Are traditional funds opaque too?

I was pleased to read that Bill McQuaker, head of multi-asset funds at Henderson Global Investors was quoted by FTAdviser.com as saying that the criticism aimed at structured investments is unfair, especially given that traditional funds hold them without the same level of scrutiny as our industry.

Mr McQuaker commented that “one of the key elements, rightly or wrongly, is that people view the structured product world as opaque.”

Certainly, some traditional fund managers and financial advisers have long complained that structured investments are too complicated.

Both use derivatives!
As readers of this blog will know, the tailored payouts from structured investments are created using derivatives. They are often combined with actual or synthetic holdings of other assets such as cash, equities or bonds.

The same ingredients are employed by a variety of traditional funds to deliver performance and risk management and leading fund management houses such as Henderson, Newton, Jupiter, Schroders and Fidelity use listed and over-the-counter derivatives in their portfolios.

Their applications may include buying puts to provide downside protection and writing calls against holdings to generate income, as well as replicating long and short positions in markets – leveraged and unleveraged – without having to trade the underlying assets.

The same derivative strategies also form the basis for many retail structured investments.

But are they more transparent?
A number of traditional fund managers actively allocate between different companies, sectors or markets, even those that aim to track (rather than mirror) a benchmark index. They implement those decisions using a variety of instruments including derivatives.

Bill McQuaker is quoted as saying “It’s possible that people aren’t aware when they buy funds that they’re exposures to derivatives, but we don’t shy away from telling people we do.”

In many cases, retail investors holding traditional funds would find it difficult to replicate their manager’s investment strategies or performance. If delivering alpha was straightforward, every fund would be doing it and they aren’t, so traditional funds may not be as transparent as some people would argue.

Is there a level playing field?
In theory, both funds and structured investments should be viewed by investors, regulators, finance industry professionals and commentators in a similar way.

Yet the disclosure requirements for structured investments in most countries are more onerous than for traditional funds that actively use derivatives, even when those funds may describe a primary objective as “capital protection” or “capital preservation” without a formula for doing so.

The playing field does not appear to be very level. This became clear to me when I joined Skandia. Some of my investment management colleagues were surprised that the regulations and disclosure requirements for a structured fund were so much greater than for a traditional fund using derivatives.

Ironically, there may be advantages for structured investment providers in establishing more funds that do not have clearly defined formulaic payoffs. Funds that use derivatives and aim to deliver protection or income are therefore less transparent but more lightly regulated. Would that be a better outcome for retail clients?

In summary, Bill McQuaker was right to point out that more education is required to increase the common understanding of structured investments. In the UK, the industry has set about that task and must continue without letting up. Additionally, providers need to keep investment solutions simple too!

However, investment professionals and regulators should also ask why one product using derivatives can be treated so differently from another using the same strategies, and whether this truly benefits consumers?

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