Monthly Archives: November 2015

General, Legal

Have I received Investment Advice?

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investment-advice2

In this week’s post I would like to discuss the concept of Investment Advice. Unfortunately there is a big misconception on what a financial advisor’s role is in modern financial markets. Some investors have the incorrect idea that a financial advisor is there to tell you exactly what to do with your money and that every time they speak to an advisor it means that they have received advice.

In reality most investors do not even receive advice from their advisor but information. From a legal point of view there is a specific definition for what financial advice is and just because your broker told you that he/she has been selling the bond of XYZ limited lately it does not mean that he/she gave you advice to buy that financial product. Just because the features and characteristics of the product are explained to a client it does not mean that such client received advice to buy that product.

To go a step further, even if the advisor carries out an appropriateness test on a client whereby the advisor asks the client certain question to establish the knowledge and experience of the client in relation to a particular product, it still does not qualify as giving financial advice.

Financial services providers in Malta and across the EU are subject to the Market in Financial Instruments Directive or MiFID in short. This directive defines investment advice as follows:

“‘Investment advice’ means the provision of personal recommendations to a client, either upon its request or at the initiative of the investment firm, in respect of one or more transactions relating to financial instruments”

Thus, the directive is quite specific in what actually amounts to investment advice as opposed to other things such as promotion and sell or simply the provision of information. In order to clarify the concept further, the CESR (Committee of European Securities Regulators) in October of 2009 had published a consultation paper entitled “Understanding the definition of advice under MiFID” (Ref. CESR/09-665). In this paper it was established that for a service to amount to investment advice ALL of the following 5 tests had to be met:

  1. Does the service being offered constitute a recommendation?
  2. Is the recommendation in relation to one or more transactions in financial instruments?
  3. Is the recommendation at least one of the following: a) presented as suitable?; b) based on a consideration of the person’s circumstances?
  4. Is the recommendation issued otherwise than exclusively through distribution channels or to the public?
  5. Is the recommendation made to a person in his capacity as one of the following: a) an investor or potential investor?; b) an agent for an investor or potential investor?

In the rest of the post I will be going through the above 5 tests to elaborate more on what is being meant in more detail.

MiFID

Test 1: Does the service being offered constitute a recommendation?

In specifying that a service will only amount to investment advice if it constitutes a recommendation, the Directive draws a distinction between providing advice and simply providing information. Advice requires an element of opinion, in contrast to the provision of information that does not make any comment or value judgement on its relevance to decisions which an investor may make.

Hence, when an advisor simply provides facts about a product such as the interest being promised, the maturity date, who the issuer is and what its business is, there is no element of advice yet. Even if an advisor explains to a client that the current interest rate scenario is one where investing into a long dated bond makes the investment more risky than investing into a short dated bond, this is still an element of fact and not an opinion.

In theory a recommendation not to buy a particular financial instrument could also amount to investment advice. However, all of the 5 tests mentioned also have to be met. Moreover, the recommendation not to buy a product has to be based on an opinion and not simply facts. Case in point, the recent Bank of Valletta Notes that are being issued at a rate of 3.50% fixed for 15 years. As I explained in a previous post (see link here), the fact that the bond is likely to be illiquid, and is long dated with a low fixed interest rate means that based on facts, and not simply an opinion, the bond presents a big liquidity and interest rate risk.

Test 2: Is the recommendation in relation to one or more transactions in financial instruments?

Both generic advice and general recommendations are not investment advice under the Directive. In the case of generic advice, the consultation paper explained that this is owing to the fact that they do not relate to a particular financial instrument. So as an example, if a financial advisors tells a client that based on what the client has explained to the advisor such client should invest in bonds – no financial advice has been given. The terms bonds, shares, commodities are too generic in nature and can relate to many different instruments at once. For example, buying a bond issued by the government of Venezuela and a bond issued by the Republic of Germany are both transactions in bonds, but it is easy to understand that they are quite different in terms of risk.

In contrast, general recommendations are not investment advice because, being addressed to the public in general, they are not by definition presented as suitable for, or based on an evaluation of the personal circumstances of, a particular investor. So if a client sees a billboard on the side of the road that is promoting the sale of a particular financial product this cannot be construed as being advice.

Test 3a: Is the recommendation presented as suitable?

If the presentation of the information seeks to influence the client’s choice then the firm might be making an implied personal recommendation. If a disclaimer does not change the nature of a communication, meaning that the communication would still create a reasonable expectation by the client that he/she is being advised, the firm may be viewed as providing investment advice. Thus, disclaimers cannot be relied upon, on their own, to ensure that a service does not involve presenting a recommendation as suitable.

