Investors take time out to refocus on risk

The year is almost over, and likely to go down as one of the worst years in investment market history. My first article for 2008 (Money Management, January 31, 2008, pp 12-14: ‘A tough year ahead’) attempted to identify some of the major challenges in store, but I’ve still been shocked and somewhat humbled by the speed and depth of the crisis and its crushing impact on global financial markets and economies.

Certainly, many of the issues I raised in that article have become front-page news.

My concerns about gearing were even understated given the collapse of Opes Prime and others, and continuous record days of margin calls.

Margin lending is fast becoming the strategy of a few sophisticated investors only, with margin loans outstanding down over $10 billion (or 27 per cent) in the nine months to September and another massive decline likely in the current quarter. Internally geared share funds will be lucky to survive as a product category.

As I feared, 100 per cent gearing into most protected structured products has proved a costly strategy.

Investors face the difficult choice of exiting now with large losses or paying what in some cases will be high interest rates for years, simply to pay off the loan principal.

The leveraged structured product industry will be much smaller going forward.

The current crisis has highlighted the dangers of leverage and just how much leverage had developed in every nook and cranny of the financial system.

The de-leveraged world that emerges from the carnage will ultimately be a healthier and more stable one, but it will be painful getting there.

Frugality is back in fashion. I suspect that much of the forced de-leveraging will have taken place in the current year.

However, de-leveraging by choice, as the risk appetite of the full range of financial participants declines, will take years to play out. This will reflect a generational change in the attitude to risk.

As expected, the ‘set and forget’ style of strategic asset allocation with constant high exposure to growth assets is being discarded, consciously or unconsciously.

The most popular response will simply be to build much more conservative asset allocations, either by not rebalancing back into growth assets, or by new clients allocating much more exposure to cash and bonds.

However, with equity markets 50 per cent down and long-term valuations on growth assets the most attractive in decades, now is not the time to be decreasing exposure to growth and risk assets for most long-term investors.

Cash rates are probably heading to less than 3 per cent per annum and government bonds on average are offering running yields little higher.

Investors are positioning for deflation while the actions of central banks and governments suggest the longer-term risks to inflation are growing rapidly and need to be considered in portfolios.

The big concern is that the strategy most planners and investors adopt is to avoid what we have just been through, rather than what might be ahead.

Investors wrong-footed in the current crisis will be wrong-footed again if they keep looking in the rearview mirror without considering how the world may evolve.

Alternative investments have attracted a lot of attention and controversy.

In an environment much more hostile than a conventional equity bear market, correlations with mainstream assets have converged and some have clearly disappointed (fund of hedge funds, commodities, private equity) while some others (managed futures, selected hedge funds, some infrastructure), have performed well.

Others have depended on how investors achieved their exposure. For example, gold bullion has been one of the few financial or commodity variables to remain in a bull market and perform well, especially in Australian dollar terms, although gold mining stocks have been dismal, at least until recently.

Still, a sensible spread of quality alternative investments has significantly outperformed the dramatic declines in equity markets and their role as a diversifier in portfolios has been confirmed, if not embraced enthusiastically.

However, liquidity issues with some alternatives have come to the fore suggesting that multi-manager, multi-asset allocations investing across the liquidity spectrum of alternatives will be the more robust way for retail investors to gain alternatives exposure in the future, rather than via a number of separate specialist funds.

With traditional equity and property market valuations looking attractive, some believe one can largely forget about alternatives.

While some tilting away from alternatives and towards traditional investments makes sense given the attractive value, the risks and volatility of traditional assets in the next few years is expected to remain high (albeit not at the extreme levels of recent months).

So, the case for alternatives to aid diversification remains, particularly given that future opportunities in some alternative areas have also been dramatically enhanced by the events of the past year.

My concern over the looming liquidity mismatch on some retail products has been an issue for a much broader spread of funds than expected.

Property funds, hybrid property funds, high yield funds, mortgage funds and hedge funds have been forced to suspend or restructure redemption arrangements. Even one equity index provider was forced to suspend redemptions for a period.

The universe of truly liquid investments has narrowed alarmingly as investors have de-leveraged and rushed for cash. The Government deposit guarantee has been a contributing factor in some of these.

It has become clear that liquidity is dynamic and that what is liquid in good times can become quickly illiquid in tough times.

Further, the platform driven retail industry is poorly placed to handle less liquid investments. I suspect that many of the product categories hit by redemption freezes will not

be available to retail investors in the future, at least in their

current form.

Unfortunately, this may also mean that retail investors may not have as much access to some asset categories that make sense and can help diversification.

