What is a complex investment product?

A continuing area of uncertainty for product manufacturers, distributors, financial advisers, brokers and investors is what exactly constitutes a “complex” investment product. The topic was raised when I was a speaker at the CFA Institute’s ETFs Best Practice Beyond the Physical vs Synthetic Divide roadshow in Europe.

When the events were organised months ago, the organisers and speakers agreed the discussion on ETFs had moved on from the physical versus synthetic debate. However, the debate has moved back into the headlines as Lyxor and db X-trackers, the two largest synthetic ETF providers in Europe, announced they would start offering physical ETFs. Lyxor said it would convert some existing products from synthetic to physical while db X-trackers plans to launch a family of physical ETFs in addition to its synthetic range with similar benchmarks. Both firms said they were adjusting their offerings to adapt to investor preferences.

Many investors said they preferred physical ETFs because they found the synthetic structure more complicated to understand compared with a physical ETF. This raises the question of how to define a complex product. In Europe there is no agreed regulatory definition, and this omission has come into focus following regulatory consultations and guidelines on the protection of retail investors from complex products.

Should the definition be driven by the structure of the product (a Ucits fund versus an exchange-traded note, for example), the type of index (market cap, smart beta, strategy benchmark), the way the payoff is generated, the expected payoff or some other criteria?

The answer is important for the financial industry and retail investors. During the CFA Institute’s recent roadshow, one regulator suggested product providers could conduct a survey of their retail investors to see if they understood the product – if the answer was yes, the product would be deemed not complex.

However, the lack of complexity will not necessarily mean risk is not present: a debt instrument without collateralisation is not a complex concept to understand but it presents full counterparty exposure in addition to investment exposure.

Another roadshow suggestion was that as long as the retail investors understood the index and expected payoff it was not complex, and it is not important that retail investors understand how that return was generated.

An illustration of how to differentiate between complex and non-complex products is to look at ETFs and ETNs. In the case of an ETF you are dealing with a product exposure and delivery mechanism regulated in the EU through the Ucits framework. The Ucits guidelines have been developed with the goal of creating funds suitable for distribution to retail clients in Europe. Most Ucits funds would be considered non-complex but we see this is being questioned. ETNs are not regulated: in terms of investment exposure or the method by which that exposure is delivered. ETNs offer unsophisticated exposures but there is the possibility of exposures and risks that justify a complex designation in some cases.

The Ucits VI consultation and Mifid II are likely to provide more insight into the definition of a complex product and how the distribution and use by retail investors should be controlled. Will regulations aim to control product development or distribution or will it be a combination by making some complex products available to retail investors but not on an unadvised basis?

Aricle link: http://www.efinancialnews.com/story/2012-12-10/etfs-what-is-a-complex-investment-product