Another test may better gauge the sophistication of investors

First published in The Australian, Tuesday 27th February 2024

The Federal Government recently indicated they intend to review the “Sophisticated Investor Test” which has generated widespread debate about the best way to truly gauge an investor’s sophistication. 

The current test uses the net assets or income of an investor to determine whether they meet the definition of a sophisticated investor under the Corporations Act. Investors below the threshold are deemed “retail investors” and any advice or products offered to these investors is highly regulated to protect their interests. ASIC has suggested increasing the thresholds in line with inflation since 2001 when the test was first introduced. A reasonable position, but it fails to address a key issue – is this the best and only way to gauge an investor’s sophistication?

Why change the test?

The government’s motivation for this change is two-fold. First, a reported increase in the number of investors losing money in schemes that were inappropriate for their circumstances, such as Mayfair 101. In most cases these were examples of questionable product being sold to investors based on dubious advice. This would not have been prevented by a test, no matter how sophisticated the investors were. At the same time, the government can’t be expected to prevent fraud – rather detect it and punish it. The best protection against fraud remains the ancient wisdom of Caveat Emptor or Buyer Beware, which every Year 9 Commerce student will be learning in the next few weeks.

Second, modelling from the Australian National University suggests that under the current test, 43.6% of Australians will qualify as Sophisticated Investors by 2041 driven primarily by forecast house price growth. There is a long-running debate in financial advice circles about whether your primary place of residence (PPR) is actually a financial asset. A simple but impactful fix would be to remove the PPR from the calculation of net assets. This would provide a clearer and more realistic picture of an investor’s financial position.

Potential impacts of the change

Shifting the goalposts will mean some investors who are currently sophisticated will suddenly be deemed retail and will only be able to access advice and products designed for retail investors. These investors may be forced to divest products that are no longer appropriate and replace them with products designed for retail investors. The potential transaction costs and tax implications could be significant. 

Investors who currently receive advice from wholesale advisers may be forced to find a new adviser licensed to provide advice to retail clients. Aside from ending a relationship with a trusted adviser and taking a chance with a new one, there is the administrative headache and cost that would be incurred. 

Advisers who are only licensed to provide advice to sophisticated investors will suddenly have clients they need to “let go”. This would be detrimental to their business, as often these businesses are built by starting with clients with smaller asset bases and growing with them. It also limits the ability of advisers to deal with the next generation of the families they advise – next gen education is often a key value proposition for these firms.  

Finally, the change would reduce the pool of potential investment into private equity, venture capital and other less-liquid products. These investments can deliver fantastic returns when properly researched and added to client portfolios where appropriate. The changes would also interfere with the capital markets and stifle investment into these economic growth engines.

A third way

There is no doubt that an asset-based or income-based test is a blunt instrument to assess an investor’s level of sophistication. A Powerball winner does not immediately become Warren Buffett overnight (as studies of past lottery winners show). On the other hand, the analyst working on the model of a financial product will likely have tertiary and post-graduate qualifications in finance, but at the start of their career is unlikely to have the assets or the income to be deemed sophisticated. 

The government could introduce a third way to qualify as a sophisticated investor – an actual test. Luckily, such a test already exists. Every staff member of a financial institution that gives general advice to investors must have an RG146 qualification as mandated by ASIC. That is the standard to give advice, so we can safely assume that anyone who passes that test must have a reasonable understanding of financial markets. 

Simply increasing the financial threshold of the sophisticated investor test will not protect investors from shady operators. Neither will the proposed changes improve the ability to assess who is actually sophisticated.

Sensible, practical ideas like excluding the PPR from net assets and introducing a standardised test, or “investing license”, will go some way to improving how we define retail and sophisticated investors and the appropriateness of the advice and products available to them.  

^{John Taylor - Head of Private Capital, Dexus}