If a person places special emphasis on the advantages of one product over others for a client, in a way that would tend to influence the decision of the recipient to select that particular product over others presented, this could well amount to investment advice. Again, it must be stressed that all the other 4 test must also be satisfied for the service to be deemed as being classified as investment advice. So if an elderly client who is retired and is reasonably assumed to be interested in fixed income products is presented with a product that offers a fixed income, this alone does not mean that investment advice has been given.

Test 3b: Is the recommendation based on a consideration of the person’s circumstances?

If a firm has information about a client’s circumstances, including information on areas like his investment objectives or financial situation (i.e. investment advice or the service of discretionary portfolio management had previously been given to the client), it might reasonably be expected that the information is being used to create a picture of the client’s needs and wants to form the basis of a recommendation.

In some cases, it would not be reasonable to expect that a firm will access and use all of the information that it may happen to hold about a client’s circumstances. However, if information on a client was collected recently, or indeed over time as part of an established relationship, a client returning to the firm for follow-on advice can reasonably expect his previous information to be taken into account.

A related issue is that some marketing activities could be inappropriately classified as investment advice, if they are distributed to existing clients on whom the firm holds information. In situations where those activities either involve the presentation of a financial instrument as suitable for an investor or where the firm is making a recommendation based on the consideration of a person’s circumstances, investment advice would have been provided.

It has to be stressed here that the recommendation must relate to something specific. So if for example all the clients of a firm who have previously invested in bonds are sent a mailshot about a new bond that is coming to the market, this alone does not necessarily classify as investment advice. If a letter is sent specifically to a client there would for sure have been a solicitation of the product by the investment service provider to the client. Thus an appropriateness test would need to be filled in since the service would not have been at the initiative of the client. However, this does not necessarily mean that investment advice was given.

investement-advisor

Test 4: Is the recommendation issued otherwise than exclusively through distribution channels or to the public?

Not all messages to multiple clients would automatically constitute advice, but there are circumstances in which they could. Three elements that should be taken into account:

  1. the target audience (if the personal circumstances that led the individual to be contacted are highlighted);
  2. the content of the message (e.g. if it contains a solicitation or judgement regarding the advisability of the transaction); and
  3. the language used (e.g. the tone and the way it could be understood by the client).

Test 5: Is the recommendation made to a person in his capacity as an investor or potential investor?

Where the client’s primary purpose for seeking advice is in order to generate a financial return or hedge a risk, the client’s objective is patrimonial in nature and if advice is provided such advice would be deemed investment advice. Conversely, where the client’s primary purpose for requesting the advice is for an industrial, strategic or entrepreneurial purpose, the objective of the client is industrial, entrepreneurial and strategic in nature and the advice provided would be corporate finance advice and not investment advice.

The Bottom Line

The aim of this post is to clarify what is understood as investment advice from the perspective of MiFID. There is a big misconception about this topic in the local market and I hope this post helped to clarify issues that might not have been known to investors. As always please refer to my general disclaimer and note that this post was neither investment, legal or any other form of advice. Anyone interested in further discussions about this or any other topic covered in my posts can contact me on kd@financebykd.com.

KD

Alternative Investment, Equities

Ethical Investing – Where do You draw the line?

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tank-iStock

According to Invetopedia.com, the definition of Ethical Investing is the use of one’s ethical principles as the main filter for investment selection. The idea can be applied by either eliminating certain industries altogether, for example gambling, alcohol and tobacco, or by over-allocating into industries that meet one’s ethical guidelines.

There are many funds that use this principle when it comes to choosing the investments (mainly equities) that they allocate their clients’ funds to. But at the end of the day, should one really care where the money is invested, as long as it is profitable? This question will be answered different for every investor since every investor will have his/her own criteria as to what is or is not appropriate. I am just simply trying to ask – where do you draw the line?

 

One may argue that investing in a company that manufactures tobacco or alcohol for example is not a really big issue. People who consume such products know of the negative effect that these products have and they choose to consume them anyway. On the other hand the products are addictive and hence they also have an immoral control over the consumers, especially addicts. Furthermore, it may be highlighted that such firms invest a lot of money into lobbying and propaganda and so they are not really playing fair and thus tricking people into consuming their products. So should I eliminate these companies from my portfolio?

To be honest, shouldn’t we really think the same of fast food producers? They are the cause of a lot of health issues, yet we do not restrict the intake of fast food consumption for people under a certain age as we do for alcohol and tobacco consumption. So should I not invest in the shares of McDonalds or The Coca Cola Company based on my ethical thinking?

With the legalisation of the personal consumption of Marijuana in certain US states one can now invest in companies that produce this product. The same arguments brought up for the tobacco and alcohol industries can be used here. By investing into such a company am I indirectly causing people to consume more of the product?

Reasons to invest in these industries.

Such industries that invest in addictive product such as alcohol, gambling and tobacco tend to be less affected by economic trends. The reasoning is that even in an economic downturn, people will still gamble, they will still smoke and they will still drink. Thus, having equities of companies that offer these products in one’s portfolio will add to diversification and theoretically lead to less of a downturn when the majority of shares are going down.

