News

Models can mislead investors

by James Chu
02/03/2018
Models can mislead investors

The effectiveness of PRIPP and KID – resulting in the danger of over-modelling

There is an investment that can produce over 523 billion percent if the energy market performs well. This sounds too good to be true and leads to the question is this a Ponzi scheme or another boiler room scam?

The answer is no. It is a legitimate, exchange traded investment that returns three times the daily change of a natural gas index. This type investment falls under the scope of PRIIP and so the product provider needs to provide a key information document (KID) to investors before they make any decision to invest. This jaw dropping figure is the average annual return of the investment in a favourable future scenario, using the prescribed model set out in the PRIIP regulations.

The regulators have very good intentions regarding the PRIIP regulations and the KID. However, there are unintended consequences on the prescriptive ways in which the potential returns and risks are calculated. This example illustrates the danger of relying on models when making investment decisions. I call this blind faith “over-modelling”.

In the above example, the provider indicates on the KID that the recommended holding period is just one day. This is right, as the instrument is designed for day traders who want to trade opportunistically – and with leveraged gains or losses – on natural gas. The prescribed model set by the regulator requires for simulation of the underlying commodity index over this very short recommended holding period (one day), using the daily historical return over last 5 years.

The KID model targets longer term investors, not for instruments used by day traders with a recommended holding period of one day. This projection is therefore pointless. Yet the regulations require these meaningless figures to be included on the KID.

It is also clearly apparent that projecting future returns using historical data does not really work for commodities. Commodity prices are driven by global economic and overall supply/demand picture. Will the economic backdrop in the last 5 years be the same in next 5 years? You do not need a crystal ball to tell you that there is already at least one difference: the US interest rate has started rising and so the answer must be no.

The regulators may think that by using prescribed models, it will force providers to show forward looking information in a common and standard way and eliminate bias. Instead, another form of bias could be introduced through over-modelling. We believe that this in turn can undermine the credibility and effectiveness of the KID.

We are actively participating in feedback in the financial industry and to regulators about KID, which is due for a review at end of 2018. If you need help to understand the KID or a Reyker structured product, please do not an email to our investment specialists on investments@reyker.com.

You can also find our guide to KID on our website here.

James Chu

James Chu

James is Director of the Markets and Investments Team at Reyker. A CFA member and industry expert, James specialises in Structured Products, derivatives and development of service offerings for Reyker. A face at most industry events, James is sure to provide insight into some of the most controversial topics in the market today.