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Behavioral Biases and Protecting Derivative-linked Securities Investors
2020 Mar/03
Behavioral Biases and Protecting Derivative-linked Securities Investors Mar. 03, 2020 PDF
Summary
In making a decision to invest in a complex financial product such as derivative-linked securities, investors often rely on selective information, a rule of thumb, or distributors’ solicitation instead of taking into account every piece of information. Financial firms that issue and distribute those securities have an incentive to capitalize on and profit from such behavioral biases. Although it’s certainly important to plug the loopholes in existing policy tools, equally critical towards a more effective investor protection in complex financial products would be a novel approach to minimize investors’ behavioral biases. More concretely, I propose three areas for improvement: Eradicating sales practices that mislead investors towards behavioral biases; enhancing the way of information provision with the aim to help investors better understand a risk-return profile of derivative-linked securities; and a shift away from today’s up-front fee scheme that is blamed to wrongfully induce financial firms to capitalize on investors’ behavioral biases.
In Korea’s market, derivative-linked securities such as ELS and DLS have grown to a flagship product whose outstanding balance reached KRW 106 billion since its launch in 2003. In terms of the outstanding balance, Korea’s derivative-linked securities exceeded the net asset value of equity funds (privately placed and publicly offered combined), and recorded the highest net issuance in the world. However, investor protection with regard to derivative-linked securities has been at issue for two reasons. First, it’s hard for ordinary investors to properly understand the nature of those products. Second, although the danger of losses in fact is fairly low in many of the products, the size of losses—if there’s any—could be quite significant. This was what exactly happened to some of interest rate linked securities, which incurred heavy losses and sparked controversy last year. As Korea’s financial authorities probed into the case and revealed some evidence of mis-selling involved in those products, Korea is now in the midst of discussions about how to bolster investor protection in derivative-linked products.


Shortfalls in protecting investors in derivative-linked securities

In general, an investor protection framework in derivative-linked securities is summed up into three parts; i) restricting who can invest, ii) bolstering information disclosure, and iii) preventing conflicts of interests. The first is realized by the suitability test that limits eligible investors and thus drives out investors who are financially illiterate and unable to bear the risks.1) Information disclosure is in place aiming to enhance investors’ understanding of financial products. For example, the current framework stipulates the duty of explanation, and mandates the provision of the information documents. Lastly, the fee regulation and the ban on the unfair solicitation are in place to prevent the conflicts of interests, seeking to ban a financial firm from infringing the interest of investors. After some derivative-linked securities on overseas interest rates reported heavy losses in 2019, the financial authorities proposed regulatory improvements, which appear to focus on eliminating loopholes in the existing framework and thus making the regulation more effective.

However, what’s recently gaining ground is a view that a conventional investor protection framework alone cannot achieve the intended policy goal when it comes to a complex financial product including derivative-linked securities. What’s needed, according to that view, is a new policy tool taking into account investors’ behavioral biases. Proponents to the view argue that, a policy tool assuming a rational investor who fully considers investment purpose, financial conditions, and product nature to come up with a fully-informed investment decision is ineffective because actual investment decisions are often swayed by selective information, or emotional and psychological states. Given that, a policy fix that mandates distributors to disclose more information on complex financial products leads to an overload of information. An exposure to excessive information is more likely to predispose investors to unconsciously rely on selective information, a rule of thumb, or solicitation, rather than helping them digest every piece of information to form a rational investment decision. Simply put, stronger information disclosure could unexpectedly lead to behavioral biases and potential conflicts of interests, instead of lowering the risk of adverse selection from information asymmetry.


Behavioral biases of investors in derivative-linked securities

The following behavioral biases are empirically observed among investors in the derivative-linked securities markets in and out of Korea. First, they tend to overestimate investment returns. The UK Financial Conduct Authority (FCA) carried out a survey among retail investors about the expected returns on equity indices and derivative-linked securities using those indices as underlying assets. The expected returns on derivative-linked securities presented by respondents are found higher than those computed based on the distribution of their expected returns on the underlying assets. The differences between the two returns are about 1.9% per year, which remains consistent among five product types surveyed. That suggests that retail investors have difficulties in linking the performance of derivative-linked securities to that of the underlying assets, and have excessive expectations for the performance of derivative-linked securities.

