2.5 Understanding Risk and the Risks of Investing in Schemes
Key Takeaways
Consultants must explain the risks of a scheme to investors before they invest and direct them to the relevant sections of the prospectus or offering documents.
For an investor, risk is the chance that the actual return will be less than expected, and higher returns require taking higher risks.
Investing through a scheme does not reduce the volatility of the underlying investments, but diversification reduces its effect for investors with limited capital.
In extreme conditions, such as when a material part of a fund's assets cannot be valued, dealing in units may be suspended until conditions improve.
Risk warnings must state that past performance is not a guide to future performance, past distributions are not guaranteed, and unit prices and distributions may go down as well as up.
The Consultant's Duty to Explain Risk
Like any investment, schemes carry risk. The study guide says Consultants must ensure investors are given an explanation of the risks before they invest, and must direct them to the relevant sections of the prospectus or offering document. Product Highlights Sheets and promotional material can help explain the differences in risk between schemes. FIMM's practice question asks what a Consultant must give an investor: the answer is an explanation of the risks, not a guarantee, gifts or an unlimited right to cancel.
What "Risk" Means
- A dictionary definition is "the probability or chance of injury, loss, damage or harm".
- For an investor, risk is the chance that the actual return will be less than expected.
- Risk is linked to objectives: high returns require higher risk. If the risk needed to reach a goal is uncomfortable, the investor must lower the expected return.
- Risk can also be measured as variability of total return. Listed shares, whose prices swing, are riskier than a fixed deposit whose value does not move.
The "safe" investment that is actually risky
A long-term investor with limited capital who keeps everything in fixed income or cash may fail to reach the goal (education fund or retirement). For that investor the traditionally low-risk choice becomes the risky one.
Risk is personal
The same equity fund is lower-risk for someone who can hold it for many years and ride out short-term swings, and much higher-risk for someone who needs the money in a few months. That person might be better advised to use a less volatile fixed income or cash scheme. So the Consultant must understand each client's objectives, investment time horizon and attitude to risk before recommending a scheme. The study guide's Diagram 2.7 lists the factors that affect a client's ability to handle risk; understanding them reduces disputes.
Risks of Investing in Schemes
Investment risk
This is the main risk. For equity funds, share-price movements flow through to the NAV; REIT investors are exposed to the property cycle. Prices reflect local and international economic and political factors and sentiment.
Important
Owning investments through a scheme does not and cannot reduce the underlying volatility of those investments. What diversification does is reduce the effect of that volatility for an investor with limited capital.
Other risks
| Risk | What the study guide says |
|---|---|
| Business risk | The Scheme Provider may cease operations. The effect is limited because the Trustee holds the assets, but day-to-day management may be disrupted, so investors should also look at the provider's financial health. |
| Liquidity risk | In extreme conditions (markets in turmoil or closed) the liquidity buffer may run out and securities cannot be sold. If the value of a material part of the assets cannot be determined, dealing may be suspended until conditions improve. Temporary liquidity shortfalls alone may not justify suspension. |
| Regulatory risk | Changes in law, for example tax law, may affect investors. |
| Change in management fee | Fees may change. Where needed a meeting of investors is called and a vote taken, and investors are usually given time to sell before changes apply. |
| Interest rate risk (borrowing) | Investors who borrow to invest take on extra risk if rates rise. This applies to UTS only, since loan financing is not allowed for PRS (Chapter 7A). |
Interest rates also matter for fixed income funds: when rates rise, existing bond prices fall and so does the NAV of a bond fund, and longer-maturity holdings are hit harder (section 2.2).
Mandatory Risk Warnings
Offering documents, advertisements and promotional materials must carry warnings such as:
- Past performance of a scheme is not a guarantee or indication of future performance.
- Past income distributions are not guaranteed and may not be repeated.
- Unit prices and income distributions, if any, may go down as well as up.
The study guide notes that when Consultants and clients understand these risks, the number of complaints falls considerably.
Applying It: A Short Scenario
A 58-year-old retiree needs RM40,000 in six months to pay for a child's wedding and asks about an aggressive regional equity fund that "did 25% last year". A Consultant who follows the study guide would:
- explain that last year's return is no indication of future returns;
- point out that a six-month horizon gives no time to recover from a fall, so equity investment risk is high for this goal;
- consider a money market or short-term fixed income scheme instead; and
- record the discussion and the reasons for the recommendation.
Which statement about investing through a scheme is correct according to FIMM's study guide?
Underlying volatility remains, but diversification reduces its effect on the investor
Investing through a scheme eliminates the volatility of the underlying shares
Investing through a scheme guarantees that the investor recovers the amount invested
Investing through a scheme removes the need to consider the investor's time horizon
Which warning statement must appear in scheme advertisements and promotional materials?
Returns are guaranteed by the Trustee for the first year
Past income distributions are not guaranteed and may not be repeated
The SC recommends the scheme for retail investors
Units can only be redeemed after five years
A client keeps all retirement savings in fixed deposits for 25 years because they are safe. Why might the study guide describe this as risky?
Fixed deposits are not supervised by any regulator
Fixed deposits cannot be withdrawn before maturity
Fixed deposits are more volatile than equity funds
Low returns may fail to meet the long-term goal
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