But this is not the full story of course. Yes these shares can lead to a less risky portfolio and potentially better returns, however they do not come without certain other negative features. If you take the tobacco and alcohol industries these are frequently subject to lawsuits and new regulations that limit their ability to market their products. When we have a new research paper come out that this product or that product causes more harm than we previously thought, these shares will suffer.

On the gambling side, if we take for example casinos, all the large casino shares have interests in Macau which is the “Las Vegas of China” (although it is much larger than Las Vegas to be fair). This means that these stocks are affected by the news coming out of China which is still a volatile market. A quick look at the shares of companies like Wynn Resorts Ltd and Las Vegas Sands Corp will easily allow one to appreciate the volatility of such shares.

Ethics and Profits

What about the fire-arms, ammunition and military supplies industry?

Now let us take it a step further. For argument’s sake, let us assume that with the industries that produce addictive products that have detrimental health issues an investor argues that one cannot save someone from their own foolishness and hence they should not eliminate these companies from their portfolio. In other words, these companies pass the ethical criteria for this investor. What if we now consider arms and ammunition companies? What if we consider companies that develop jet fighters, missiles and other military supplies?

With the current tensions around the world following many terrorist attack incidents, the most recent being the Paris Attacks which have led to France declaring war on ISIS some investor are backing companies like Boeing, Lockheed Martin and BAE Systems to do well. These companies sell the supplies that would be used by military and hence the current scenario is looking very profitable for them. So this begs the question – Should I invest in this industry to profit from the conflict in Syria? How much is too much?

The shares of these three companies are up an average of 10% over the past 3 months alone. With tension very high and more countries signalling their intentions to join France the potential for these shares to keep doing well is easy to see. This is not to say that the risk is low with these sort of companies. These is still no clear plans regarding the continued war on terror that the US had initiated back in 2001 following the twin towers events. There is nothing to say that these shares are not already overvalued in the sense that people have already pushed up the prices of these shares in the knowledge of the potential for future profits.

The Bottom Line

The aim of this post was not to argue in favour or against the concept of ethical investing. The aim was to create awareness and make investors question how much they are willing to accept from an ethical point of view when it comes to choosing the products they invest into.

Fixed Income

BOV Issues a Convertible Bond

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BOV

It has just been announced that Malta’s largest bank, Bank of Valletta Plc (BOV), will be issuing a subordinated 15 year bond with a coupon rate of 3.50%. What is most interesting about this issue is the fact that the bonds being issued are gong to be convertible bonds. This means that in the case that the Bank is facing financial difficulties and requires a bail-in these bonds can be either written down or converted into common equity (shares).

Capital Adequacy

BOV like all other EU banks is facing much tighter capital requirements. Following on from the 2007/09 Financial Crisis the EU Regulators have become much more strict on the amount of capital that banks should hold. Thus, Banks are required to hold higher levels of capital in comparison to the assets that they hold.

In accounting we learn that

Assets = Liabilities + Capital

This means that any asset that a business owns is financed either by the capital that the owners put into the business, or through borrowings of some sort. The bigger the capital base, the more the shareholder or owners of the business have at stake if the assets of the business had to deteriorate in value. Thus, the bigger the capital base the more money the owners would have at risk. Hence, one would expect owners (shareholders) to be more cautious in their approach when they have a business in which they have invested a large amount of capital, as opposed to one with minimal capital invested.  Capital also acts as a buffer and so the larger the capital pot, the larger the buffer in the case of a deterioration in asset value.

Based on this simple idea, the European Central Bank (ECB), as the regulator of all major EU banks, has been pushing the banks it regulates to hold more capital. When it comes to financial institutions the riskiness of the assets held by the business is a major factor affecting the calculation of how much capital is adequate for such entity to hold. In a nutshell, the riskier the assets the higher the level of capital required to be set aside.    

The below video explains capital adequacy through good simple examples:

 Why a Convertible Bond?

Convertible subordinated bonds are considered as part of a bank’s Tier 2 capital. This means that it is counted as part of the required capital that BOV must have in place to cove its risk-weighted assets. Keep in mind that the local market is predominantly interested in interest paying assets and that interest rates have been very low for quite a while now. As a result, BOV, like all the other banks, has experienced an increased in deposits. Deposits for a bank are a liability since it is money owed to clients.

As a result, when deposit are increasing at such a high rate the ratio of assets financed by liabilities (deposits) will increase compared to the ratio of assets financed by capital. Thus the capital ratios of the bank will start going down and more capital is needed to act as a buffer.

Besides this €150 mln debt issuing program (€75mln of which will be issued in the coming days) that will see the bank increase its Tier 2 capital, BOV had also mentioned plans to increase its Tier 1 capital. This will be achieved by a new equity injection which most likely would be in the form of a rights issue. A rights issue is a new issue of shares that is made available to the existing shareholders. The shareholders would then have the option of either buying up the new shares and investing more money into the bank, or else they can simply sell the right to buy the new shares.

