Beware the mis-sellers

PUBLISHED : Monday, 20 June, 2011, 12:00am
UPDATED : Monday, 20 June, 2011, 12:00am

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Have you ever wondered whether your financial adviser is selling you something you do not need? Or opened your annual statement for an investment product to find out that most of the money you ploughed into a supposedly 'safe' investment has all but disappeared because of fees and charges, or a market crash?

You may have been unlucky, or perhaps you misunderstood what you were buying because of mis-selling.

The definition of mis-selling, according to Eleanor Wan, chief executive of the Institute of Financial Planners of Hong Kong, is very broad. Wan defines mis-selling as 'selling the customer something that does not meet their needs or risk appetite.'

To find out if this has happened to you, consult a lawyer. But to make sure you do not spend unnecessary time and money on legal disputes, here are some common signs your financial adviser may be selling you something you did not want, did not understand or never requested.

1) Chasing commission

Most financial advisers in banks or independent wealth management companies here are not paid directly by their customers. Instead, they earn their money from fund managers, banks or insurers that pay them for convincing the customer to sign up to a particular product. Almost all investments generate commission for the seller, making so-called advisers extremely motivated to put their own financial needs ahead of their customers'.

'The real job of most financial advisers is to distribute the products of certain vendors,' says Rob Jones, the founder of Hong Kong-based FCL Advisory Limited, a wealth manager that does not take commissions from vendors and charges clients an annual fee instead. Unscrupulous advisers will put their own financial needs first by convincing you to invest in a high-charging product without fully explaining all the potential costs and making sure you are happy to pay up.

To guard against this, insist that your financial adviser gives you an exact illustration of potential charges and fees. Demand information on the total fees and charges you could pay depending on how your investment performs over the life of the product. You should get illustrations that assume minimum annual growth of 3 per cent and a maximum of 9 per cent.

Many investment products levy charges when they lose money, so also ask about the total fees for a 3 per cent to 9 per cent annual loss.

2) Failing to justify the costs of very long-term minimum investments

Take the 25-year savings plans widely on sale here that are issued, mainly, by European insurers. These can involve hefty charges and early termination penalties.

Because fund managers and insurers really like the idea of customers giving them money regularly for a 25-year period, they offer extremely handsome rewards to advisers who can persuade you to sign up. One Hong Kong-based financial adviser, who asked not to be named because he fears he would lose access to providers' savings products, said it was usual to be offered 10 per cent of the value of a client's regular savings plan as a commission. So an adviser who signs you up to a savings plan where you commit to save HK$1 million over 25 years could be earning a tenth of your total investment - or HK$100,000 - upfront as commission.

Usually such plans appear to be a hybrid of a savings scheme, an insurance policy and a mutual fund-based pension.

Commonly, the products involve the customer paying a regular 'premium' each month into the plan. They can switch their money regularly in and out of a selection of mutual funds.

Take this generic 25-year savings plan offered to Hong Kong investors by a British insurer.

The insurer kindly provided an illustration for the Post of the money a hypothetical customer who saved US$1,000 a month under the plan for 25 years - a total of US$300,000 - would get at the end of the term. It said that if the saver's mutual fund investments grew 7.6 per cent, the investment would be worth US$540,549 after 25 years.

The savings plan does look expensive compared to a cheap exchange traded fund (ETF). ETFs are very low-cost funds that track the price performance of anything from commodities to global stockmarkets. We have chosen US fund manager Vanguard's Total World Stock ETF for comparison because the company provides helpful cost calculators on its website.

If you saved US$300,000 into Vanguard's global equities ETF over 25 years, assuming the same 7.6 per cent annual growth as the British insurer provided in its illustration, your investment would be worth US$811,485 at the end of the 25-year term and you would have paid US$21,974 in costs. This suggests that, over 25 years, the British insurer's product would have cost our hypothetical customer close to US$250,000 more in fees and charges than the ETF.

The insurer's plan, like most other mutual fund-based, long-term savings plans on sale here, also carries early termination penalties. If you cashed out after five years, you would lose three-quarters of the money you saved for the first 18 months.

So if your financial adviser recommends a long-term savings product, make sure they explain the total costs of the product, perhaps via an ETF comparison. Also make sure they explain why this plan is better for your individual needs than a low-cost ETF.

