The Rise (and Risk) of the ‘Sophisticated Investor’

There is a long-held belief, though spoken mostly in hushed tones, that it’s perfectly fine to bend the rules to get ahead in life.

Breaking rules isn’t antisocial, harmful or selfish; it’s a sign of ingenuity, wit, and creative thinking. Or so they say. If you bend the rules, provided you do so within the legal framework, you are an inspiration to others. If you break the rules outside this framework, however, you are for all intents and purposes a criminal.

There are fine margins at play here, and far too many moralistic potholes to avoid.

Perhaps this explains why laws are ever rarely set in stone. They start out as seemingly broad and all-encompassing buffers against man’s own ineptitude. Yet they eventually come to resemble a long-winded disclaimer, every addition and precedent more harmful to the person they are meant to be protecting than the last.

Perhaps nowhere does rule-bending take on so much importance as it does in financial markets. In the pursuit of more money and financial security, there’s no rule that can quash an investor’s thirst for higher returns.

In a libertarian ideal, there is much to be admired in this way of thinking. But in a world where experiences teach us time and again that consumer rights and protection are frequently abused, we can’t help but wonder whether we need more regulation.

From the Sydney Morning Herald:

Investors whose wealth has increased through soaring property prices and rising assets face being pushed into riskier financial products as they gain sophisticated investor status, experts say.

While it may seem like an attractive option for investors to attain “sophisticated investor” certificate allowing them to participate in complex share placements, exotic bonds and exclusive private equity deals, experts are calling for an urgent rethink of the criteria.

Yes, we agree that if ever there was a sign showing the extent of financial lunacy in Australia, this might be it. And no, you didn’t read that incorrectly. We are worrying about the very wealthy becoming wealthier, or perhaps slightly poorer. We’re not quite sure. But, either way, our tissues remain firmly concealed in their rose-laden Kleenex box.

Yet, before we dismiss this as ‘rich-people problems’, we need to remember something: A growing number of Australians have seen their net-worth increase substantially in line with rising asset prices.

So the experts might be on to something. Is it time then that we consider protecting the people against themselves?

The difference between a witting and unwitting investor

At first glance, this development doesn’t look problematic. A vast number of investors have accumulated wealth, and they’re looking for ways to keep growing said wealth.

Nothing wrong with that, is there?

In principle, no. And, given the option, it is preferable to let people control their wealth without regulatory oversight.

But that comes with one small caveat.

In the case of people who understand the risks involved in what they are doing, it is perfectly reasonable to give them freedom to make risky investments.

In the case of people who don’t understand the risks — and who cease to be protected by the legal framework they believe they’re a part of — it brings up a whole host of concerns.

We can look to the housing market crash during the financial crisis to illustrate what a lack of regulatory oversight can result in.

The subprime crash shows us the risk in allowing large numbers of people to invest in products they don’t understand. Remember, the housing market boom, which eventually caused the bust, was driven by subprime loans. These were loans that were made to people on low incomes, at low rates, and which were pushed by banks.

There is certainly an argument to be made for the fact that people who agree to something should take responsibility for what they are doing. But things aren’t always that black and white. History shows us that predatory tactics often lure people into making ill-advised decisions.

We’re not here to moralise, though. The point is that such actions lead to disastrous consequences. Not just for the people involved, but for entire economies.

The subprime housing market is only the most obvious recent example of this. And while we have to be careful about making comparisons between ‘sophisticated investors’ and the housing collapse, there are some key takeaways from it.

Just look at some of the statistics:

In the case of the US housing market, there were four million completed foreclosures between January 2007 and December 2011. There were a further 8.2 million foreclosure starts. Granted, the effects on the Australian property market were less severe comparatively. But we rode the wave only as a result of government-led stimulus measures. China’s rampant growth at the time also played a major role in preventing a hard landing in Australia. Even so, the Aussie government still spent $3.9 billion on insulating some 2.7 million homes. In total, tens of billions were spent to cushion the blows of the financial crisis.

