Kicking the tyres on a product

We need to remember that there are many in the financial planning profession whose experience does not extend beyond the last 15 years. What this means is that many of our newer practitioners have no actual experience of dealing with clients when investment markets, or particular products, go bad.

For those of my generation, the 1987 stock market crash and the unlisted property and mortgage trusts failures were very much the reality. As a consequence, we have learnt to apply a healthy cynicism in our approach and in our views as to how markets and particular products are likely to perform.

One of the most important lessons we learnt was never to believe too blindly in the strength of the brand of any financial institution.

The second lesson, and one that has never been as important as it is now, is the need to personally understand the actual product you are recommending. Markets have generally been performing well, and experience teaches that this can lead us to relaxing our caution.

What is required of every financial planner is a certain level of due diligence in relation to any of the products to be recommended to clients. That is, you have to ‘kick the tyres’ of most of the products you are considering as appropriate for recommendation.

The first step, of course, is the research you receive. Independent research, however, is only the first step in the process, and not the process itself. Research does not investigate the underlying aspects, or the risks of the investment to the level expected of a financial planner. It will provide a broad assessment of these matters, and this in itself will point you in the direction of the things that you should look out for.

Bear in mind though that not all products require in-depth examination. Some are fairly standard, such as domestic equities, managed funds or balanced funds, and do not warrant a rigorous due diligence approach.

Others, however, will require you to apply your own critical analysis. That is what the law expects of you, as does each of your clients.

In the 2003 judgement relating to the case brought by ASIC against the financial planning firm of Saxby Bridge, we were provided with some definitive insight into where independent research sits. ASIC had contended that in order to satisfy the requirements of the law to undertake a reasonable investigation into the relevant product, the investigation must include two aspects — due diligence and securities research.

It was said that due diligence involves verification and validation of statements of fact and opinion provided to the adviser by third parties. Securities research involves a comparative analysis of the relevant product with similar products. This was the test that was applied in determining whether the firm, and its advisers, had met the required standard. Clearly, the review of independent research is not always enough to discharge your duty to the client.

So, what do you need to look at in relation to particular products? The following thoughts will give you some direction.

Do you understand what the product is investing in?

In the case of more sophisticated products, such as absolute return funds, it may be less clear. If there are no investment mandate restrictions, and a wide range of investment possibilities, then you should look more closely into the product. If you cannot understand where the money is actually being invested, you need to find out more. So, for example, when looking at an absolute return fund, if the actual investments are not transparent, how can you understand what the fund manager is doing with regard to the valuation of complex or less liquid assets? What is the valuation methodology for sophisticated investments?

How long have the parties been in the industry, and how well do you know them?

Again, this is a very relevant question for products where a specialised expertise is called for, as with absolute return funds, property trusts, mortgage funds and agricultural investments.

What is the structure of the investment?

If the structure is a little more complex, you should understand why this is so. If there are interposed sub-trust investments, what is the reason for this?

Does it mean, in effect, the dilution of any investor rights should anything go wrong?

Are there any related entities dealing in or with the investments?

Investment in or loans to related entities or trusts may not be as negative, but it is imperative that you understand why it is occurring in a particular product. There should be a demonstrable benefit for the investors.

Related entity arrangements can create conflicts of interest, and you should understand whether these could exist, and if so, the impacts upon the performance of and viability of the investment.

How often can redemptions occur?

The product may offer only limited opportunities to exit the fund. If so, you need to understand the potential implications of this to any changed circumstances affecting your clients. You should also be fully confident you understand why the particular type of product actually needs to limit fund outflows.

How are fees calculated?

Performance fees increasingly have become the preferred remuneration method. On its face it can appear to be a more equitable method of calculating investment management fees. On the other hand, it can provide an incentive to chase return with a short-term view.

What is the past performance, and how have distributions been funded?

If the fund is new, the past performance data will be limited. It means you need a stronger basis upon which to recommend a newer entrant into the industry.

When recommending a property trust you should look carefully at the source of the distributions paid. There have been some serious property trust failures where the problems were masked by distributions being paid from loans and other sources separate to actual income generated.

What are the real risks?

Open any Product Disclosure Statement for an explanation of the risks and there is a sameness about the text. The disclosure of risk is very broad and intended to ‘cover the field’ in terms of legal protection for the fund manager.

You need to look beyond this and determine for yourself what you think is the reality as far as the investment of your client’s funds are concerned.

Trust your own judgement. You won’t lose a great deal, or too many, clients by being cautious. It takes some degree of experience, or resilience, to rely upon your own instincts rather than general market sentiment.

Lucille Benetto is head of complance, Lonsdale Financial Group .