Apparently quite a lot, given the funds management industry’s penchant for imaginative names for new products. The creative licence on a name has the potential to attract more clients and grow funds under management.

The implicit ‘promises’ of low volatility, absolute returns and capital assurances continue to be some of the most alluring terms emerging from the boardrooms of product manufacturers. These seemingly simple terms are used, but underneath are often highly complex tradeable financial assets that underpin a variety of investment strategies. It’s vital investors are clear about what they are investing in, or how products work, leaving no opportunity for them to be misled.

It’s unsurprising that investors and advisers look for alternative investments that appear to make lofty promises and give assurances of stability and capital protection. It’s been a challenging 10 years, with the Australian sharemarket broadly moving sideways during this time.

Yet I can’t help but think that we’ve been here before. Whilst the investment community still actively speaks of the global financial crisis (GFC), it appears that many have forgotten some of the pivotal things that led to investors losing money permanently during that time. During the GFC investors lost money in a variety of ways, but the following attributes were commonplace in many failed investments:

  • Derivative-based investments
  • Complex investments
  • Illiquid investments engineered into, or represented as, liquid investments
  • Capital protected products
  • Tax-effective schemes

During the GFC people often didn’t fully understand the structure of the products they were investing in, or the severe consequences if things went wrong (sub-prime mortgage-backed securities, anyone?). I think we might be in similar territory now, with complex products and strategies being packaged up and given appealing names. Recently products with the following broad names and descriptions have gathered tremendous interest:

  • Smart Beta
  • Tactical Beta
  • Absolute Return
  • Real Return
  • Asset Allocation Alpha
  • Income Funds
  • Fund of Funds Hedge Funds
  • Objectives (or Goals) Based Investments

The list goes on. It’s easy for these types of products to attract interest when they appear to offer a simple solution. From that perspective the similarities between these products and those launched during the GFC are clear – offers of solid returns with less risk.What's in a Name.Chart Image.16.08.04.With Source.Low Res

But how many of those involved understand them? Do investment managers comprehend fully the risks that are being employed, particularly downside risk; do advisers fully understand what they are recommending and can they explain it to clients; and do end investors grasp what they’re buying? In my experience most market participants give insufficient consideration to the consequences of things going wrong.

Conducting detailed research and due diligence in these product categories is arguably more important than any other categories. It’s more important than ever that investors understand where they are investing and the products they are buying. Most advisers are seeking the best outcomes for their clients, but some complex products can magnify risks. Product knowledge is imperative. We need to understand the outcomes, especially the potential for negative returns or worse, permanent loss of capital. As a general principle I try to take the following view – if you can’t fully explain it to your mother then you probably shouldn’t be investing in that product.

It’s not always necessary to pursue complex solutions to achieve good outcomes, there are other choices. It can pay to keep it simple. A straightforward equity strategy with valuation at the core of the approach can endure over the long term, and deliver great results to investors.

Consider the current Australian market. We are at a unique junction, where certain sectors and stocks have been pursued with such vigour that their high prices now represent significant capital risk. These once defensive sectors are now quite expensive, yet the large majority of investors see this as the “new normal” (much like they thought technology and media stock prices could be justified in the late 1990’s). The momentum behind sectors like health, infrastructure, REITS and financials has led to lofty prices. The relentless pursuit of income and dividends has pushed prices higher.

With the market having traded sideways for nearly 10 years you might expect the market in aggregate to be cheap but this is not the case. Our base case is that the market is most likely expensive, but the sectors mentioned above are particularly so. Which is not to say there are not opportunities, they are just not targeted in more benchmark-aware strategies.

As a contrarian investment manager we look in the more shunned parts of the market and currently we are continuing to see tremendous investment opportunities in value stocks. In 25 years the opportunity for outperforming the market has rarely looked this attractive for contrarian investors.

We cannot predict the future, but we do know that trees don’t grow to the heavens. Share prices will ultimately reflect the value of the underlying businesses. Paying a lot less for companies than they are worth is a great starting place to reduce the risk of capital loss.

It seems to me that if you want to reduce the risk of capital loss whilst growing wealth you don’t necessarily need to invest in complex structures with fancy names. Adopt a strict approach to valuation and take a long term and contrarian approach…these are the tenets of a proven and enduring strategy.

 

Chris Inifer holds a Bachelor of Business Economics and Finance (RMIT University) and a Postgraduate Diploma (with Distinction) in Financial Planning.