Great debacles of our time: The great mezzanine financing collapse (part 2)

This is part 2.

Part 1 is here.

We were starting to really get stuck into the the sheer carnage caused by the collapse of Westpoint, Fincorp and ACR.

In part 1, we looked at a couple of burning issues created by these debacles:

1. The role that adviser commissions played in the collapse of these businesses and the loss of investor savings;
2. Mezzanine finance and portfolio theory - how is it that advisers can spot a wildebeest when it walks and quacks like a duck? and;
3. Financial literacy and retirees. Is it wrong to target a vulnerable sector of the community when pushing risky products?

The media has been completely enjoying this horrific financial pile-up. And why wouldn't they? There are thousands of angles to explore this from - advisers, investors, the companies involved, the executives, the trustees, the liquidators administrators, the federal government, regulators etc.

And why not? They all had a role to play in this. Whether good or bad, savoury or otherwise.

I'll do my best to cover some of the angles, but I'll re-iterate the important lesson to be learnt from this:

"If it looks too good to be true, that's normally because it is."

Let's look at some interesting stats from this. According to an article in the Fin of Saturday 2 June, 2007 by Robert Harley, the following numbers come up. There were:

• 20,000 investors burnt; and
• AUD $800 million lost.

No matter which way you crunch the numbers, this adds up to serious money and serious lost dreams.

The financial regulator, ASIC, is looking very battered and bruised after some fire from both sides of Parliament. But was ASIC being made a scapegoat?

This blogger thinks that they were. And these are the reasons why:

4. Mezzanine finance is a risky proposition.

Even though the issue of debentures and unsecured notes are done through a trustee, there is very little recourse available through a trust deed for investors. The trust deed itself is normally written by a the company who is issuing the paper.

Trustees are usually appointed through a tendering process whereby the one that offers their services most cheaply will win out. Not only that, but during the tendering process, preference will be given to trustees who promise no questions asked.

Trust Company, the trustee appointed to look after ACR's investors maintains that ACR did all that was required from Trust, and met all their obligations under the trust deed right up until the bitter end.

Is this a conflict for trustees?

I don't really think so - provided that there is proper disclosure given up front. If this is done, then the job of the trustee is mostly done. The trustee just needs to look after the rest, but they still have a duty to act on behalf of the investors.

How about ASIC?

ASIC polices the issue of these investments, but really only up to the point where disclosure is concerned. If the issuer of this paper is meeting their disclosure requirements, then ASIC's job is done.

How the company that has issued the debt then operates in servicing their debt obligations is between the trustee, the company and their investors.

This is a bit different to a bank or a superannuation fund.

Banks and super funds have their day to day activities policed by a number of bodies, all of whom ensure that their prudential and regulatory duties are being upheld.

For banks, the regulatory side of things is monitored closely by the Reserve Bank, and APRA monitors their prudential undertakings to ensure that all is good.

Super funds also have APRA keeping tabs on their prudential requirements, except for DIY super funds which are looked after by the ATO. The ATO also looks after super funds' regulatory arrangements.

In the case of debentures, unsecured notes and other debt instruments, there is no body that looks after the prudential goings on of the company that issues them - it really is caveat emptor.

This adds a whole new level of risks that banks and super funds don't have.

Where disclosure is inadequate, this is pretty much the only area where ASIC can step in and so something about it. And in fact, ASIC did so - the article in the Fin reports that ASIC stopped ACR from issuing capital raisings three times until they fixed stuff up. Which ACR did.

ASIC also issued 11 warnings about Fincorp's goings on both before and after their CEO, Eric Krecichwost resigned as CEO (and as a director) in 2005.

This would appear to point the finger of blame in an entirely new direction, and in a direction that investors will not like, at least for investors who didn't use financial advisers:

5. Investors really only have themselves to blame

This really only applies to investors who just saw the advertisements and went berzerk. It doesn't really apply to investors who sought financial advice.

ASIC appeared to be doing everything short of double-checking the disclosure given by these companies for mistakes and errors.

But the whole deal looked too good to be true for retail investors.

What happens in the institutional world?

Harley's article mentions that where professional lenders, like the ubiquitous Macquarie Bank are concerned, rates of 20% or higher are the norm.

(By the way, just once I'd like to do a post where I don't mention Mac Bank. How in the name of Crikey do these guys end up in everything that I write?)

