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Should you be worried about unregulated investments?

Investment | Investment Trusts

By Justin Modray, published 15 April 2011.
Helpful? 13

If you own 'unregulated' investments could you end up losing your shirt if things go wrong? Or is there nothing to really worry about?

Traditionally, most investments you'd ever likely hold within your ISA or pension will have been regulated by the Financial Services Authority. This gives a valuable security blanket for two reasons:

  1. Investment companies authorised and regulated by the FSA must adhere to quite a few rules and criteria, which should weed out the cowboys (although, the system has sadly not proved infallible).
  2. If you lose money due to fraud or mis-selling then you can lodge a compensation claim via the Financial Ombudsman Service (FOS). And, if the offending company or adviser is no longer solvent to pay your claim, you'll be covered by the Financial Services Compensation Scheme (FSCS) which currently covers 100% of the first £50,000 of investments per person per firm.

But with unregulated investments becoming more common there's an increasing risk you won't benefit from such protection, so it's important to know where you stand.

What are unregulated investments?

Very simply, they're investments that are not regulated by the FSA. This can include shares, investment trusts, offshore funds (including exchange traded funds) and other unregulated collected investment schemes (UCIS). Note: an overseas investment might be unregulated by the FSA but regulated by a similar overseas authority.

Just because an investment is not regulated by the FSA it doesn't mean it's unsafe. But it does give cause for concern if higher risk and/or potentially dubious investments are bought by inexperienced investors who don't understand the risks they're taking and won't benefit from any investor protection if things go wrong. The FSA has been particularly concerned lately over UCIS that invest in higher risk overseas property ventures (e.g. African plantations and geared property funds ).

Are unregulated investments always unprotected?

Not necessarily, and this is where things can get a bit confusing.

If you purchase an unregulated investment on the advice of a FSA authorised and regulated financial adviser then you would be covered by the FSCS if you lose money via fraud or mis-selling, but only if the adviser becomes insolvent. Otherwise you'd have to take your compensation claim to the adviser and, if unsuccessful, to the Financial Ombudsman Service (FOS).

If you buy direct from an unregulated investment provider, via a non-FSA regulated financial adviser or on an 'execution-only' basis then you won't enjoy any UK investor protection. For example, if you buy an investment trust on the advice or a regulated financial adviser or via an investment trust company's regulated 'share plan' then you will be covered by FSA regulation and protection. But buy the same investment trust via an execution-only stockbroker and you won't be covered.

When buying overseas regulated investments always check whether you're covered by any local investor protection and compensation schemes. European Union members must have such schemes in place, but outside the EU it can be a rather hit and miss affair, so check carefully.

Does holding an unregulated investment within an authorised/ regulated SIPP mean I'm protected?

No. Holding an unregulated investment within a regulated SIPP doesn't automatically give FSA protection. And SIPP providers will also usually absolve any liability for the investments you choose to buy via their trustee agreement. So buy an exchange traded fund or unregulated offshore property investment within your SIPP and that investment won't be covered (unless bought on the advice of a regulated financial adviser).

Should I be worried if I own unregulated investments that aren't covered by any compensation schemes?

Maybe, it really depends on how much potential risk you're taking.

If you buy an exchange traded fund run by a large European bank then the risk is generally low.

Firstly, the fund must 'ring-fence' its assets via a third party, called a custodian. If these assets are shares in the companies of the index being tracked then, with the (very unlikely) exception of fraud, there's not much that can go wrong (ignoring the loss of money from falling share prices). If the assets are instead 'synthetic', i.e. a financial instrument whereby another bank (counterparty) agrees to pay the index returns, then there's a bit more risk as the counterparty could go bust (although under EU law counterparty exposure within a fund can't be more than 10%).

And secondly, even if the fund did lose money due to fraud the bank providing the ETF would likely step in (assuming they're still solvent) and compensate to avoid damaging their reputation (although I'm less convinced they'd do so in the event of counterparty failure).

But buy an investment from a small unregulated company in an overseas country where you wouldn't fancy fighting for your money in court if things go wrong, then you're probably taking a risk too far.

Conclusion

As with most things in life, it boils down to common sense. Buying unregulated investments needn't be a bad idea provided you understand the risks and are comfortable with them. But make a bad decision and you could end up losing your shirt with little or no prospect if ever getting it back.

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