One of the key discoveries of the credit crunch was that complex financial products were much riskier than they first appeared, and investors got burnt when they underperformed because they did not understand their risk profile.
To try to prevent such risk from reoccurring, a group of investment bank-ing executives, the Counterparty Risk Management Policy Group (CRMPG), has suggested that high-risk products, such as credit default swaps (CDS) should only be available to sophisticated investors who understand the risks and can afford to take them.
The report, ‘Containing Systemic Risk: The Road to Reform', does not suggest pension funds be precluded from investing in high-risk complex instruments, but argues such products should only be sold to sophisticated investors. But some investment experts fear pension funds could be restricted from investing in appropriate investment products.
Most pension funds have tended to avoid ‘toxic' investments. Yet the group argues "all participants [in high-risk complex instruments] should be capable of assessing and managing the risk of their positions in a manner consistent with their needs and objectives" and have "the capability to understand the risk and return characteristics of the specific type of financial instrument under consideration". And this does go to the heart of the problem for pension funds as well, as they would be considered as sophisticated investors in certain conditions.
Julian Le Fanu, a policy adviser to the UK's National Association of Pensions Funds (NAPF), says while the report might tackle the lack of boundaries to protect investors in the US investment market, the UK's Financial Services Authority already places a requirement on any investment provider to ensure an investor is capable of understanding the risks of the product it invests in, as has the recent introduction of the EC's Markets in Financial Instruments Directive (MiFID).
"We have been through a round of investor reclassification, particularly through MiFID, with new boundaries in client classifications, so financial institutions' classifications have been reviewed to ensure they are in line with the requirements of the MiFID," said Le Fanu,
"[Firms] do have set procedures for dealing with these different types of clients so one of the changes for sophisticated clients is that even investment managers or banks may not be willing to provide these products to you."
If the CRMPG were to adopt a policy of selling only to sophisticated investors, it would need to define who that investor is and ensure products are applicable. The spotlight could then turn back onto pension funds, suggests Le Fanu, as the ongoing debate is whether pension fund managers with trustee boards, as is the case in the UK, really have sufficient knowledge to understand what they are investing in.
"One of the effects of insisting that pension funds as treated as though they were not at all sophisticated is it would close them out from access to certain instruments which might be beneficial to them. It is important pension funds have access to the sort of instruments that help to manage their liabilities," he said.
The CRMPG suggests traders and providers of complex instruments be required to issue documents profiling the risk of the product and the impact it might have on the investor's assets. But Le Fanu is concerned it will slow trading, and potentially increase costs as a result, because "the effect of lots of health warnings will be to put every complex trading instrument out of reach of less-sophisticated clients because you cannot be making disclosures the whole time".
There is also a real concern about the impact this could have on new investment ideas for pensions. One UK-based investment consultant says his team was asked by a pension fund a few years ago to look into using CDS as protection against the liabilities of its own sponsor's investments. The concern is that pension funds could be prevented from investing in new investment ideas because they are initially deemed to too complex or high risk, as was the case with the arrival of hedge funds.
Daniel Peters, investment consultant and actuary at Aon Consulting, believes the new proposals could do little to really prevent any sophisticated investor from entering a deal, unless the provider firmly said it was unwilling to trade. But the impact could be to limit access to investment innovation.
"To say pension funds should not invest is a blank statement. Who is going to stop them investing? I can't imagine there would be legislation preventing their investing."