Second, they tend to underestimate investment risks. Rieger (2012) and Kunz et al. (2017) analyzed investor perceptions on investment risks of barrier reverse convertible (BRC) securities2) based on multiple underlying assets. Because BRC securities incur a loss if any of the underlying assets sees the price falling below a threshold, the investment risk increases with the number of underlying assets, regardless of their risk levels. However, it is found that investors underestimate the investment risks inherent in BRC securities on multiple underlying assets. It appears that investors often fall for fallacies, misbelieving that a low-risk underlying asset could offset the risk of a riskier underlying asset, or that a product based on multiple well-known underlying assets is safer.3) In the end, they are found to prefer derivative-linked securities with higher investment risks.

Third, they tend to show overconfidence in their own investment performance, or over-extrapolate recent performance. Derivative-linked securities are more likely to be invested by a more overconfident investor whose subjective self-assessment on his/her own financial literacy exceeds the objective assessment. Also found is that more new investments flow into derivative-linked securities if their underlying assets or similar products have recently outperformed.4) 


Behavioral biases, and financial firms’ profit maximization

If investors in derivative-linked securities show behavioral biases as described above, financial firms designing, issuing and distributing such securities have incentives to capitalize on, or even bolster the biases for the purpose of profit maximization. A derivative-linked security investor’s tendency to overestimate returns while underestimating risks actually poses distributors an opportunity to sell a product at a price higher than the fair value, which actually has been widely observed in many countries including Korea. Empirical results, although somewhat varying across analysis targets and periods, suggest that derivative-linked securities are overpriced 1% to 8% compared to the theoretical value. This in the end erodes investment returns to investors in those securities. Also notable is that such overpricing becomes more evident in securities with a more complex payoff structure, more volatile underlying assets, a higher coupon rate, and non-principal protected products. This evidences investor biases about risk-return profiles of derivative-linked securities, and also how financial firms’ product pricing reflects such biases.

According to a financial authority’s survey on the losses incurred by securities linked to overseas interest rates,5) financial firms packaged those securities as a safe, principal-protected products, specifically targeting customers who prefer time deposits. This in fact could be deemed as an act of inducing investors to underestimate investment risks. Even today, it’s not hard to find a derivative-linked security’s marketing materials that label the best case scenario return as the expected return. This intends to induce an overestimation of expected returns although it’s higher than the actual expected return taking into account the possibility of losses. It’s important to note two previous analysis results:6) First, a more complex, riskier derivative-linked security is more likely to be overpriced; and second, a financial firm with a pool of less financially literate clients tends to sell a more complex derivative-linked securities. What seems inferable from those results is that the complex nature of derivative-linked securities may not be a byproduct of financial innovation, but a strategic choice financial firms make to profit from investors’ limited understanding and behavioral biases.


Investor protection policy considering behavioral biases

Despite the lack of analyses on behavioral biases of Korea’s investors in derivative-linked securities, there seems to be a high possibility of behavioral biases and inefficient decision making. One of the reasons is the lack of understanding on derivative-linked securities among investors. In a derivative-linked securities investor survey by Park and Cha (2017), 37% of respondents said they do not understand the concept of “underlying assets”. When asked if they know the concept of the “exercise price” and “knock-in-barrier”, 57% and 73% said no, respectively. As such, many investors invest in derivative-linked securities without proper knowledge about key concepts about the payoff structure. Another reason is the ever-rising complexity of derivative-linked securities. Complexity in those products could be measured by the number of underlying assets and payoff conditions. The average number of underlying assets of ELS and DLS shot up from 1.7 and 1.2 in 2011 to 2.9 and 2.1 in 2019, respectively. Such an increase is also observed in the number of payoff conditions, from 7.0 and 2.4 in 2011 to 8.1 and 3.8, in 2019, respectively. This illustrates Korea’s derivative-linked securities shifting towards a product exposed to a greater complexity and risk factors. Lastly, a large proportion of those investors are senior investors who rely heavily on solicitation, advertisements, and promotional materials when making investment decisions. As of end-June 2018, investments from those aged over 60 accounted for about 42% of total investments in derivative-linked securities, while those aged over 80 took up 4%.

