Since the advent of MiFIDII in January 2018, the PROD rules have required ‘manufacturers’ and ‘distributors’ to consider a number of attributes of funds or products, primarily for the purpose of identifying a ‘target market’, i.e. types of investor for whom the product or fund is considered to be appropriate. Manufacturers are effectively ‘segmenting’ their products/funds and Distributors should be ‘segmenting’ investors/clients and matching the correct product/fund with the correct investor/client. The latter sounds like an update of, and perhaps a more sophisticated version of, the client segmentation that firms were supposed to do when RDR came along in 2013.
Many firms did identify client segments at that time, but the exercise was often fairly simplistic, aimed at defining which clients received the ubiquitous yet flawed gold, silver or bronze service. Segmentation was documented for compliance purposes and mostly ignored thereafter. PROD needs to be taken rather more seriously than that. Firms that observe PROD rules in a similar half-hearted or lip service manner could well suffer substantial regulatory difficulties. The FCA has made clear its intention to scrutinise how well firms implement PROD.
What is required?
Manufacturers (normally, but not exclusively, what is more usually referred to as providers or fund managers) must assess each fund / product against the set of attributes defined in the European MiFID Template (EMT) or European PRIIPS Template (EPT). There are some obvious attributes such as name of manufacturer, type of product, unique reference and the like. Of most relevance for the purposes of this article and consideration by distributors (broadly this means advisers but beware – it is possible to be both a manufacturer and a distributor) are the attributes that describe the investor type. These are:
- The type of clients to whom the product is targeted
professional client and/or;
- Knowledge and experience
(and for Germany only, Expert investor).
- Ability to bear losses
NO capital loss;
Limited capital loss;
Limited capital loss (level defined);
No capital guarantee;
Loss beyond capital;
(Note that a YES indicates that a product is suitable for investors that can bear losses beyond the capital invested. It does not necessarily mean that the product is designed to result in losses beyond the invested capital.)
- Risk tolerance and compatibility of the risk/reward profile of the product with the target market
Using either PRIIPs or UCITS methodology – see later comments on the dangers of this factor.
- Clients’ Objectives and Needs
There are several categories – preservation, growth, income etc.
Many of the answers will be in the form of ‘Y’ (Yes), ‘N’ (No) or Neutral – some might be blank. Firms need to be wary of neutral or blanks. Indications so far, from real life EMT data, are that neutral, and particularly blanks, can actually mean the manufacturer has not assessed the factor or does not know how to categorise it rather than that it does not apply.
In addition, although not strictly an investor attribute, the EMT also identifies a product’s suitability for a target market by reference to the ‘distribution strategy’, i.e. how it will reach target investors – advised, non-advised, execution only or through portfolio management.
EMT risk tolerance
For the remainder of this article we are going to take a closer look at the risk tolerance data in the EMT and highlight some pitfalls for the unwary.
As indicated above, there are two methodologies prescribed by the rules:
(actually there are five, but one is ‘internal’, one only applies in Spain and one only applies in Germany)
- SRRI (Synthetic Risk and Reward Indicator)
… this methodology is used for UCITS – pre-dates SRI and only considers ‘Market Risk’.
Market risk is the possibility of an investor experiencing losses due to factors that affect the overall performance of the financial markets in which he or she is involved. Market risk, also called “systematic risk,” cannot be eliminated through diversification, though it can be hedged against in other ways;
- SRI (Summary Risk Indicator)
… this methodology is used for PRIIPS – uses a more complex ‘Cornish Fisher’* methodology to assess Market risk and also considers ‘Credit Risk’.
Credit risk is the possibility of default in an investment – in particular Corporate / Fixed Interest Bonds. The primary method of mitigating credit risk for advisers and investors is due diligence and diversity.
*Cornish–Fisher expansion is an asymptotic expansion used to approximate the quantiles of a probability distribution based on its cumulants. It is named after E. A. Cornish and R. A. Fisher, who first described the technique in 1937. We will not be examining that in any detail – the description above should be enough to put you off, and the maths is beyond most mere mortals. In any case, it’s not really essential to understand it in order to implement PROD.
Both SRI and SRRI score products on a scale of 1-7, where 1 is the lowest risk and 7 the highest.
It is important to recognise that the PRIIPs SRI is calibrated differently from the UCITS SRRI. This is because there is a much wider range of products, with a much wider range of risks, within the scope of PRIIPs.
This means that the risks of a PRIIP and a UCITS cannot be directly compared by reference to the SRI/SRRI. A 3 on one is not the same as a 3 on the other.
This should have been a temporary issue, applying only until all UCITS funds would be required to start producing the PRIIPs KID. Firms offering UCITS were required to issue KIIDs instead of PRIIPs KIDs under a transitional exemption that was due to expire at the end of 2019. As a result of industry concerns about many aspects of KIDS, the transitional exemption will now not expire until 31 December 2021.
Concerns about KIDs centred around a widespread industry view that KIDs as designed and mandated are seriously flawed. In particular:
- The statement of costs can be confusing and ignores some elements of cost;
- KIDs incorrectly describe risks and likely performance*;
- KIDs are widely considered to OVERSTATE expectation of performance*;
- SRI is widely considered to UNDERSTATE the real-life risk of a fund.
* This is because future performance scenarios are extrapolated from past performance. Given the bullish market in recent years, many investment funds show unrealistically optimistic results, with positive performance even in so-called “unfavourable” scenarios.
The AIC issued an informative paper on this whole topic back in 2018 and it is well worth reading. One example they give is that 70% of all VCT KIDs show a risk indicator of 3, which is defined as ‘medium low risk’, a rating for VCTs with which most advisers would rightly disagree.
Mapping product / fund risk tolerance to client risk profile
Mapping risk of solutions to client risk is a process that every firm should have in place. Both SRI and SRRI score products on a scale of 1-7, where 1 is the lowest risk and 7 the highest but, for the reasons indicated above, firms should ignore these for the purposes of risk mapping against their chosen ATR scale.
For example, like many risk tools, ATEB’s risk process defines 7 different risk ratings but these CANNOT simply be allocated 1-7 against EITHER the SRI or SRRI rating from the EMT because of the flaws in the design of the EMT risk tolerance indicators.
Firms will either buy a risk mapping service from a third party or will do it in-house. Despite some technobabble marketing, at bottom, the process is not actually rocket science. Most mapping is ultimately based on the asset allocation between ‘growth assets’ and ‘defensive assets’. The latter being cash and quality fixed interest with everything else usually being in the ‘growth asset’ category, in our opinion. Firms need to take a view on property, the impact of currency risk, and more exotic beasts such as absolute return funds and structured products. We would normally consider these to be in the growth camp.