Does More Regulation Make Investment Products Safer?
Regulated versus unregulated is a false dichotomy. Virtually no investment product or company is unregulated today, and offshore funds are rarely “unregulated.” So, we will discuss degrees of regulation.
Onshore regulation, and that of retail products including pensions and insurance, can be more extensive and intrusive than offshore regulation and that of products restricted to accredited/sophisticated/institutional investors. But all these types of regulation seem to be increasing. Does extra regulation reduce the risk of loss?
Regulation is a huge and growing topic, so for now we will focus on a few well-known areas where regulation may provide false comfort: leverage, insurance companies, pension funds, and longevity.
Leverage is one area where onshore, regulated fund structures can often impose limits. Some types of undertakings for collective investment in transferable securities (UCITS) will cap leverage at 200% gross exposure and Investment Company Act of 1940 mutual funds can have a 300% asset coverage limit that works out at a 133% gross exposure limit. In contrast, neither offshore fund regulators, such as the Cayman Islands Monetary Authority (CIMA), nor the state of Delaware caps leverage. However, many Cayman Islands, Delaware, and other funds have self-imposed leverage limits, as low as 200% or 300%, in their offering documents. Such limits can be tighter than those for UCITS funds that use a value at risk (VaR) limit instead of a leverage cap.
Note that all of these limits only apply to balance sheet leverage. Notional leverage can be obtained off balance sheet through myriad means — total return swaps, notes, certificates, or investments in leveraged portfolio holdings. Before 2008, banks were sometimes 30 or 40 times leveraged, on a look-through basis, and the equity tranche of a structured credit vehicle could be even more leveraged. Plenty of bank stocks are down by 80%, 90%, or more since 2007, although banks are some of the most heavily regulated companies. The multiple regulators overseeing banks in the United States did not remove the need for taxpayer-funded bailouts in 2008, whereas hedge funds, which are less heavily regulated, did not need bailouts in the credit crisis. Clearly, fund-level leverage limits cannot remove the risk of leveraged-related loss, and only education or advice, not regulation, can help investors gauge leverage-related risks.
Insurance Company Shenanigans
Just as banks are closely regulated, so too insurance companies are more weightily regulated than many investment firms. Relationships with retail investors make reporting, compliance, and inspection requirements more onerous, and there are special solvency rules for insurers. Nevertheless, in 2015, the United Kingdom’s largest insurance company, Aviva, was fined £17.6 million for failing to prevent the inappropriate allocation of trades among accounts. This fine was on top of £132 million paid to certain funds to compensate them for performance shortfalls arising from the scheme, which saw traders at Aviva allocating profitable trades to accounts that paid higher fees and loss-making trades to those that charged lower or no fees.
What is astonishing is that this abusive behavior continued for eight years, between 2005 and 2013, before being discovered. During that time, Aviva would have had annual audits, multiple inspections, and visits from regulators, internal audits, and numerous compliance reviews. Clearly, extra levels and layers of regulation and supervision cannot guarantee proper behavior. Ultimately, only the integrity of individuals working in the investment industry can ensure that.
In the 1990s, another regulated UK insurance company, The Equitable Life Assurance Society, completely failed because it could not sustain fund guaranteed annuity rates that represented promises to pay certain fixed interest rates on retirees’ pension funds. After years of legal battles, the directors were found liable, but pensioners who had bought these regulated products ended up with a lower than anticipated standard of living. Unlike in the Aviva case, neither Equitable Life nor its service providers, regulators, or the government had the wherewithal or willingness to compensate the investors.
Yet the guaranteed annuity rates were, arguably, only one implied part of a final salary or defined benefit pension promise. This, arguably, faces greater uncertainty.
Political Pension Promises
Pension funds are often subject to extra regulations, but these cannot always guarantee that the funds will keep promises. Thanks in part to compulsory contributions and universal coverage, the Netherlands has the largest per capita pension assets of any European country, and Dutch pension funds are regulated by the central bank. Yet in recent years, many of these funds have not increased pensions in line with inflation and have even made absolute cuts to pensions in payment.
Public pension funds in the United States have gone through similar experiences. The state of Rhode Island limited cost-of-living increases in 2011, for example.
Regulation is at its most insidious when it emanates from politicians who are cravenly making unsustainable promises to further their own careers. A highly sinister view is that pension regulation has become an instrument of governments’ broader policies of financial repression: forcing pension funds to buy bonds with very low yields helps governments to finance deficits and keep borrowing costs down. (Most pension funds can hold cash instead of bonds on negative yields, however.)
Government bonds may have been a great investment since the early 1980s, but a longer perspective shows how inflation in former decades all but destroyed the real purchasing power of government debt. If other assets could generate better real returns, or if inflation is a concern, then pension funds investing in government bonds could be a dangerous investment. The following chart shows how the interest rate collapse since the early 1980s is almost a mirror image of the rise during the prior 30 years; bond prices move inversely with interest rates.
Relentlessly Rising Longevity
Has any politician the courage to stand up and warn that pension promises may be inherently unpredictable because life expectancy is? The new requirement for US pension funds to report a depletion date, after which they will not be able to pay benefits, marks a major advance.
Regulators do not force pension funds to insure against life expectancy rising faster than forecasts, so this “known unknown” could cause more funds to make cuts. Dealing with longevity may not be a priority for politicians because the time horizons involved are well beyond their election and reelection cycles, and there is no byproduct benefit in terms of reducing their own short-term funding costs. Some investors may, to an extent, be able to self-insure against longevity risk through buying a deferred annuity that would start paying out at the age of, say, 85. CFA Institute is raising awareness of longevity risks with webinars such as this one.
Long before regulators began requiring ever more copious disclosures in the areas of risk factors and potential conflicts of interest, fund offering documents were creating long lists of potential risks and conflicts that could cause investors to lose money. Any investor who seriously expected the conflicts to materialize would not invest in the fund. However, it is only because investors have confidence in the integrity of the individuals preventing conflicts from arising that they will entrust asset managers with their money.
More and more regulation may help to ensure better levels of disclosure, particularly regarding fees and costs, and regulation can also provide a minimum framework of risk mitigants, such as safe and segregated asset custody, independent valuation, and independent oversight — all of which are becoming universal across more and less heavily regulated vehicles. Inspired by their own integrity and education and by industry and professional codes of conduct, such as the CFA Institute Code of Ethics and the Hedge Fund Standards Board, many asset managers are constantly striving toward best practices that go well beyond the minimum for regulated fund products. Some more lightly regulated products might turn out to be less risky than more heavily regulated ones.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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