European securities regulators say that complex products being sold to retail investors have produced relatively meager returns, and require better disclosure.
The European Securities and Markets Authority (ESMA) has published a new research report that examines the growth of complex financial product sales to retail investors in the European Union (EU). Specifically, it focused on so-called alternative investment funds, and structured products, and concluded that the returns on products sold over the past five years have been weak.
The report notes that assets under management in alternative funds grew from €20 billion ($27.4 billion) in 2007 to €85 billion in 2012, and structured products have become an even bigger asset class, €770 billion invested in these products as of the end of 2012. However, it also found that “while their sale to retail financial consumers has increased, there is evidence to show that both products have produced relatively low returns” — 3% for alternative funds, and 2.5% for structured products. Ona risk-adjusted basis, the returns are close to zero, it notes.
The report suggests that the growth of this market may have implications for both financial stability and investor protection. “From a consumer protection perspective, retail investors may face difficulties in understanding the drivers of risks and returns of complex products. As a result, it might be particularly challenging for investors to make proper investment decisions,” it says. “If retail investors do not properly understand the risk and reward profile of complex products, unexpected losses might lead to complaints, reputational risks for issuers and a loss of confidence in the regulatory framework and, more broadly, in financial markets.”
Specifically, the report says that the strategies used by some alternative funds might not be easy to determine, and, therefore their comparison to a proper benchmark might be challenging for retail investors. Comparing alternative funds to traditional mutual funds, proxied by equity and bond indices, the report says that the risk-adjusted returns for traditional funds are higher, especially for bond indices. However, it also notes that investors in alternative funds may be less exposed to losses when markets are bearish.
Similarly, for structured products, the report finds that the risk and reward profile of these products is not straightforward and is hard to understand. “In particular, the payoff structure, intrinsic value and expected returns of structured products might be difficult to assess,” it says. “Given that retail investors may not possess the expertise needed to assess the drivers of the performance of structured products, they could be at risk of facing unexpected losses. In particular, the analysis of the issuer credit risk embedded in structured product may be particularly challenging.”
The ESMA says that it will use the report’s findings in its policy work on improving investor protection “by promoting better information disclosure at the point of sale about the total costs of investing in complex products and specific risks attached to each product.”
($1 = €0.73)