Investment advisors are required to understand the structure, features and risks of every investment they recommend. This requirement is called the know-your-product (KYP) rule. It’s an easy rule to recite, but it’s sometimes a challenge to put into practice — especially when the product is new and complex.
Take, for example, synthetic exchange-traded funds (ETFs). Unlike ordinary ETFs, synthetic ETFs don’t mirror their benchmark index by owning a basket of stocks replicating that index. Instead, synthetic ETFs use derivatives to mimic the benchmark’s performance. This is innovative and apparently offers some advantages in the form of reduced costs and lower tracking errors, but it also gives rise to concern in some quarters.
Among those expressing concern are the very smart regulators and central bankers who make up the Financial Stability Board. Even they can’t predict how synthetic ETFs might behave once interest rates normalize from current rock-bottom levels. Therefore, the FSB warns that synthetic ETFs may give rise to “liquidity illusions”. This means that in times of market stress, the derivatives underlying these investments may lock up while actual stocks in each benchmark index keep on trading, at which point the value of synthetic ETFs might evaporate. Or not. No one really knows because the quantum of our experience with that scenario is essentially zero.
So, how can meaningful KYP be conducted in such circumstances on such a product, whose key performance characteristics are, as yet, unknown? Is it sufficient for advisors to just understand what the product is designed to do? Or must they understand what it’s likely to do when it interacts with the real world — not just a mathematical model of the market?
Little clear guidance is available on these questions. A staff notice published by the Canadian Securities Administrators earlier this year states that registrants must perform a critical analysis of the features inherent in the product and how those features affect the investment’s potential risk and reward. Recommendations of the product should proceed, it says, only on the basis of some reasoned assessment of the investment’s “actual potential.”
This really just begs the question of whether a complex product’s true potential can be gauged with any air of reality or confidence in the absence of at least some actual track record. We live today in a world in which investment choices are multiplying rapidly and products are bound to become ever more exotic and complex as they seek a differentiating competitive edge. There’s a proliferating intricacy to the way these products interact with the market — and more ways for things to go sideways unexpectedly. In this environment, it’s increasingly becoming pretty much a fantasy to believe that anyone can tell you the “actual potential” of an investment still untested in the real world.
But what’s the alternative? Few would support a return to the old practice of calling every new product risky until it completes a multi-year sea trial. That approach would be denounced today as stifling innovation. So, too, would any suggestion of a quarantine confining complex new investments to the institutional market until each product’s dynamics are fully understood. (There’s already a vocal segment of the investment industry that sees the current limits on distribution of prospectus-exempt securities as a misguided quarantine.)
Still, it’s a poor choice to just carry on with what’s becoming fiction and pretend it’s protecting people. The problem, in truth, is that the KYP rule was really designed for a simpler, plain-vanilla time; but in today’s complicated world it’s wobbly, focusing too much attention on the product and not enough on what’s best for the investor. So, instead of asking: “What’s this new product’s actual potential?,” the more important question is: “Is it in this investor’s best interests to experiment with an unproven product?”
Looked at this way, the importance of having a ‘best interests’ standard is easy to see. It provides an overarching guiding principle, one that works to protect investors even where component duties — such as the KYP rule — may be insufficient on their own.