Banking & Finance

Is the Interest of 3.50% Adequate?… Not Really!

All the above is evidence that BOV needs to increase its capital reserves and the main reason for issuing this convertible bond is in fact to meet capital requirements. In their latest financial results which were published just a few weeks ago BOV also noted a deterioration in the assets they hold. This was a direct result of last year’s  Asset Quality Review and the stress tests carried out by the European Central Bank. These exercises highlighted that BOV had higher specific risks which have resulted in an overall impairment charge of €32.7 mln, a significant increase of €13.3 mln over the impairments recognized in the previous financial year.

The facts described in the above paragraph, coupled with the facts that this is a 15 year (i.e. long term) bond being issued in a scenario of historically low interest rates, and on top of all this it is ultimately a convertible bond, make the 3.50% annual return too low versus the risks involved. Keep in mind the inverse relationship between interest rates and bond prices. Although interest rates are not expected to be increased in the short term, there is a good chance that they will go up in the medium to long term. When they do, this bond will be one of the worst hit domestically issued corporate bonds given its long term maturity. Thus, the bond presents a high level of interest rate risk (please click here to view a previous post that discusses this in more depth).

Besides a significant interest rate risk the bonds also present  liquidity risk. The local market is limited in its size and many investors tend to buy and hold. Thus it may be difficult for an investor to sell off these bonds once they start trading on the market if such investor wanted to sell before the maturity date.  If this bond was a regular bond (i.e. not a convertible bond) this risk would be quite low, at least in the short term. However, given the fact that this bond is in fact a riskier type of bond which in legal financial jargon is referred to as a complex product, BOV has had to issue it in two separate tranches. This fact has made the bonds subject to higher liquidity risk,as I explain below

The bond is being issued in the following two tranches:

  1. Tranche 1 – Subject to a minimum 25,000 nominal holding throughout the life of the bond
  2. Tranche 2 – Subject to a minimum of 5,000 nominal

Here’s the complication. In order to protect the retail investors the Regulator has forced BOV to issue the bond in the above tranches which are subject to certain compliance requirements from the point of view of the financial intermediaries which will be selling the bond.

In order for a financial intermediary to be able to sell the first tranche (subject to minimum of 25,000) the intermediary must prepare what is known as an appropriateness test. This test basically checks the knowledge and experience of the applicant to see if the product is “appropriate” for the client based on his past experience, his qualifications and his field of employment. Should the intermediary determine that the applicant does not posses the required knowledge and experience, the transaction can still be completed, however the intermediary needs to inform the client about this (this is normally done in the form of a risk warning which the client signs). If the client buys this tranche he/she must always maintain a minimum of 25,000 bonds.

In order to sell the second tranche (subject to the lower minimum of 5,000) the clients need to pass a suitability test. This suitability test is used when a financial intermediary is advising the client directly to buy the product (or when adding the product to the client’s discretionary portfolio). A suitability test, besides checking the knowledge and experience like the appropriateness test does, also includes checking the financial bare ability of the client (i.e. if the client can afford the investment) and also the investment objectives of the client (risk tolerance and investment objectives). Thus, in order for this second tranche to be sold the intermediary needs to be advising the client to buy this bond issue. This puts a lot of responsibility on the intermediary and cannot be done if the client fails any part of the suitability test. Moreover, I am not sure why an intermediary would recommend a long term convertible bond with such a low interest rate.

Given the restriction imposed on holders of tranche 1 bonds, it will be harder to sell off these bonds since batches of 25,000 would most likely have to be sold at one go. Moreover, if many applicants opt for these tranche 1 bonds they might not be even allocated any bonds. The issue is subject to a maximum of €75 mln. Thus, if many applicants apply for these tranche 1 bonds , even if they were all allocated the minimum of €25,000 they might still in total add up to more than €75 mln. In such a case BOV stated that it would have to draw lots and allocate 25,000 to some applicants and 0 to others.

Interest-Rate-Uncertainty

The Bottom Line

Given all the above I still think that the issue will be sold and that the €75 mln will be collected. The fact is that there are not that many attractive interest paying investment available given the low interest rate scenario. When faced with such a situation investors would tend to take on more risk and accept less favourable terms. There could still be an opportunity to buy the bonds and sell them for a quick profit in the short term, however this opportunity has been restricted by the liquidity issues mentioned above. Hence, I am not a big fan of this issue and consider the return being offered as too low for the risks being faced when holding such bonds.

As always please refer to the disclaimer – this is simply my personal view and nothing should be taken as advice. I am not a legal expert and clients need to view any investment from their own personal perspective – the aid of a financial intermediary is always preferred.

KD