The Financial Conduct Authority (FCA) has warned that the appropriateness or suitability of alternative investment products for investors is not being adequately considered.
In a ‘Dear CEO’ letter, the regulator also revealed it would be reviewing firms over a number of areas related to this.
In particular, the FCA warned against high risk alternative products – for example the Enterprise Investment Scheme (EIS) – being made available to less-sophisticated investors.
The FCA also said it had found that Client Assets Sourcebook (CASS) oversight and controls are not always robust, creating a risk of loss to client money and custody assets.
Inappropriate products and risk
Alternative finance products contain a number of advantages. They usually have high growth potential, and a number include generous tax benefits.
However they are also higher risk, and can feature reduced liquidity. Therefore, they are not considered appropriate for everybody.
In the Dear CEO letter, the FCA has said it will review retail investor exposure to alternative investment products offered by alternatives firms.
In particular, it will be testing if firms:
- Are aware of who their customers are;
- Place a clear focus on acting in the best interests of their clients and funds;
- Have taken reasonable steps to ensure that investors adequately understand the risks they are exposed to; and
- Ensure clients are not inappropriately exposed to products that carry risk beyond their risk profiles.
Recently, where the FCA has found industries offering inappropriately risky products to consumers, they have acted severely. This included creating the ‘restricted investor’ class for peer-to-peer investments, and outright banning retail investors from investing in mini bonds.
CASS and market integrity
As it was concerned that firms did not always have in place robust CASS oversight, it planned to test whether firms that hold the correct permissions had robust control oversight to:
- Support the oversight of CASS operations
- Maintain adequate books and records; and
- Operate in a CASS-compliant manner.
As the FCA recognised that alternatives firms have scope to take significant risk – including credit, market and liquidity risks – they need to have robust risk management controls in place to avoid excessive risk taking.
Therefore where firms adopt very high-risk investment strategies, particularly where significant leverage is employed, the FCA said it expects equally high quality risk management controls. To keep tabs on this, it said it may undertake in-depth assessments of firms’ controls.
The importance of due diligence
The FCA’s letter highlights the importance of due diligence for IFAs looking to invest their clients capital in tax advantaged vehicles.
EIS, for example, requires capital to be locked away for a long time – investments must be held for a minimum of three years to benefit from EIS tax reliefs, although many funds aim to provide exits for investors within a four to seven year period, investments can remain tied up for far longer.
Mark O’Donnell, Senior Investment Analyst at MICAP, said: “An IFA needs to be sure the client can afford to be without their capital for this period and individual losses across the portfolio should be expected, so diversification is key for investors. These are high risk investments, and so should only be part of a wider portfolio strategy. With money tied up this long, it is important to also conduct due diligence of the managers themselves, on their governance and financial health.
With the FCA’s focus now firmly on this sector, it is crucial not just that advisers research and compare the whole of market, but also that they can evidence that research with a clear audit trail. MICAP can certainly help in this regard.”
IFA’s also need to bear in mind how hands on will the fund be (for example, do they take a position of the board of their investments),what the track record and history of the management team is, and what level of capital do they have behind them to continue operating for the entire term of the investment.