A complex debate
One misconception doing the rounds these days is the notion that some products are more complex than others. Structured products, warrants, hybrids, exchange traded- options are some of the examples cited as being complex which implicitly means that shares, bonds and property are not complex – or at least less complex – for the retail investor to understand.
The reasons given for describing the products listed above as complex typically revolve how they are explained, what they offer and the risks they entail. In particular, it’s the fear the investor does not appreciate the risks involved in such products – especially if they are geared – is what gets our regulators and consumer advocates all hot and bothered.
Although I can sympathise with their concerns, I can’t agree on the approach of labelling products as complex. The simple fact is that most financial products are complex.
Let’s take shares, for example. How to buy and sell shares would be understood by most investors. But that’s completely different to knowing whether an individual share investment is a sound or complex proposition.
Companies that issue shares have many moving parts – management, the health of the industry sector in which they operate, the amount of leverage on their balance sheets, intellectual property and their business model risk.
More often than not they will be involved in derivative transactions to manage their risk, hedging their foreign exchange or forward selling their products. The list is endless and similar to many of the concerns raised for so-called complex products.
In theory, this is what an investor buying into a listed company should understand. They reality, of course, is that many retail investors would only have a cursory knowledge of how a company operates and the associated risk. They are relying on their advisor, broker or media to get knowledge.
This is why I believe looking at any individual product is the wrong approach. What investors need to focus on is the overall investment strategy of their portfolio, to ensure it is diversified – crudely speaking, making sure all your eggs are not in one basket.
Getting the strategy right isn’t easy, either. The asset allocation that suits your risk profile can be complex and is time consuming. It takes education, experience and knowledge that only professional advice can provide and even though it is the investors’ money more education needs to be done around the value of advice rather than label single products as complex.
Research shows that it is the asset allocation strategy that can add significant value to a portfolio and not the choice of an individual stock or product.
In my opinion, this is where the debate should be at – getting investors to understand the importance of asset allocation, risk management and the value of advice. The discussion about a product’s complexity is, in my view, a side issue.
Once the asset allocation is in place then the actual stocks, bonds, property, hybrids, managed funds, hedge fund, or whatever, largely fall into place. If the allocation calls for 4% to high yielding hybrids, then the risk inherent in that decision has been made in terms of the entire portfolio; the actual hybrid/s bought is simply not as relevant.
In this sense having a professional advisor that you trust to work with you to determine the asset allocation and then advise you of how to flesh out that portfolio is critical. If they are doing their job correctly, explaining the complexity of all the products will be a key part of their role, whether it is BHP or a managed fund offering third world equities.
About George Lucas
George Lucas is managing director of Instreet Investment Limited. He has over 24 years' experience in the investment banking and funds management industries specialising in developing, managing and structuring financial products.
He was previously a director of two listed investment trusts, chief investment officer at Mariner Financial, and a senior equities derivatives trader with Citibank and First Chicago in London.
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