There have not been than many new issues of Tier 1 or Tier 2 hybrid securities from Islamic banks since ADIB issued the world’s first hybrid perpetual Tier 1 Sukuk, which may go some way to explain why there has been relatively little research into investor reaction to the new instruments.
In the absence of such research, it might be useful to look at what research there has been in the conventional world into investor perceptions of the place of hybrids in the risk pyramid. To that end, there has been a very useful piece of research just published in Australia that was commissioned by the Australian Securities and Investments Commission (ASIC).
How behavioural economics help us understand investors’ reactions to hybrid securities
ASIC commissioned the Queensland Behavioural Economics Group to undertake a research study into how behavioural biases influence individual investor’s preferences towards hybrid securities when compared to less complex financial products like bonds and shares. QBEG undertook the pilot study because ASIC was worried that some retail investors do not fully understand the complexity of hybrid securities and the risks they pose.
Behavioural economic research tends to demonstrate that many decisions, including investment decisions, are skewed by cognitive biases rather than rational consideration alone. The objective of the pilot study was to identify any behavioural biases that might affect allocation to hybrid securities within an overall investment portfolio and assess how the perceived risk of hybrid securities compares with shares and bonds.
The study results
The pilot study used techniques developed in behavioural economics, which places participants in a simulated environment in an experimental laboratory. The findings of the pilot demonstrated participant’s perceptions of the risk of different investment types.
Illusion of control
When subject to illusion of control bias, investors can feel that they can exert control over their environment and influence the outcomes. Allocation to hybrids increased by nearly 14% for participants who demonstrated the illusion of control bias. The presence of illusion of control implies that investors may think that they will have the ability to control risks involved in hybrid securities, for example by withdrawing ‘in time’ from an investment.
When subject to overconfidence, investors may have a misguided sense of their own ability to withdraw from an investment early and consequently be protected from risk. The average allocation to hybrids was higher by more than 10% for participants with overconfidence bias. Overconfidence relates to unwarranted belief in one’s cognitive abilities, intuition, and judgment. Overconfidence could lead to portfolio under-diversification i.e. holding concentrated positions in a few hybrid securities. Overconfidence may tend to make investors underestimate downside risk and perceive hybrids to be safer investments than they actually are.
Investors susceptible to framing bias make decisions that are influenced by the formulation of the choice (i.e. how it is presented). The average allocation to hybrids was higher by more than 10% for participants with framing bias. The framing effect is likely to be more pronounced for hybrids as many of the risks are not immediately apparent, rendering the risk-return trade-off more appealing than shares and bonds.
Ambiguity aversion bias leads to a preference of known risks over unknown risks. The presence of ambiguity aversion in participants resulted in nearly 11% higher allocation to shares. Susceptibility to ambiguity could result in investors holding a smaller proportion of hybrid investments. As a result, it could highlight the risky nature of hybrid securities.
Cognitive substitution describes the behaviour of decision makers to unconsciously replace hard questions, i.e. ‘how risky is a hybrid security’, by easier ones, i.e. ‘do I know the company (brand) issuing a hybrid security?’ Branding can result in a greater proportion of portfolios allocated to known brands of issuers of financial products. The recognisability of the brand name of the issuer of a hybrid security in this experimental study did not influence investment choice. This may indicate that where information is provided in a succinct and standardized manner the effect of a brand name may be negligible.
Participants were asked a range of risk attitude questions about the investment options according to five broad risk perception factors. The questions were based on knowledge that risks in different investment options can be perceived in different ways.For example risk may result from a lack of trust, the way information is presented, or from an underlying volatility of returns. Hybrids were seen to be riskier than shares and bonds on two counts: distrust of issuers/products and poor knowledge of the product. However, acknowledging the difficulty in understanding hybrid securities did not deter participants from buying them. Possibly due to framing bias, participants focused on certain obvious features of hybrid securities and ignored important descriptive information.