Secrets Of Success: Precipice bonds, an accident waiting to happen

The news that one of Britain's biggest independent financial advisers (IFAs), the David Aaron Partnership, has gone into administration is a shocking reminder of how precarious the business of selling financial products in this country has become. The firm had thousands of clients and pursued a very visible and high-profile marketing campaign. Its glossy fund and product brochures spoke of a successful and prosperous business, so the disclosure that it has run into financial problems was something of a surprise.

What appears to have tipped the firm into administration is fears about the scale of its potential liability for compensation over the sale of so called "precipice bonds", a product whose inequities I have had cause to mention more than once in this column. These bonds, you will recall, offer investors attractive-looking returns and capital guarantees, until or unless the stock market falls by more than a fixed percentage within a given time-frame, at which point losses to the investor increase dramatically, in some cases threatening nearly all the investor's original investment. It is easy to be wise after the event, but even with foresight it is safe to say that these noxious inventions were a ludicrously inappropriate thing for sell to ordinary investors.

It is true that, had the market not fallen so sharply between 2000 and 2003, the risks might never have been realised, which on a charitable view, is what those who sold the bonds so heavily must have calculated. The nature of investment risk is that it becomes apparent only when the unexpected occurs, but it is folly of the highest order to assume that just because something is against the odds, it cannot happen. In any event, the prospect of the stock market falling sharply and therefore triggering the "precipice" clauses was nothing like as remote as their advocates made out at the time they were being sold.

When David Aaron and others described the precipice bonds as "relatively low-risk", they presumably assumed the kind of market fall that would trigger the high-loss precipice clauses was a relatively rare occurrence. Indeed, in some cases the product literature was able to point out that a fall of the necessary scale had never happened in the 20 years (or whatever) that the relevant benchmark index had been calculated. In reality, that fact itself was a clear warning light to anyone with a genuine insight into the nature of investment returns. On the basis that stock market returns are eventually subject to mean reversion, the odds that a market fall of 40 to 50 per cent might occur, steadily increase the longer the great bull market continued without serious setbacks.

Nobody has ever seriously accused the average commission-based IFA of being an expert on investment. A good bedside manner, a few basic concepts and a gift for sales patter are much more valuable attributes. Although the link between commissions and quality of financial advice is not as clear-cut as it appears, it is hard to avoid the conclusion that with precipice bonds the heavy selling of these products was motivated almost entirely by the fat commissions that intermediaries and bank/life assurance sales forces were capable of earning from them. This is simply because the investment case for thinking they could be suitable for 99.9 per cent of the population does not exist.

Yet it appears the David Aaron Partnership did persuade thousands of their clients to put their money into these bonds, backed by leaflets and brochures which highlighted their attractions, including the claim that they had "a low downside risk". I don't know what thinking led them to this conclusion, and it is probably wise not to ask. Clients who have suffered losses will presumably have a good chance of success with their compensation claims when the facts of each case are studied.

But it would be wrong to rush to judgement on particular cases. What this episode, and other cases like it, does do is raise further questions about the inadequacies of the system of financial advice we operate. Giving financial advice is no easy professional task, not least because most consumers don't know what they want, and many have wholly unreasonable expectations. However well-intentioned individual IFAs may be when they set up shop, a system in which most advisers depend on sales commission for income must inevitably create conflicts of interest and potential mis-selling.

The problems of conflicts of interest are most likely to become apparent during sharp market downturns. Networks of IFAs have overheads and employees to pay for. They can rarely scale back their fixed costs quickly enough to cope with the loss of income during a period where sales of financial products dry rapidly. It would be surprising if it was not at times like this that a passion for best advice finds itself taking second place to the instinct for survival, and what you can shift takes precedent over what the client might actually need.

Maybe Mr Aaron and his colleagues failed to understand the nature of the products they were selling. Maybe the firm's potential bill for compensation was disproportionate to the error in recommending these bonds in the first place. It is difficult for an outsider to say.

But precipice bonds were an accident waiting to happen. It is another wake-up call to the financial services business, which remains astonishingly indifferent to the damage which each case like this does to the credibility of the business they operate. Apart from anything else, it means that our culture of over-zealous regulation and retrospective compensation will continue to grow. Neither is a healthy development.

jd@intelligent-investor.co.uk