The managers that performed better have generally been those non-benchmark tracking and quality/value oriented managers; although, for equity managers this simply means their losses have been less. However, some such managers have suffered very badly as some big calls have failed.

Global managers that were largely unhedged have obviously benefited from the decline in the Australian dollar.

I warned that the limitations of broker research would be highlighted for those recommending direct shares for clients. I suspect many groups doing so will have to reassess this approach and move back to managed funds and/or multi-managers.

The product rating-focused models of the research houses will have to continue to evolve if only because there will be fewer products to rate going forward and more demand for portfolio construction and allocation advice in addition to regulatory pressures.

As expected, none of the new financial services’ initial public offerings slated at the beginning of the year have taken place and many listed financial services businesses have had a particularly tough year, having to placate both disappointed shareholders and investors. Some of these businesses will not be around in listed form a year from now.

However, no financial services business, public or private, can automatically and complacently expect that they will easily and definitely survive through this period.

I warned that 2008 would be a stressful year where the industry would be truly tested and its long-term value subject to enormous scrutiny. Increased regulation has already begun to impact and will increase across the spectrum of the financial services industry for the next few years.

Let’s hope there is some improvement to the ad hoc, reactive approach (with little concern for the consequences) that has been the feature of regulation in 2008 in areas like short selling and the deposit guarantee.

Character and integrity becomes vitally important in periods like now.

No one in the investment industry has been immune from mistakes in the past year. But it is how we respond to those mistakes and issues that really matters.

Openness and honesty is

crucial with the best interest of investors the key priority.

The investment banking transaction-focused model is largely dead for this industry.

Looking after people’s money, whether as an adviser or fund manager, is something that can only be properly approached from an ongoing fiduciary arrangement rather than a transaction basis.

From this perspective, strong and trusting relationships, between planners and clients, and between participants in the financial services industry will become more important. Investors and planners will become sceptical of financially-engineered products or those created for short-term appeal.

What we have been through wasn’t just a housing bubble, a stock market bubble, a commodity bubble or even a hedge fund bubble.

Rather it was an across-the-spectrum risk-taking bubble funded by easy credit and extreme leverage.

We reached the point where everyone was an investor in risk assets whether they had the funds or not, or whether their risk appetite or time horizon suited.

The past year has highlighted that markets are not driven by scientific laws but by human behaviour and while valuations provide a long-term (but loose) anchor, markets can do crazy things at times and those moves can actually influence, through feedback, the fundamental values they are supposed to reflect (George Soros’ Theory of Reflexivity).

Risk measures such as standard deviation and value at risk become largely useless at such times, although it shows that periods of extreme volatility are clustered. Black swans happen — just because it hasn’t happened before don’t rule it out.

Periods like now should put the final nail in the coffin of the efficient market view of the world, although it doesn’t rule out using passive investment approaches in certain areas and for some investors simply because this period has starkly illustrated how difficult it is for active managers to perform well.

The behavioural flaws that make markets inefficient (and wildly inefficient at times like now) are the same flaws that make markets extremely difficult to beat and is why identifying smart investors is not easy.

There is no doubt the global economy is facing a period of serious weakness.

The loss of wealth suffered globally in the past year has been massive — around $40 trillion. For some investors, these losses are permanent either because of the nature of the losses (forced sales, failed funds/companies) or because they have chosen to exit the investment game and will not participate in any recovery.

For other long-term investors who can stay invested and even take advantage of exceptional values, losses can be expected to be gradually recovered over time.

However, even if markets bottomed now, the financial services/investment industry will suffer for an extended period (years not months) and it will be quite a different one that emerges from this crisis.

Surviving through this period will provide great opportunities both from an investment and business perspective for participants in the industry.

Still, this is a time to keep looking forward, not to dwell on past mistakes and issues.

While it is hard to see through the current carnage, markets are already pricing in a dire outlook and offering opportunities and values not seen in most investors’ lifetimes.

It is the responsibility of this industry to ensure that clients are in a position to benefit from these opportunities through well-diversified portfolios they can feel comfortable committing to in the medium to long term.

This will not be easy, but the reputation and value of the financial services industry depends on it.

If planners give up and simply provide shell-shocked clients the poorly diversified portfolios focused on cash and fixed interest they are increasingly demanding, clients will eventually give up on planners and the industry as they realise they can easily do that themselves or that such portfolios are poorly placed to deliver in the long term.

So farewell to 2008. A challenging, historic and ultimately stressful year for most participants in the financial services industry.

Enjoy the few Christmas parties still going ahead. And bring on 2009. Quickly!

Dominic McCormick is the chief investment officer at Select Asset Management.