So you can see how unwitting investors are at mercy of being taken advantage of by those pushing financial products, by advisers, or simply by making unqualified decisions on their own.

And there’s nothing to suggest we couldn’t see similarities here as sophisticated investors pile into risky investments.

No one there to protect you

Perhaps the biggest problem in all this is that there are ever more Australians becoming sophisticated investors by the day. And we’re not just talking about those that are voluntarily doing it. In 1991, a law was enacted that automatically turned retail investors into sophisticated investors if they invested $500,000 in a particular product.

Back then, $500,000 was a large figure for most people. 26 years later, your run-of-the-mill home in Sydney or Melbourne is worth that alone.

The SMH reports:

As it stands, investors with net assets — including their residential property — of $2.5 million and/or a gross income of [at] least $250,000 a year for the last two years qualify for an SI certificate signed by an accountant. This enables them to participate in pre-IPOs, IPOs and receive tax benefits for investing in Early Stage Innovation Companies (ESICs), among other things.

But as house prices have soared — the median in Sydney is up 65.9 per cent since 2012 and Melbourne is up 48 per cent — it is much easier for people to qualify for this status.

“These criterion were meant to be a significant hurdle for people,” says Peta Tilse, managing director of Sophisticated Access and founder of Cygura… “But it’s become very outdated and thanks to the booming property market, including the family home, opens that sophisticated investor door right up…”

Compounding this is the rising number of people who manage their own money using self-managed super funds (SMSFs). As more people begin to manage their money by themselves, they open themselves up to more risk.

In the case of unwitting investors that gain sophisticated status, the regulatory framework which protects them is weak, if not non-existent. As one example, ASIC offers consumer protection to retail investors in cases where companies fail to properly disclose their businesses. Yet this doesn’t apply to sophisticated investors.

In other words, when the proverbial hits the fan, sophisticated investors are on their own.

Take the example of a company with aspirations to list on the ASX. If you invested in such a company, and the ASX blocked the listing for whatever reason, there’d be no one there to help you. Now, if you happened to invest over $500,000, and became an unwitting sophisticated investor by chance, you’d find that consumer protection rights also no longer apply.

This scenario is somewhat acceptable in situations where people, as sophisticated investors, know the risks involved. But there will be people caught off-guard. And even those that do understand the risks may not fully appreciate the dangers involved.

Here come the self-managed super funds

This is particular true in the case of SMSFs. Of the roughly 600,000 SMSFs in Australia, one-third had a balance of over $1 million in the financial year 2014–15.

The reason why people typically manage their own funds is so they can exert total control over their investments. Increasingly, yield-hungry Aussie investors are falling into the trap of making ever-riskier investments in search of higher returns. It is likely that people with SMSFs will comprise a large portion of sophisticated investors going forward.

So it is not just the unsuspecting investors that we need to consider here. The more that people undertake riskier investments, the likelier it is that we’ll see them suffer major losses through ill-advised decision making. That applies not only to decisions made by individuals, but those recommended to them by financial planners as well.

For these reasons, it may be prudent to introduce news laws governing the sophisticated investor status. At the very least, some kind of qualifications should be necessary to protect people from sharks, and, frankly, from themselves. But it might be that we need to see more people trip over themselves before the government steps in. In January 2011, the Treasury invited submissions for sophisticated investor tests in the Corporations Act. To date, the government has yet to introduce any changes.

However, with the number of Australians at risk of being pushed into sophisticated  investor status rising, one suspects the government’s tune will change. After all, for every winning investment, there is likely to be a losing one.

Mat Spasic,

Contributor, Markets and Money

Markets and Money offers an independent and critical perspective on the Australian and global investment markets. Slightly offbeat and far from institutional, Markets and Money delivers you straight-forward, humorous, and useful investment insights from a world wide network of analysts, contrarians, and successful investors.

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