I have been asked recently to comment on the events that follow when a fund manager chooses to close a collective fund and wind it down, paying back all the investors.
Basics
Don’t look back in anger (m)
You want to do what!!?
A steady flow of depressing tales about cases brought to the Financial Ombudsman service (FOS) involving people investing in highly unsuitable assets via Self Invested Pension Plans (SIPPs) makes me fume.
The awards paid out to put consumers back where they should have been are paid by professional indemnity insurers or the financial services compensation scheme, both of which are rising costs for all adviser firms. In other words, the decent firms pay for the folly or plain fraud of others.
One might wonder how advisers seem to tell completely inexperienced investors with not much money that they can safely invest in what seem to be weird and inappropriate assets. Cases recently have involved house building projects and self storage pods! Even investments in gold bullion fall into this category of potential disasters.
Often the assets are outside of the normal regulated investment products and only get caught by regulatory oversight because of the use of the SIPP.
The likely scenario (I have seen this in my working life a few times) is that the client came to the adviser already thinking that they wanted to make a ‘sure-fire’ investment they had read about or a friend had drawn to their attention. The only money they had was in their pension funds and someone suggested (often the promoter of the risky investment) that if they moved their pensions to a SIPP, they could invest.
As most advisers work on percentage fees paid only after they complete an investment (so called contingency fees, which I think ought to be banned), they are motivated to proceed with the transaction. They may well feel protected from future complaints by issuing pages of risk warnings, which of course the client sees as ‘bureaucracy’ and ignores, and adding a little diversification as window dressing. In effect, they say to the client – ‘if you want to do this, who are we to argue? We can make it work, for the right money’.
This is frankly disgraceful and it is a good thing that the FOS will usually assess the suitability of the high risk/illiquid/failed investment relative to the client’s experience and risk profile, irrespective of what any suitability letters or file notes may say. In the worst cases, the adviser is found to have made an extra commission from the promoter of the investment, sometimes at a very high level. To me it odd that such advisers are not immediately banned by the regulator.
What an ethical professional adviser ought to say is that the suggested investment is totally unsuitable for the vast majority of people and should not be touched with the proverbial bargepole! Of course, such good advice may earn them no money and the client may even go somewhere else to get what they want.
A good test of whether or not your adviser is acting in your interest is what is called ‘skin in the game’. Ask the adviser – do you own this investment, or would you buy it in the way you propose that I do?
As an adviser, I usually bought investments in new funds to observe performance before I recommended them – at times I lost money as a result. Good fund managers also own personally many of the shares they have in their portfolios. In simple terms, an adviser should put their money where their mouth is.
And if they think an investment is not something they fancy, they need to talk people out of it, vehemently, or decline to act for them. One problem is that many financial advisers actually have no idea of how to assess the credibility of an investment, having no relevant qualifications or training. Make sure yours does!
Useful Links – take a look!
In or out? Deal or no deal?
As we approach some critical dates in terms of global financial risk, I have been asked about the pros and cons of being “out of the market”. By that I mean having all or a large part of your portfolio in cash.
FOMO
The obvious disadvantage in recent times to holding cash is that it generates a very low return, but that is usually taken as read and the ‘quid pro quo” for not carrying the risk of a loss of capital value. What people worry about in addition is the possibility that the market might go up a worthwhile amount while they are not fully invested. Our old friend FOMO – the fear of missing out.
Actually, it is good that people have this worry. Recent data from the Financial Conduct Authority shows that a high proportion of people who access their pension fund to get out the tax free lump sum, then go on to leave the balance in cash or a totally unsuitable default investment fund. This really reduces the chance of their pension being even as good as an insurance company pension annuity.
Before going anyway, know from where you are starting!
For those who want to know whether it is sensible to have loads of cash, some cash or no cash in their portfolio, I would suggest that one ought to think about where we are in the market cycle. In other words how are markets valued – have they been going up for ages, have they just collapsed, or something else?
An example
I will explain this with an example. Let’s say there is 40% of a well diversified portfolio in cash The rest is exposed to what we will call the ‘market’ although in reality returns will come as an average from lots of differing assets.
Let us say ‘markets’ are currently near an all time peak and we assess the possible further increase in the next 12 months as being a maximum of 10% – we read of strategists predicting “high single digit returns’ (they really do say that sort of thing).
