plastics leak into the ocean each year, equivalent to one garbage truck every minute. This is expected to double by 2030. Such pollution brings risks and opportunities for many companies.

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.