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PRIIPs - More Regulatory Jargon or an Inflection Point for Structured Investments?

Phil Lancaster, Investment Analyst, StructuredProductReview.com



PRIIPs - More Regulatory Jargon or an Inflection Point for Structured Investments?



PRIIPs (Packaged Retail Investments & Insurance Products), regulation from the European Parliament, taking effect from 31 December 2016 will require products, including structured investments, to have Key Investment Document (KIDs) that can be shown to investors during the investment decision process.

In a game of Regulatory Acronym Scrabble, PRIIPs will score a miserly 10 points, but if its aim to improve transparency in retail investment products is achieved, the payoff could be much greater, rebuilding the confidence of retail investors and advisers in structured investments.

The game of Regulatory Acronym Scrabble is made-up and not recommended to be played in any company other than with like-minded financial services colleagues with no other source of amusement

PRIIPs applies to investment products where returns are subject to the value or performance of an asset not directly purchased by the retail investor. This covers a vast range of typical investment solutions to the exclusion of deposit products (including structured deposits), securities held directly by retail clients such as equities, and packaged investments aimed solely at institutional clients.

Whilst the detailed nuances of these new Regulatory Technical Standards continue to be analysed and debated, four elements are highlighted below as being significant for structured investments:

Consistency of Content and Design



In addition to the requirements for the KID to be written in plain English and to be no longer than three sides of A4, content has been broken down into nine pre-determined elements. Also, to ensure investors are not distracted by branding and unique formatting of KIDs, behavioural economics and extensive testing is in progress to standardise design and presentation.

The new regulation intends that ‘KIDs are the foundation for investment decisions by retail investors’. The PRIIPs regulation applies to a wide range of investments and the KID will allow for key features of structured investments to be directly compared with alternative investment products. As a ‘foundation’ document, KIDs will help investors understand the headline features of products, but we would caution against them being used as the sole determinant for investment decisions. Statements of Terms, providing quantitative and detailed product information should be read and understood. Also, where qualitative opinion is sought based on factual assessment, advice or opinion, such as the ‘preferred’ status provided by StructuredProductReview.com, should be considered.

Summary Risk Indicator (SRI)



A single SRI number, on a scale from 1 to 7, will be quoted in KIDs for all retail investment products. For structured investments, the SRI will take account of Market Risk and Counterparty Risk for that particular plan.

The PRIIPs regulation has published computation methodology for the SRI which varies according to the category of product being considered. The intention of a single SRI measure is to ensure consistency in the method used to calculate risk and how this is interpreted and displayed.

The SRI has caused much debate in the structured products industry and in particular the calculation methodology for the Market Risk component. Structured investments provide defined returns, based on the value of the underlying index, and returns are unlikely to be normally distributed. Instead they may be positively skewed. In Figure 1 below we present two return profiles – return profile (A), a normally distributed set of returns, and return profile (B), a positively skewed return profile. SRI uses historical data when calculating the Market Risk Measure, and considers the 97.5% Value at Risk (VaR) at the maturity of the product. Return profile B has a fatter tail risk and under SRI calculation methodology it’s deemed to have a higher risk than return profile A. Cube Investing chief executive David Stuff highlights the issue that many capital at risk structured investments will carry a tail risk similar to return profile B, and at 97.5% VaR, will therefore be deemed riskier than they are considered presently using alternative market risk measures. Please click here to read more

Figure 1– Normal Distribution of Returns and Positively Skewed Distribution of Returns



Performance Scenarios



All investment products come with the caveat that past performance cannot be relied upon as a guide for future potential returns, yet we continually see historical performance data given prominence in marketing literature. In response, PRIIPs includes the need for forward looking performance scenarios. Structured investments provide defined returns at a defined date (or dates), where the returns are defined by reference to an underlying asset (or assets). As such, providing a description of performance in favourable, moderate and unfavourable scenarios will be relatively straightforward in comparison to alternative investment products which may find this more challenging.

Costs



Just as the Retail Distribution Review (RDR) sought to improve consumers’ understanding of the costs involved in investment advice, PRIIPs requires the clear presentation of costs from a product perspective. The breakdown of one-off costs, recurring costs and incidental costs will not be complex for structured investments, compared to others, to declare and will improve transparency.

With further guidance on the Regulatory Technical Standards still to be published, compliance approval and publication of KIDs by the end of this year will be a challenge for product manufacturers. Large manufacturing firms may hold an advantage if they have been through the RDR Directive and have experience publishing Key Investor Information Documents (KIIDs) for UCITs funds, with these documents posing many similarities to the KID document. Similarly, advisers should familiarise themselves with the features presented and terminology used in KIDs to discuss relevant points with clients.

The 31st December 2016 could be an inflection point for structured products. PRIIPs should provide much needed simplicity and transparency in documenting the key features of structured products in a KID, potentially rebutting some myths and helping to build confidence of intermediaries and consumers in these investments. The greatest benefit is likely to be enabling direct comparisons to be made with alternative investment products, allowing informed decisions and better outcomes for retail clients.

Going forward, this is first of a five article series looking at each of the above elements and our analysis at StructuredProductReview.com on what they mean in practice for structured investments.