In a previous article, we gave an overview of the target market aspects of the PROD rules that came in as a result of MiFIDII in January 2018. In that article we focused on the Risk Tolerance aspect. We drew attention to the fact that a firm’s assessment of a client’s risk tolerance are unlikely to directly map to the European MiFID Template (EMT) risk tolerance definitions and that, in any case, the EMT definitions need to be viewed with caution. At first sight, the EMT Risk Tolerance might look like Attitude to Risk (ATR) … but it isn’t!
This follow up piece looks more closely at the ‘Ability to Bear Losses’ aspect. At first sight, this might look like Capacity for Loss (CFL) … but it isn’t! Read on to see why.
A quick recap
Manufacturers (i.e. product / fund providers) have adopted the EMT as the recognised format for communicating the nature of a product to distributors (advisers) in relation to a number of criteria. With regard to the target market for a product (who it is intended for), the EMT describes the target market according to the following criteria:
- Investor Type
- Knowledge and Experience
- Ability to Bear Losses
- Risk Tolerance
- Objectives and Needs
These appear to be client attributes, but they are not, at least not all of them, and at least not in the same way as advisers generally consider clients.
The difficulty for firms trying to ensure that their investment process reflects PROD requirements is that they have to identify their target market(s), formerly known as client segmentation and, in doing this, firms have to find a sensible way to incorporate the EMT product focused criteria into a process that is client focused.
Ability to Bear Losses (ABL)
The EMT defines the possible options for ABL as follows:
Investor can bear no loss of capital. Minor losses especially due to costs possible.
Investor seeking to preserve capital or can bear losses limited to a level specified by the product.
Loss up to XX%.
No Capital Guarantee nor protection. 100% capital at risk.
Loss Beyond the Capital.
The definitions appear to refer to clients, but it should be remembered that Manufacturers apply the EMT criteria in the context of a categorising a product, not a client. This is most clearly demonstrated in the second entry, where it is a feature of the product that is the key factor, not the client.
A closer look
So, let’s take a closer look at each of the definitions.
- Investor can bear no loss of capital. Minor losses especially due to costs possible
We indicated above that ABL is not the same thing as CFL. However, at both ends of the spectrum, they happen to have the same effect for practical purposes. By definition, if a client is properly assessed as having no capacity for loss, that happens to coincide with this first EMT option – no capital loss.
For the purposes of the firm’s investment process, the proposition for such individuals is likely to be that there is no proposition. The only suitable recommendations would relate to cash or instruments with a ‘no capital loss’ guarantee of which, these days, there are precious few if any. You can still find instruments that have a no loss guarantee at a future specified date but that is not the same as a guarantee of no loss at any point. In addition, when the cost of advice is factored in, it is likely to be in both the firm’s and the client’s interest not to engage.
- Investor seeking to preserve capital or can bear losses limited to a level specified by the product
This definition is strange! It does not seem logical to categorise a client seeking to preserve capital in the same place as a client who will accept a degree of loss. A client seeking to preserve capital would more sensibly be considered to be essentially the same as ‘no capital loss’. So, we will focus on the second part – losses limited to a level specified by the product. This is an attribute of a product , not a client attribute!
How does this relate to the investment process? Well, it seems clear that the definition refers to a product that has, by definition and design, a potential for capital loss but where that loss has a ‘guaranteed’ floor. An example would be a structured product where the capital loss is limited to, say 25%, i.e. “if the XYZ index falls by more than P% during the defined period, the end value of the investment will be not less than 75% of the initial investment”.
Accordingly, firms will include such products in a recommended portfolio for diversification or risk management reasons, where appropriate. Alternatively, the firm might choose not to recommend structured products at all. Either way, the circumstances where it would be appropriate to consider structured products or the rationale for always excluding them should be documented.
- Loss up to XX%
This option identifies such a product as being suitable for an investor who specifies a level of loss that is acceptable. It is not obvious why any investor would explicitly do so, or how that would arise in the course of a fact-finding discussion. It is also difficult to identify what such a product would be other than a structured product, provided that the level of potential loss is capped within the level of loss that the client has stated to be acceptable. It would be unwise to recommend any ‘normal’ diversified portfolio and believe that there is no possibility of a loss beyond what the client has specified. There is always such a possibility, however slim.
There is another problem here, and that is to do with the way that many firms ‘assess’ CFL. We have written before about the flaws in many third party tools and the particular issue here is that the questions in, and output from, some of those tools are framed as a percentage. For example, “How much of this investment could you lose without having a significant impact on your standard of living?”
As we have stated in previous articles on the topic, this sort of question is essentially a self-assessment unsupported by any considerations of the time horizon for the investment, inflation or quantification of what the client’s ‘standard of living’ will cost at an undefined future point in time.
The flaws in the question are exacerbated by the limited answer options – generally along the lines of small, medium or large – where small, medium and large are undefined, meaning that any answer the client selects is meaningless! Where these undefined labels are replaced by numbers, for example, 10%, 20% and 30%, the answer is still essentially meaningless.
Finally, the outcome of most of the tools out there is the labelling of the client’s CFL as small, medium or large, or some stated percentage – again undefined and essentially meaningless … but even more risky now that the EMT ABL has come along. The ABL categories are not directly interchangeable with a firm’s assessed CFL. They two might coincide in effect at the black and white extremities but they don’t in the fuzzy grey middle.
So, how to deal with this in the investment process. Probably in a similar way to the previous section relating to structured products but with the addition of a thought process that goes along the lines of …
“In the event that the client states that any investment loss should not exceed a specified amount, and the limitations and implications of that constraint have been discussed fully with the client (and documented) …
… recommendations should include only investments that can be guaranteed to satisfy that specification. That would include cash based or structured investments with an appropriate maximum downside within the client’s specification.”
“… as we do not advise on structured products, it is likely that we would not engage with the client.”
- No Capital Guarantee nor protection. 100% capital at risk
This is similar to the no capital loss scenario in that, at both extremes, the effect of both factors should be the same as an assessed CFL even though the concepts are subtly different as indicated earlier.
For investment process purposes, such clients are appropriate for a portfolio with any asset allocation up to and including 100% equity. In practice, the recommendation would then be guided entirely by the firm’s ATR assessment (in terms of risk) and other non-EMT factors relating to the client’s situation, e.g. the client wants a specified level of income; or the tax situation indicates an investment bond would be appropriate and so on.
- Loss Beyond the Capital
Most firms can probably ignore this as a separate category as its effect is no different to the ‘no capital guarantee’ in practice. In addition, we are not aware of any products where the investor is liable for losses beyond the initial capital – certainly none that are suitable for retail clients.