3) Not explaining the risks

Sometimes financial advisers do not explain the risks of a product because they want to sell you something you do not need.

And sometimes they truly do not understand what they are selling you. This is a particular risk if you are buying complicated structured products that involve leverage, derivatives, or both.

'Remember that the people who design investment products tend to have advanced degrees in mathematics and are incredibly well paid,' says Jones.

'People who sell them tend not to be as mathematically advanced and people who buy them can be even less so.'

Leverage can enhance investment returns, but only because the practice is high risk.

Loading investments up with debt also makes you more likely to lose everything if the investment goes wrong. Investment banks Bear Stearns and Lehman Brothers collapsed in 2008 because they did not fully grasp the risks of leveraging their disastrous wrong-way bets on US property markets.

If your adviser gets as far as telling you a structured product is leveraged, ask them to perform what bankers call a 'sensitivity analysis'.

First, ask exactly which index, or basket of stocks, the structured product may be tracking. Then ask what happens to the value of your investment if the so-called 'underlying' moves up or down in value by, say, 5 per cent. And to make sure the salesman is not giving answers provided by the investment bank that designed the security, ask for a range of different scenarios. Throw in a wide range of hypothetical price rises and falls over different time periods.

You also should ask your adviser if structured products contain derivatives, which are financial bets on the future price of anything from the Hang Seng Index to the price of pork bellies.

The response, 'yes, there is a derivative', is not an answer. Persuade your adviser to draw a diagram of how the derivative works, without referring to any marketing literature.

If they get this far, ask them for the mathematical model the investment banks use to price this derivative. If they do not write down and explain a range of detailed equations at this point, they may be selling you something they do not understand.

And, finally, test your adviser's knowledge of the market for the structured product they are selling outside of their bank. Ask them if the investment bank that has designed this structured product only sells it to retail investors such as yourself. If the investment bank thinks the product is great, it will probably sell it regularly to its most valuable professional investors, such as large hedge funds.

If the adviser believes the product they are selling you is only on offer to retail investors, ask yourself why a large financial institution would devote its whizz kids' time to designing a complicated product to sell to you, the person who does not know as much as them.

'Remember that old Wall Street adage,' quips Jones. 'Lots of bankers have yachts. But where are the customers' yachts?'

4) Lack of regular reviews

According to Jones, a financial adviser worth his or her salt will prepare a very detailed financial plan for every individual client, and review the plan every year.

He says that, depending on the clients' risk appetite, the plan should contain a mix of low-risk products, such as a very conservative bond fund, and high-risk products such as developing country stock market funds.

Jones adds that the adviser should review that plan every year, to determine whether the client's financial situation or life expectations have changed.

If a financial adviser heavily recommends a particular product, and then makes no plans to see you again, they may only be thinking about their commission.

The opposite problem to this is what advisers call 'churn'. That is, switching customers in and out of products or funds too regularly in order to generate an upfront commission from the product providers. Mutual funds typically charge the investor 5 per cent of their upfront investment, and some of that naturally gets kicked back to the financial salesman as a reward for placing a new person's money in the fund.

5) Talking fast and loose about tax

Shanghai-based, fee-only financial adviser Tony Noto has a pet peeve - investment products have come with an 'offshore' tag and are sold on the basis that people who buy them will not pay any tax on their investment returns.

Take, for example, the so-called 'offshore pensions' commonly sold to expats in Hong Kong. One of these, issued by an Italian insurer and structured so that your pension pot sits in a company in the Channel Islands tax haven of Guernsey, claims in its brochure you can cash the pension in 'without deductions of Guernsey tax'.

That statement could be interpreted misleadingly by a financial adviser, warns Noto. 'Some people I see in these investments signed up under the impression the investment was intrinsically tax free,' says Noto.

Tax benefits, he cautions, are always 'dependent on circumstances. Every time you move, tax treatment could change.'

American citizens, for example, must pay US tax on all of their income, even if the money is sourced from a foreign country or comes from an investment product legally headquartered in a low-tax 'offshore' haven.

And Britain regularly reviews and changes its laws governing offshore investments. So who really knows whether the proceeds of an 'offshore' pension will be tax free for them in 25 years' time?

Jones warns investors to be especially wary of wealth advisers who do not mention a client's tax status at all.

'If a financial plan does not mention tax, there is something wrong with that plan, because everyone has their own tax situation.'