So if 40% of our money misses out on a 10% return, we will only get 6%. and will have missed out on 4%.
If the market is really high, we can say from past experience that a setback of 30% plus is also entirely feasible. If the market fell 30%, we would lose 60% of 30%, so 18%. That means our cash reserve has ‘earned’ 12%: the amount we did not lose.
Clearly in this example, which reflects where we are now in my opinion, the risk/return ratio is not symmetrical. There is a better risk/return ratio on holding cash than not.
Why then would I not suggest holding 100% cash? The reason is that if we had all the portfolio in cash the ‘missed return’ if the market went up would be the full 10% and that might be psychologically painful. In other words, we need to get as near as we can to having our cake and eating it, or to hedge our bets and the desired balance will vary from person to person.
Some people might say it is fine to miss out on 10% upside after a very good run, rather than take the risk of a 30% loss, especially if they need access to the investment quite soon.
I must emphasise that if markets had recently sold off, like in 2008, the estimates in the example would have to be quite different. Perhaps not surprisingly, at such times people want to carry on holding cash (another recognised psychological bias) and in fact they really need to be brave.
Surely, there is a clever option?
It would be great if there were assets you could buy that gave you a modest return and went in the opposite direction to the main investment markets. Clever people have been working on that for many years and almost completely failed. What is available is complicated and hard to analyse. I have commented on Absolute Return funds in other posts and the article ‘Real World Risk’ may interest you.
Even if you could buy an asset that always went in exactly the opposite directions to stock markets (to a degree you can if you understand derivatives), then if you put 50% of your money into that asset you would only ever make a zero or lower (because of costs) return because the two parts would cancel each other out!
Cash is still the best defensive asset and the opportunity cost of holding it is best thought of as an insurance premium well worth paying when risks are high.
With insurance, when the house has burned down to the ground, you don’t pay the premium again until you have re-invested in a new structure! If the site is just a charred heap of rubble or two years, there is no need for insurance. So after a market sell off, cash can get switched to assets that are nice and cheap!
There are other ways of dealing with the loss of return from a cash element in a portfolio notably the ‘bar bell’ approach, where some high risk assets are retained at the other end of the portfolio volatility range and then if markets do shoot up, they make a geared return that compensates for the dull cash element not contributing much. Because the return is ‘geared’, or much greater than the market average, you don’t need to have as much money in such assets and if things go wrong you won’t lose much.
Such strategies require a good knowledge of markets and asset types or a skilled adviser. Some ready made multi asset funds will use this strategy, but it is not commonplace.
In conclusion
In simple terms, a good adviser will help you fight your natural psychological biases. You will need to hold cash after making sales to bank profits following long periods of growth and conversely to invest rapidly after a market sell off. You won’t want to do either, but if you can be persuaded, your long term returns will be rather better.
Real World Risk – supplementary evidence!
Here is a question to test your investment knowledge:
Over 6 months when stock markets have been volatile investment fund A has lost 4.73%. Over the same period fund B lost 2.38% and Fund C made 5.96%. Of the 3 funds, one is Absolute Return (AR), one is Asia focused and one is an ethical global fund. Guess which is which. All data is from FT Analytics and the funds are all mainstream retail collective funds.
Normal investment convention says that the Asian or ethical funds ought to be most volatile and the absolute return fund will offer some protection is volatile times. Most advisers would tell you that adding an ethical filter increases risk.
So perhaps you would have guessed Fund A was Ethical, B was Asian and C was the AR fund.
You would score 1 out of 3. B was indeed Asian The best performer was the ethical fund and the disaster was an AR fund.
Over a more realistic assessment period of 5 years the Asian fund did best, the ethical global fund pretty well and the AR fund just about kept up with deposit returns, although it did well enough until about 3 years ago after which it fell apart.
What this shows is that using past performance data on volatility or performance as a sole or main tool (alone or in a combination) in assessing risk or choosing funds is plain stupid. It is useful data but it needs to be contextualised. Above all one needs to remember that the point we are at now is almost always going to be a different financial climate than 5 years ago and probably 3 years ago.
A fund that for a particular reason goes up steadily over several years will have low volatility and good performance but might be well into bubble territory, for example.
Many published fund pick lists and even model portfolios use “risk rated’ returns where the risk element is calculated with statistical volatility and past performance numbers as major factors. That is not a good idea in NotHarry’s opinion! See the article about risk here for a longer explanation