You have got to be KIIDding

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It’s been a while since I’ve posted but at least I’ve got something to show for it. As you may or may not know we’ve recently launched with two new partners, Beagle Street and Smart Insurance. Smart are on TV and Beagle Street are part of the mighty BGL group who you will know more commonly through these little guys.

So whilst rushing about I’ve missed a number of opportunities to add to my rants and raves, but one has been distilling like a fine single malt for a few weeks now and it’s time to crack open this particular barrel.

The Key Investor Information Document or KIID as it’s usefully known (you just know someone was up all night working up the acronym for it. Now let me start by being positive.

The KIID is a huge leap forward for consumer understanding given that it replaces the laughingly titled “Simplified Prospectus” which like the Consumer Friendly Principles & Practices of Financial Management (CFPPFM) was originally designed as a document aimed at improving customer understanding of an investment but in practice only adds to confusion.

It’s a sad indictment of the industry that in our very recent past the solution to many problems with communication of risks was for some section of the chattering classes to prescribe a document for “ordinary” people to read and understand their lofty ideals. Unfortunately these projects in practice ended up doing nothing more than making the chattering classes feel good about themselves and the clients further removed from the industry.

Now the KIID was the first step in the right direction. Indeed unlike anything that had gone before it the KIID was a summary document that was, well, a summary! By forcing the KIID on to 1 page (2 sides of course) and describing the prominent risks and sections that must be covered, the regulators recognised the reality; a large document that covers everything will not be read, a short document which perhaps cuts some corners will at least be looked at by the majority of customers. It was a triumph for real risk assessment rather than backside covering risk management which this industry is too well known for.

But, and of course there was a but – it’s me after all, one particular feature of the KIID is the risk rating of the fund. This is a big corner that’s been cut and it’s releasing a lot of chickens that will one day come home to roost.

Now I can understand the reasoning for including a risk rating of the fund. You are looking for a simple summary of a fund and of course one of the key questions any investor wants to know the answer to is how risky is the fund. I know this problem well; I’ve struggled with it for decades. Whilst working in investment marketing, I used to infuriate our sales teams by refusing to go along with traffic lights for investments fund. I wouldn’t because whilst these things might help a quick sale they do nothing for a real understanding of risk.

Alas risk is a complicated subject with a complicated answer and as Josiah Bartlett (well Martin Sheen, you know Charlie’s Dad) said in the brilliant “Game On” episode of the West Wing some things are complicated for a reason and don’t do well to be boiled down to ten word answers or a grading on a line numbered 1 to 7. Unfortunately that’s exactly what we’ve got with the KIID.

The process uses a simple enough formula designed to measure the volatility of a fund effectively through the standard deviation of its weekly fund prices. Which is just a fancy way of saying how jaggy the line is on a graph. Jaggy line = bad = 7, smooth line = good = 1.

It’s an approach riddled with holes and the KIID itself immediately tried to address them with warning notes such as: “This risk number is based on historical data and may not be a reliable indicator of the future risk profile of the fund.” Let me put it another way; past performance is NOT a guide to the future.

Obviously many investors want to understand the past performance of a fund, and want to at least study it. Indeed its absence in a publication leads to all sorts of suspicions in the mind of a client. But it should not be the lead feature of a promotion. The FSA have always rightly regulated providers to ensure they do not use past performance as the main thrust of any advertising because it just creates a false set of expectations for a client.

My problem with KIID is that by boiling the risk rating down into a single figure and placing it on such a prominent position on the first page the client is instantly going to look at the risk rating (which is based on past performance) as the most salient message. Let me put it this way if our marketing team tried to produce a promotional leaflet with the same layout as a KIID but with a past performance chart in place of the risk and reward profile then our compliance officer would quite rightly send it back to them (with a rather large flea in their ear). Placing so much emphasis on a single and naive view of past performance is just plain dangerous and will only lead to trouble in the future.

Some funds for example produce very low levels of day to day, or month to month volatility only to fall off a cliff at a later date. Corporate Bonds have exhibited these features in the past, property funds and traded endowments are other dangerous examples. However even stylised equity funds go through phases where they can seem remarkably stable (as the prevailing economic conditions favour their style of investment) only to crash and burn as the market and conditions change. It’s these situations that will see a fund rated 1 or 2 suddenly switch to a 6 or 7. How many customers are going to feel ripped off when that happens and who is going to deal with the fallout? Are we really all going to say we were only obeying orders?

KIID was a nice try on the part of the regulators but it’s flawed and I for one can hear it ticking. There are other ways to describe the risk and reward profile of a fund, but they take more than 1 to 7 or 10 words, they are also more complicated and less user friendly. But the history of this industry has shown when faced with complication it is better to recognise those difficulties rather than cutting too many sharp edged corners which end up drawing blood in the fullness of time.

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