Making Sure You Know The Risks

December 6th, 2010

December 2010: The effect of the credit crunch has led most people to re-assess the level of risk associated with investing as some products that were perceived to carry minimal risk actually resulted in investors losing some or all of their capital.  The most-high profile example was the impact on some products which relied on guarantees provided by Lehman Brothers.

If all this bad news has passed you by relatively unnoticed you may be one of the fortunate investors for whom the financial crisis may have had little significant impact, other than the “standard fare” of reduced investment returns.

So what can we learn from this? First of all it is important to stress that the Lehman’s collapse was an extreme case which was unforeseen by the investment markets. However, it does emphasise that investors should always make sure they fully understand the risks associated with any investment.  There are also some high-level questions you can consider before investing into a particular scheme or fund:-

1. Is the scheme regulated by the FSA?

One thing to be aware of is that not all ‘collective investment schemes’ or ‘CIS’ (a term for investments where money is ‘pooled’ by different investors and invested by a fund manager) are regulated by the Financial Services Authority.   Almost all funds marketed in the UK fall into this category (unit trusts are a good example)

A regulated CIS will either be an authorised (UK scheme) or a recognised scheme (a non-UK scheme).  In both cases, however, regulated schemes need to meet certain minimum requirements in terms of legal structure, the types of assets they can invest in, and also ensure that they have an adequate ‘spread’ of investments to reduce (although obviously not eliminate) the risks.

Although the fact that a fund is regulated does not necessarily eliminate any investment risk – the value can still go up and down and you could still get back less than you have paid in – it does mean that there are certain basic safeguards. For example, operators of regulated funds must ensure the fund assets are segregated from their own assets and held by an independent custodian.

CIS schemes that are not regulated cannot be promoted to the general public and are likely to be suitable only for more experienced investors – These schemes will often either invest in niche assets not available within regulated schemes or have highly focused investment strategies which increase the investment risk.

To make things slightly more confusing, some ‘funds’ will not actually meet the definition of a ‘collective investment scheme’ at all and are again therefore unlikely to be regulated by the FSA.

2.  What does the scheme invest in and what are the risks?

This might seem a straightforward question, however some investment funds/products continue to employ ever-more complex strategies to try and maximise returns.  Such techniques could include ‘gearing’ (the fund borrowing to invest), short-selling (selling shares and then ‘betting’ that they fall in value before buying them back), and the use of derivatives (complex financial instruments linked to the performance of a particular asset).

Even some regulated funds may (to a degree) employ these and other techniques and therefore it is important you understand the key risks, although there are restrictions in terms of the extent to which regulated funds can be exposed to a particular underlying investment.

Ensuring you have a diversified portfolio, spread across different asset types such as cash, bonds, property and equities is, as always, key but it is also important to be aware that there are a wide variety of investment strategies within each area.  Consider, for example, a commercial property fund – A mainstream ‘regulated’ fund will invest across a range of properties (spreading the risk) and perhaps even in the shares of property companies.   Contrast this with an ‘unregulated’ fund which might look to invest in a single commercial development opportunity – This may offer the potential for significantly higher returns but, due to the risks being concentrated on one development, also the risk of greater (even total) loss of capital in the event that the development is unsuccessful.

3.  Would I have access to the Financial Services Compensation Scheme (FSCS) if things do go wrong?

The FSCS is the UK’s statutory fund of last resort for customers of financial services firms. This means the FSCS can pay compensation to consumers if a firm is unable, or unlikely to be unable, to pay claims against it – This is known as being in ‘default’.

Whether you would be covered by the FSCS in various scenarios is, however, a complex question and would need to be considered on a scheme-by-scheme basis. In the context of an investment fund recourse to the FSCS may be available if the operator of the scheme ‘defaults’ but what the FSCS will not cover, however, are losses resulting simply from the inherent investment risks associated with the scheme.

Some scenarios that might at first appear to be covered are in fact investment risks associated with the product:- Capital-protected (or ‘structured’) products are a good example because the capital protection would usually be provided by a 3rd party and the  FSCS would not cover the loss of capital as a result of a 3rd party (the “counterparty”) not meeting its obligations.

It should, however, be noted that there are also limits to the level of payout in relation to any ‘default’ where the FSCS does apply.  This is currently £50,000 for investments but one thing to be aware of is that this would apply per fund management group and a fund management group may operate a number of funds.

The location of the scheme also has to be considered in the context of any compensation that may be available.  For example, ‘recognised schemes’ based overseas may conduct business in the UK – This means they will be a member of their home territory compensation scheme, which will protect customers in that country. Where the financial services firm’s home state scheme provides a lower limit of compensation than the FSCS the investment services firm may choose to join the FSCS to ‘top up’ the limit of protection to the level available in the UK (although not all ‘recognised’ schemes will choose to top up in this way).

For some products it may be the case that there is no compensation available at all. For example, in the case of overseas based operators of unregulated collective investment schemes, which are often based in far flung locations for tax reasons, there may be no compensation available at all in the event of the provider defaulting unless local provisions exist.

Summary

As mentioned previously, all investments carry risk – you should not invest if you cannot accept any loss to your capital – but it is worth considering that not all investments are the same.

As a general rule the ‘keep it simple’ principle applies to those investors who want to minimise the chances of any nasty surprises later down the line and it is also important to have a ‘diversified’ portfolio to ensure you are not unduly exposed to one specific risk  or investment.

Although it is difficult to generalise, specialist funds which invest in ‘alternative’ assets, complex derivatives, or offer attractive ‘headline’ double-digit returns are unlikely to fall within the norm and may prompt you to consider the questions mentioned above.   Of course these types of funds are not necessarily unsuitable investments but will not be right for everyone.

The golden rule is to ensure that you seek advice before investing.  Your Financial Adviser will be able to discuss the options and also help you find the right investment solutions.

The value of your investment can go down as well as up and you may not get back the full amount invested