SMSF funds represent around one-third of the $1.7 trillion held by the entire super funds sector in Australia – a honeypot for investment advisers of all types. But many traditional asset classes – bonds, residential and commercial property, shares – have been posting unspectacular returns.
That’s pushing some SMSF investors to seek returns from more arcane instruments – exchange-traded options strategies, structured products, non-vanilla warrants, hedge funds, hybrid securities and leveraged derivative products, such as contracts for difference. SMSF advisers need to understand the risks – and how to explain them to clients.
ASIC’s danger list
The Australian Securities and Investments Commission (ASIC) has signalled very clearly its concern about sales of complex products to retail investors and SMSFs. It has set up a Complex Products Working Group, and it led an International Organization of Securities Commissions (IOSCO) investigation into retail structured products.
Further, in a new report this year, it has warned SMSF advisers that it is watching the field closely. Besides warning accountants s complex products report also serves another purpose: it sets out for investors and their advisers
where the worst risks are.
- Hybrid securities: These often have “very complex terms”, says ASIC. Features such as long maturities, interest deferral or potential conversion into ordinary shares push up
investor risk.
- Contracts for difference (CFDs): “Complex features of CFDs include embedded leverage, counterparty risk and a lack of transparency of costs in the pricing spread,” says ASIC.
- Managed funds with complex non-standard or non-linear payoffs: These may be called ‘capital protected’ or ‘capital stable’ and yet have complex conditions defining the scope
of the protection.
- Hedge funds: These may use leverage, derivatives and short-selling, or seek returns with a low correlation to markets, in ways that expose investors to more complex risks.
- Structured products: These can be “highly geared or speculative structured products where all the investor’s outlay is at risk”.
Non-vanilla warrants: These can “lead to complex payoffs or risks”.
- Agribusiness managed investment schemes (based
on individual contracts): Long investment timeframes and the vagaries of farming may make returns difficult to predict – plus, their legal structures may “impose obligations on investors that are not always well understood”.
Disclosure is not enough
ASIC Commissioner Greg Tanzer went further in a February 2014 speech to the SMSF Professionals’ Association of Australia (SPAA). He cautioned SMSF advisers that ASIC is watching all the stages of the product sales process, including client advice.
For ASIC, the key risk posed to investors by complex products at the point of sale is that they might receive poor-quality advice – or no advice at all – which can result in poor product selection. This can happen to the most experienced of advisers and investors, and the fallout is not pretty.
Tanzer also warned that providing complex product investors with product disclosure statements (PDSs) will not be enough. This is because research shows many people react to complexity in a way we might not expect. Instead of working harder to understand the most important complexities, as detailed in PDSs, they put the complex problems aside and look at something they can understand – such as the product’s advertising.
Tanzer pointed to one clear warning sign – product disclosure that is not clear, concise or effective, and that uses ‘obfuscatory’ language. “Don’t blame yourself for not being able to understand,” he told his audience of advisers. “It’s a problem with the person making the disclosure.”
Tanzer’s bottom line: complex products make it even more important for advisers to communicate to clients exactly what they’re getting into. “In some cases, advisers may have misrepresented the product as being less complex than it was,” he warned.
The dangers of ‘capital protected’
Chris Magnus, a financial adviser at Ark Total Wealth, recalls how products such as capital protected investments came unstuck in 2009 and 2010.
These products required no money upfront and a chance to make extraordinary profits from the booming stock markets, while offering the promise of not losing your capital. Investors piled in, not realising – or caring – that they were signing up for multi-year loans, with stiff exit penalties if the investments went south.
In one instance, as the worst of the global financial crisis (GFC) had already receded, Magnus recalls how he was approached for help by a person who’d been lent $1 million with no deposit to invest in a capital protected product. It was a portfolio of indexed funds.
No one had explained to the starry-eyed investor that if the combined value of these indexes dropped below $1 million, the funds would, in effect, be frozen at the cash rate until seven-year options matured – and he’d still be up for the interest payments. Paying out the contract cost the investor about $300,000.
Magnus says the same motivation is behind a recent surge in enquiries he’s been receiving from clients wanting to use their super funds for more complex trades, using strategies based on derivatives and CFDs.
“These are people who are working hard and they don’t see any light at the end of the tunnel – until they get promised that their dream of being able to work from home or retire early will come true,” he says. “What some of these investors really don’t understand is there’s a huge amount of risk associated with these products, especially CFDs and forex.”
Hybrids: not what they seem
ASIC calculates that self-managed superannuation funds make up two-thirds of all investors in hybrid securities, which get their name from combining certain features of bonds and shares. They have been popular with ASX-listed corporations, especially banks looking to meet regulatory requirements. Since late 2011, they’ve raised more than $18 billion.
But as ASIC notes, many of these hybrids combine complexity with heightened risks from their long maturity dates and features such as interest deferral or the possibility of conversion to ordinary shares.
Bank hybrids – the bulk of that $18 billion raised – have performed largely as expected. But as fixed-interest consultant Dr Philip Bayley, of ADCM Services, points out, several non-bank hybrid issues have failed in ways many investors did not expect would happen.
Bayley points to the Elders hybrid issue, which attracted many investors wanting a stable income. What they got was a security with no maturity date that could suspend all payments to investors at the company’s discretion – and soon did, with not much hope of reinstating them any time soon. Stable income turned into no income and not much capital either – securities that once sold for $100 now trade around at $21.
As Dr Bayley notes, investors found it hard to properly analyse the hybrid’s structure and the conditions that could trigger changes in their value. Now they’re paying the price.
The gatekeeper’s duty
As ASIC’s Tanzer pointed out in February, investors will keep being attracted by promises of high returns out of products they don’t understand. That leaves SMSF advisers as the gatekeepers, he noted.
“Investors’ confidence and ability to make informed investment decisions depend critically on gatekeepers in the system doing their job.”
