The Australian Securities and Investments Commission (ASIC) recently released Report 427 about the relationship between investors’ behavioural biases and their decision to invest in hybrid securities, as compared to less complex financial products such as bonds and shares. The report, which discusses the findings of a pilot study commissioned by ASIC and produced by Queensland Behavioural Economics Group, builds on earlier ASIC and ASX commentary regarding hybrid securities.
The study was prompted by ASIC concerns that, despite the information made available by ASIC and ASX to the public and improved disclosure by issuers, retail investors are still struggling to understand the complexity of hybrid securities and the risks they pose.
What are hybrid securities?
‘Hybrid’ securities have characteristics of both debt and equity. Like debt securities such as bonds, hybrid securities offer a fixed or variable rate of return for a specified term. However, they also include equity-like features proposed to provide investors with a higher rate of return than regular debt securities. The equity component may arise because they give investors an option to convert the hybrid securities into shares, or because they are accompanied by equity-like risks such as market price volatility and issuer credit risk. Broadly, hybrid securities fall into the following three categories, either alone or in combination:
- convertible debt securities - debt securities that convert into equity securities
- preference shares - equity securities with debt-like features, and
- capital notes - debt securities with equity-like features.
The multifaceted nature of hybrid securities means they attract a higher level of risk than debt securities, while their inherent complexity may make those risks difficult for retail investors to fully understand.
ASIC has indicated that prospectus disclosure for hybrid securities should be informed by the way investors make decisions. Regulatory Guide 228 refers to a 2012 paper by the Commonwealth Office of Best Practice Regulation about using behavioural economics to design more effective regulatory interventions, a concept which serves as the foundation for the ASIC-commissioned pilot study and Report 427.
Findings of ASIC Report 427
In the pilot study conducted in May 2014, subjects were tested to reveal their behavioural biases and their perceptions of risk, and then participated in a test of allocating an investment portfolio across bonds, hybrid securities and shares. The study identified several cognitive and emotional biases that influenced the participants’ decision making with respect to allocating their investment portfolio. Allocation to hybrid securities:
- increased 14% for participants exhibiting an illusion of control, an ‘unfounded belief that a person can exert control over their environment and influence the outcome of uncertain events’, manifested by believing they could control the risks associated with hybrid securities
- increased 10% for participants exhibiting overconfidence, an ‘unwarranted belief in a person’s own cognitive abilities, intuition and judgment’, manifested by their underestimation of the risks associated with hybrid securities and lack of portfolio diversification
- increased 10% for participants exhibiting framing basis, ‘decision making influenced by the way that choices are presented to a person’, manifested by their choice of hybrid securities over bonds and shares because the risks were less readily apparent, and
- decreased 11% in favour of shares for participants exhibiting ambiguity aversion, ‘preference of known risks over unknown risks’, manifested by their preference for shares over other securities because the associated risks were better understood.
While hybrid securities were perceived overall as more risky than bonds and marginally less risky than shares, only the risk criterion ‘distrust of product/producers’ influenced the participants’ decision not to invest in hybrid securities. In particular, ‘poor knowledge of the product’ did not discourage participants from investing in hybrid securities. These findings indicate that behavioural biases have a greater role in investment decision making than perceptions of risk.
What do the findings mean for issuers of hybrid securities?
The findings of Report 427 appear to support ASIC’s concern that, while retail investors may correctly perceive hybrid securities as riskier than debt securities such as bonds, their behavioural biases affect their ability to appreciate the form and scope of those risks in relation to their underlying investment.
ASIC states in the report that the findings will inform their conversations with industry, assist in developing regulatory interventions, and contribute to their programs to educate investors on making more informed decisions (e.g. through ASIC’s MoneySmart website).
No doubt the findings will flow through into further commentary on prospectuses and other disclosure obligations in respect of hybrid securities. In the meantime, issuers of hybrid securities can at the very least expect additional scrutiny from ASIC on the form and content of their disclosures in the capital raising process.