Uncertainty is always going to exist in financial markets. Depending on your risk appetite, this can either be thrilling or daunting. There is pressure to achieve superior returns and this can be even more prevalent during periods of uncertainty, whether you are a financial adviser or an individual investor. Under this pressure, the appeal of non-traditional, complex, investment products, offering ‘guaranteed’ returns or limited downside, increases.
Temptation is rising
2016 has certainly started uncertainly; markets have been horrible. Historically-low bond yields are making it difficult for investors to achieve return targets without increasing risk. Property prices are at an all-time high with a very unimpressive average rental yield of 3.5% gross (as at June 2015 – the latest figure available). Despite recent falls share markets remain expensive on average. Therefore it’s quite conceivable that investors are looking for unconventional solutions to increase returns.
The income and return pressures faced by advisers, coupled with a plethora of recently-launched ‘low-risk’ strategies can be a dangerous combination. And let’s face it, it is tempting; who doesn’t like the promises of low risk, meeting income requirements and achieving superior returns for clients – in other words the nirvana of investing?
In recent years flows have moved away from equity funds. Between 2011 and 2015 there was a 50% decrease in the number of Australian equity funds launched versus between 2007 and 2011, but a 57% rise in Australian alternative strategies and a 100% increase in Australian multi-strategy income funds! During uncertain environments investor appetite creates demand for these alternative and multi-strategy products and fund managers are more than happy to provide the ‘perfect solution’. The industry is very good at giving clients what it thinks they want, instead of what clients need.
What are these products?
ASIC provides examples of complex products, such as hedge funds, hybrid securities and notes, capital-guaranteed and capital-protected investments and agribusiness schemes to name but a few. While some of these products appear to solve the current low-return problems, many are difficult to understand.
Before considering investing in these products it is important to consider the potential downside and not solely the potential gains. Unfortunately, sometimes, these complex strategies have flaws that don’t become obvious until it is too late. As you will see in the example below, quite often they provide a good short-term solution. But when it doesn’t work out, how bad can it get?
“Put horse dung and rubbish into a grinder and make sausage”
According to The Age, this was how some commentators described collateralised debt obligations (CDOs), the process of packaging bond bundles, loans and asset-backed debt securities into investment parcels. CDOs include the high-risk subprime mortgages used by, for example, Sydney-based hedge fund manager Basis Capital in the Basis Yield Fund.
These investments were sold by advisers as low risk but proved to be anything but. In 2007 the Basis Yield Fund collapsed and many investors didn’t get their money back.
What happens to one manager is unlikely to happen to all. But examples such as this should at the very least encourage us all to consider six key points:
- Can I understand the product I am investing in?
- Do I understand the range of possible outcomes – both the upside and the downside?
- Is it possible for me to explain the product to my client during a challenging period?
- How transparent is the manger?
- On what basis will the strategy endure for the long term?
- Do I understand the liquidity (how do I get my money out and how long does it take)?
Assessing the quantitative dimension of complexity can be difficult, but it is essential to understand what you are getting into. High risk and high complexity could be a very dangerous combination. Ask yourself, are you willing to accept extremely risky assets with a lack of understanding of how a product works?
The benefits of keeping it simple
The good news is it is not essential to invest in complex products to achieve strong returns with limited downside risk. Carefully choosing select, straightforward investment products can:
- Reduce the probability of drastic loss, of a magnitude not even contemplated
- Ensure the product is easy to understand and explain and therefore builds your and your clients’ confidence
- Improve knowledge and therefore improve the quality of conversations with your clients.
As Warren Buffett said in the Berkshire Hathaway annual report in 1994, “Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary results”.
Joy Yacoub holds a Bachelor of Economics and a Bachelor of Commerce (UNSW), specialising in Economics, Finance and Business law.