Retail investors' understanding of risk and diversification still lacking, departing FMA boss says, wishing he had 'got out in the community more'

By Gareth Vaughan

A proper understanding of diversification and investment risk is still lacking among many New Zealand retail investors, says outgoing Financial Markets Authority CEO Sean Hughes, emphasised by some people putting all their savings into rental property.

Hughes, the FMA's inaugural CEO who steps down next week after three years in the job, also told interest.co.nz in a Double Shot interview his main regret was not having got out more into the community and regions and spoken to "real New Zealanders" about their investment experiences. Hughes also questioned the role of what are effectively vested interests in the regulation of KiwiSaver.

Asked to what extent retail ma and pa investor understanding of investment risk on the one hand, and financial literacy on the other, have improved over the past three years Hughes says he still has concerns.

"I still have misgivings about whether the average investor understands about risk and the risk of being in the market," says Hughes. "I still think there is an assumption out there that when you invest in the market it is capital guaranteed in the same way as if the bank where my deposit is placed goes under, I'm going to get all my money back."

"The reality is there is no place in the world in any financial market where you are absolutely capital guaranteed. And of course your projected investment return is not guaranteed as well. So there does need to be a conversation and understanding that when you invest, the higher the rate of return the higher the rate of risk and there is a chance that you won't get your money back," Hughes adds.

However, this doesn't mean people shouldn't invest.

"Because the only way in which you can improve your lot and advance is to take some risk. But it needs to be educated risk and the risk needs to be appropriate to your own personal circumstances. If you are somebody who has only got a very small amount of money to invest and you need that money, you need to rely on it being there at the end of the day, then don't take a high risk investment."

"We saw in the last decade that people thought they were diversifying their asset in terms of their investments by spreading it across several finance companies. That's not diversification," Hughes says. "We see it today, particularly here in Auckland, with people putting all of their investments into property and to residential property for renting purposes. Again that's not diversifying your assets."

"So this understanding of the way in which markets work, the nature of risk and pricing risk in a way that's appropriate to your own circumstances, is still something that we've got a long, long way to go on. And it was never going to be anything we could've fixed in the first three years of FMA's existence," says Hughes.

'I would've liked to have spent more time in the community'

Hughes says much has been accomplished by the FMA, but "the missing piece in the puzzle" is investor education.

"For me it would have been ideal if we could have also got out into the community more, spoken to mums and dads, understood their fears, listened to some of their experiences that they had during the GFC (global financial crisis) and the collapse of the finance company sector. I think that would have been a really important and appropriate thing for us to do, to sort of show the human face of FMA," Hughes says.

"At times in this job, particularly as chief executive, it's very easy to get bogged down in internal governance and the bureaucracy of running an organisation and approvals processes. Ideally in a perfect world, and if I had been able to stay on for longer, I would've liked to have spent more time in the community, out in the regions and actually talk to real New Zealanders about what their experiences were. And what they are missing in terms of their own education and understanding in terms of the way markets operate."

"So I'm hoping that Rob (Everett his successor) will get a clean sheet of paper and be able to have the time and the interest to do that sort of thing. Because I think that is where FMA of the future should position itself, very much there to assist and support a growing population of what I hope are confident New Zealanders in a successful, thriving financial market. But it's up to him now," Hughes says.

KiwiSaver regulation 'relies on people who themselves are involved in the market of KiwiSaver'

Meanwhile, Hughes points out trustees and fund managers are a key component of KiwiSaver regulation, even though they're "involved in the market of KiwiSaver." He says this ought to be questioned. These comments come after Hughes pointed out last year KiwiSaver lacks the type of prudential regulatory regime that's in place for retirement savings in Australia.

"When I made those remarks a year or so ago we had no licencing regime for fund managers and we had not in fact started the process of licencing statutory supervisors or trustees," says Hughes. "Since that time there has been a significant increase in the regulatory standards. We've now gone through the process of licencing statutory supervisors and trustees and not every applicant for licencing got through. So that has been an increase and an improvement in the system."

"From next year under the Financial Markets Conduct Act fund managers will also be licenced and so there will be new standards also put in place," adds Hughes.

"Now is it the same regime as Australia? The answer to that quite clearly is no."

"Is there a business, regulatory or political case for implementing an APRA (Australian Prudential Regulation Authority) like model for KiwiSaver in New Zealand? I think it's something that should be looked at but at the end of the day the decision doesn't rest with the regulator it rests with the Government and with the implementation of a prudential model that will obviously entail some cost," Hughes says.

"But if we get the right standards in place around things such as liquidity, capital adequacy, risk management, unit pricing, outsourcing, all the things I regard as sound prudential governance or prudential regulatory steps, then whether you need a separate regulator to do that or not is really by the by."

"At the moment the only regulator for KiwiSaver outside of the IRD in terms of its work, is FMA. And my question is; is that too big a burden to place on one regulator because at the same time we're also relying on trustees to do their job and in time we'll be relying on the fund managers to do their job."

He notes that in comparison in Australia both the Australian Securities and Investment Commission and APRA have roles in overseeing retirement savings.

"In New Zealand we are placing a great deal of reliance on front line entities like trustees and fund managers. Is that the right thing to do? Well, only time will tell. But as the KiwiSaver total funds under management get up to around $50 billion in the next decade, you'd have to ask yourself is it time at some point to revisit the model and say have we got it right, are we placing too much trust in the hands of people who themselves are involved in the market of KiwiSaver?"

*This is part two of the Sean Hughes interview. Part one can be seen here.

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