Somehow, in the torrent of MiFIDII, GDPR, DB Transfer and myriad other rule changes during 2018, and with no let up in the flow of changes during 2019 in sight, the full implications of the new FCA PROD Sourcebook might have passed by many firms. The rules contained in PROD (or, to use its catchy Sunday name, Product Intervention and Product Governance) are significant and far reaching in terms of how firms research and select products and funds.
The PROD rules take over where RPPD (this guidance also had a catchy Sunday name – ‘The Responsibilities of Providers and Distributors for the Fair Treatment of Customers’ and can be seen here) left off, replicating what was in there and adding to it. The primary addition is that PROD comprises, and has the force of, rules not guidance. So there are serious implications for firms whose processes do not satisfy the requirements in PROD.
One of the fundamental tenets of PROD is that product manufacturers must identify a target market for each product and product distributors must take account of that in deciding whether and when that product should be used and, in particular, its match to:
- their own target clients (compatibility); and
- a specific client (suitability).
It is worth pointing out here that distributors can also be manufacturers – for example, where in-house model portfolios are created.
Target market – investor attributes
In assessing the target market for a product, the ‘typical investor’ is rated against a number of criteria or attributes namely:
- Investor type
- Knowledge and experience
- Ability to bear losses
- Risk tolerance
- Objectives and needs
We intend to do an article in the near future explaining these in more detail and covering other aspects of the European MiFID Template (EMT) which is a standardised format in which most manufacturers will communicate details of a product.
Meantime, this article is intended to make firms aware of some specific issues around EMT risk tolerance ratings and mapping products to the firm’s risk scale.
There are 5 risk tolerance bases but one is ‘internal’, one only applies in Spain and one only applies in Germany. So, for the purposes of firms operating in the UK, the two bases that we need to consider are:
- SRRI – in relation to UCITS;
- SRI – in relation to PRIIPS.
SRRI – Synthetic Risk and Reward Indicator
This indicator is based around 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. SRRI predates SRI and is based on different legislation.
SRI – Summary Risk Indicator
This indicator is based on market risk, but uses a different methodology, and also factors in 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.
SRI uses a more complex Cornish-Fisher methodology to assess market risk. The Cornish–Fisher expansion is ‘an asymptotic expansion used to approximate the quantiles of a probability distribution based on its cumulants’. From that last sentence you will quickly conclude that fully understanding the underlying maths of SRI is probably not an option for most non-mathematicians. That is fine. It is not necessary to understand that level of detail, just that SRI is different from SRRI.
SRRI and SRI differences
Both indicators score products on a scale of 1-7, where 1 is the lowest risk and 7 the highest. However, arising from the different legislative base and because there is a much wider range of products, with a much wider range of risks, within the scope of PRIIPs, the PRIIPs SRI is calibrated differently from the UCITS SRRI.
This means that the risks of a PRIIP and a UCITS cannot be directly compared by reference to the SRI/SRRI.
This should be a temporary issue which will be addressed when all UCITS funds start producing the PRIIPs KID. At present, firms offering UCITS are required to issue KIIDs instead of PRIIPs KIDs under a transitional exemption due to expire at the end of 2019.
Problem solved come January 2020? Unfortunately not!
- KIDs are widely considered to be seriously flawed;
- They incorrectly describe risks and likely performance and the statement of costs can also be confusing;
- KIDs are widely considered to OVERSTATE expectation of performance;
- SRI is widely considered to UNDERSTATE the real-life risk of a fund.
Useful further reading around these issues is the 2018 paper published by the Association of Investment Companies called ‘Burn Before Reading’. The paper can be accessed here.