A crisis of trust
New scandal prompts calls for the transformation of Korean investment industry’s culture
Last October, Lime Asset Management, South Korea’s largest hedge fund manager with 5.7 trillion won (US$4.6 billion) of assets under management, missed a payment on one of its maturing funds as a result of losses suffered on foreign investments made through one of its parent funds. A flood of withdrawal requests from worried customers prompted the firm to suspend redemptions of three of its funds.
An investigation by the Financial Securities Service (FSS), the enforcement arm of the Financial Services Commission, the country’s financial regulator, uncovered a range of misconduct at the firm. These misdeeds included stock parking and manipulating yields on convertible bonds by trading them over the counter with related securities firms to hide losses from investors. Around 10 people have since been arrested. The company’s deputy chief executive officer and the former chief investment officer are in hiding.
The results of an external audit of Lime Asset Management announced this February showed that investors in two of the firm’s master funds would lose as much as 634 billion won or around 40% of their initial investment. Most of these investors are senior citizens who were sold these products as part of their retirement plan.
The scandal is only the latest of nearly a dozen that have come to light in Korea since the 2008 global financial crisis. It has exposed the sales-focused culture of the industry, which often sacrifices customers’ interests for the sake of profit to the intermediaries. It has damaged customers’ trust in the financial industry and hurt its growth. Deep introspection and comprehensive reform are needed.
Lime Asset Management’s investment products were sold by 19 financial entities, including major national institutions Woori Bank, Shinhan Investment, and KEB Hana Bank. They now stand accused of selling these products while being fully aware of the risks, and without properly disclosing them to their clients. Some continued selling the funds even after the company’s liquidity problems became apparent.
According to a report by management consulting firm Oliver Wyman in February, these misselling practices are not isolated. The FSS’s initial investigation in August 2019 found that Korea’s six national banks sold 822 billion won of high-risk derivatives-linked products to around 4,000 investors, in many cases without proper disclosures of risks and to clients for whom such products were unsuitable.
The phenomenon isn’t recent. The report says there have been as many as 11 misselling scandals in Korea since the global financial crisis, involving structured derivatives, equity-linked securities, real estate, and exchange-traded notes. The FSS says financial misconduct led to 2.2 trillion won of investor losses between 2010 and 2018.
In the wake of the financial crisis, Korean regulators have worked to strengthen investor protection. They established consumer protection bodies and went as far as refining the incentive schemes for executives and staff of financial companies in a change to the Code of Financial Consumer Protection in 2016.
Nevertheless, the trend is not encouraging. The Korea Financial Investors Protection Foundation’s annual review of 28 fund retailers published in January found that results were on average lower last year than in 2018. It found that many firms do not understand clients’ objectives and do not adequately explain product features.
The Korean wealth management business is traditionally driven by product sales. Sales personnel are compensated with commissions. In 2016, regulators introduced the concept of Independent Financial Advisors (IFAs), who provide services on a fee-only basis and are prohibited from receiving sales commissions. They also imposed on non-IFAs the obligation to disclose sales commissions to clients ahead of each transaction.
These reforms were designed to provide greater transparency about the cost of financial advice, to exert downward pressure on commission, and to provide advice channels that are free of conflicts of interest.
But IFAs have not become popular. Korean investors typically are not aware of conflicts of interest caused by sales commissions and do not fully appreciate the potential value IFAs can provide.
The situation is further complicated by the unusual popularity of lightly regulated, opaque private funds. As of December 2019, private funds accounted for 412 trillion won, or 36% of assets under management in Korean asset management companies, almost double the 237 trillion won in public funds. That’s a much bigger share than in other markets; in Hong Kong SAR, for example, private funds account for only 18% of assets under management versus 35% of public funds.
Private funds, which fall into the alternative asset category, are sold to a small number of eligible investors through private placements. Many of them are feeder funds or onshore vehicles manufactured by local fund houses, which allow Korean investors to invest in global hedge funds. They can be sold to ordinary, nonprofessional investors, but the minimum commitment must be 100 million won, or 300 million won for highly leveraged or private equity funds, effectively limiting the target group to wealthy individuals.
According to Oliver Wyman, as reported by Ignites Asia, the sales pitch for such products often implies that the risk of loss is negligible, and full disclosure of embedded risks often is not provided.
Focus on client needs
In 2019, CFA Institute published a report titled “Sales Inducements in Asia Pacific,” which analyzed the role of sales commissions and advice fees in shaping the culture of the wealth management industry and the quality of service that investors receive. The report focused on four markets: Australia, Hong Kong SAR, India, and Singapore.
We stressed that sales commissions create conflicts of interest and may cause the sales staff to neglect their clients’ best interests. Banning sales commissions outright does not necessarily solve this problem, however, as evidenced by cases of misconduct in financial advice in Australia, which continued even after commissions were banned in 2012.
CFA Institute is of the opinion that a healthy industry can support a range of fee- and commission-based business models. Measures must be in place, however, to protect investors against misselling. Investors should be fully informed about the risks of the product they are buying, and client-facing staff must be monitored for adherence to know-your-client, know-your-product, suitability, and disclosure requirements. Enforcement also should be strengthened.
In the medium to long term, the industry should evolve toward a client-centric culture, in which staff and management remuneration is aligned with clients’ interests — for example, through a balanced scorecard approach, as is common in Singapore.
The role of IFAs in providing unbiased advice should be promoted through investor education and by strengthening the level of duty of care they owe to their clients from the current standard of suitability to best interest or fiduciary duty.
Korea’s wealth management industry is in a crisis of trust. To restore investor confidence, regulators, industry organizations, and financial institutions must work together to address the underlying causes of the problems.
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