What’s needed under the circumstances is to go beyond the effort that plug the current regulatory loopholes by bolstering the suitability test, the duty of explanation, and financial firms’ compliance, etc. Toward more effective investor protection in the derivative-linked securities market, it’s desirable to minimize the impact of behavioral biases in the process of investment decision making as follows. First, todays’ distribution practice bolstering investor biases should be eradicated. More concretely, it’s necessary to limit bias-inducing practices, e.g., misleading investors to see derivative-linked securities as an alternative to a time deposit, underestimating potential losses and exaggerating expected returns, over-extrapolating past performance and sales, misguiding investors to treat the risks of underlying assets and those of derivative-linked securities equally, etc. Second, an improvement is needed in the way investors are provided information on derivative-linked securities. To help investors better informed about a complex financial product such as derivative-linked securities, there’s no other way than to make select and summarize product information. But investor choices depend largely on what information is provided and how it is provided. Further empirical evidence is needed to find out the most effective way of information provision that could help investors accurately grasp the risk-return profile. Third, the up-front fee scheme needs an overhaul and the cost transparency needs to be enhanced. Under the prevalent up-front fee scheme, financial firms are more likely to recommend high-fee, high-risk products to investors who underestimate the risks of the high-risk products. If financial firms’ profits and performance measurement are closely linked to ex-post, after-cost investment returns from the perspective of investors, this could lower the incentives for capitalizing on or inducing investors’ behavioral biases. Hence, it’s advisable to come up with a fee scheme or performance measurement scheme that helps address the conflicts of interests between financial firms and investors.


Conclusion

Under the low interest rate and low growth trends, derivative-linked securities are expected to receive high demand among investors aiming to increase investment returns. Those securities are also valuable as they provide investors an opportunity to invest in hard to access assets such as foreign stocks, commodities, etc. with a payoff structure that is unobtainable with traditional assets. What’s necessary is an investor protection environment that effectively prevents behavioral biases arising from the complex structure of derivative-linked securities from leading to an irrational investment decision. That should be a long-term, desirable direction for both investors and financial firms.
 
1) The cooling-off period could be regarded as one of the tools limiting the investor pool.
2) This product has a similar risk-return structure similar to that of Korea’s most prevalent derivative-linked securities.
3) The former is called a “dieter’s paradox”, whereas the latter is linked to a “conjunction fallacy”.
4) Bergstresser (2008), Abreu & Mendes (2018), Shin (2019)
5) Financial Supervisory Service (December 15, 2019)
6) Celerier & Vallee (2013)


References

Abreu, M., Mendes, V., 2018, The investor in structured retail products: Advice driven or gambling oriented? Journal of Behavioral and Experimental Finance 17, 1-9.
Bergstresser, D., 2008, The retail market for structured notes: Issuance patterns and performance, 1995–2008. Harvard Business School, Boston MA.
Célérier, C., Vallée, B., 2013, What drives financial complexity? A look into the retail market for structured products, Paris December 2012 Finance Meeting EUROFIDAI-AFFI Paper.
Hunt, S., Stewart, N., Zaliauskas, R., 2015, Two plus two makes five? Survey evidence that investors overvalue structured deposits, FCA Occasional Paper (9).
Kunz, A.H., Messner, C., Wallmeier, M., 2017, Investors’ risk perceptions of structured financial products with worst-of payout characteristics, Journal of behavioral and experimental finance 15, 66-73.
Rieger, M.O., 2012, Why do investors buy bad financial products? Probability misestimation and preferences in financial investment decision, Journal of Behavioral Finance 13(2), 108-118.
Shin, D., 2018, Extrapolation and complexity, Working paper.

(Korean)
Financial Supervisory Service, December 5, 2019, The Dispute Settlement Committee tells banks to compensate DLS investors for 40%-80% of losses, Press Release.
Park, J.H., Cha, K.W., 2017, Analysis of ELS investment behavior and ELS types: Principal guaranteed vs. non-guaranteed ELS, Journal of Consumer Studies 28(2), 227-250.