Anyway, you can bet that where professional lenders are involved, all sorts of caveats are written into the contract to ensure that the lender has some recourse.

Retail offers simply don't have this kind of bargaining power. These investors were pretty much sitting ducks for the walloping that they got, and I hate to say it, but they really only have themselves to blame.

6. How do we protect investors from this sort of thing happening again?

Well this is an age old question.

Investing, much like supply, demand, democracy, revolution and innovation only works because of two base human emotions - fear and greed.

I would also add laziness to this, but I'll detail why on another day.

Investors who got burnt were basically shovelling everything that they had into these investments. In a nutshell, they got greedy.

Of course, where advisers were involved, this complicates things a little, and the blame shouldn't be sheeted home to investors entirely.

Portfolio theory says that putting large slabs of your cash into the one asset is a very silly thing to do, and history has borne this out. Diversification, while it won't protect people from market nosedives, will protect people from problems with particular parts of a portfolio.

But if you throw everything into one asset that goes belly up, you are in deep trouble.

Tony D'Aloisio, the new chairman of ASIC, says that all products like these coming on to the market should all be professionally rated.

This is possibly a constructive solution, but D'Aloisio knows only too well that investors will bear the cost of such risk ratings.

D'Aloisio's other solution is better, though:

7. Can we educate investors about risk?

I think that risk is so important that I honestly believe it should be taught at school as the fourth 'R'.

I'll do a Financial Tip on risk a little down the track, hell possibly even three, but risk is so important, and it's through misunderstanding of risk that people go on to get burnt in the way that they have.

I believe that we can educate investors about risk, but this should start in secondary school.

Trying to educate mature Australians about risk is shutting the gate after the horse has bolted type stuff. It really is.

Australians' financial literacy is shocking. But risk would be an excellent place to start fixing this discrepancy up. And I for one will support any initiatives that ASIC puts in place to improve this particular piece of general financial knowledge.

It's the most important piece there is.

Edit 13/06/2007: I lay the blame for quite a lot of this squarely at the feet of investors, which oversimplifies things a little bit. In the case of Westpoint investors (and some others), however, quite a lot of them sought financial advice, and the advisers in question recommended the debt in question. I've done a couple of edits to rectify this, but I may explore Westpoint's situation in a future post - it warrants some additional comment space.

Disclosure: This blogger owns shares in Macquarie Bank Limited.

Standard but necessary disclaimer: This is not advice. Only a complete idiot would think that any of this constituted advice. It's not even vaguely reasonable to consider this to be advice. If you are in any doubt as to the content of this, see a good, independent financial adviser immediately. They do exist.

Great debacles of our time: The great mezzanine financing collapse (part 1)

I haven't really blogged much about this, but the dominoes are really starting to roll within mezzanine finance in Australia. After Westpoint went down, we've now seen Fincorp and Australian Capital Reserve (ACR) hit the deck as well.

The fact that this is even major news speaks volumes about 2 things:

1. Where financial advisers stand to gain significant commissions from the sale of such products, can there be any more evidence that commission-based advice is completely wrong?

2. Where such risky products are offered, should this ring alarm bells on the general level of investor financial literacy if investors go into these with all guns blazing?

First of all, what do we mean by mezzanine financing?

Basically, in all these instances, the company that was the end user was building property developments. Sound OK, so far?

In order to undertake this level of development, money needs to be borrowed, usually from banks, to fund purchase and/or construction.

However, this will only go part way. You know how banks will generally lend up to 80% of a property's value? And possibly a bit more if the bank (which the borrower pays for, natch) buys Lender's Mortgage Insurance?

Well, more money will quite often be required for property development.

This is where mezzanine financing comes in.

Mezzanine finance is usually sourced from the issuance of certain financial instruments, usually debentures and unsecured notes. This promises the investor a fixed rate of interest for a fixed term, and at the end, the borrower pays back the principle, together with any interest that is owed.

Debentures are usually secured through a trust deed over the company. Unsecured notes are, as the name would suggest, not secured.

But the security provided for debentures is not normally worth the paper it's written on, unless the security provided are specific assets. If it is only security over the company itself, then debenture-holders will rank behind secured creditors if the borrower is wound up.

In the case of Westpoint, Fincorp and ACR, the "secured creditors" are the banks who have lent to these companies and have first mortgage claims over specific assets. So all is good for them, provided that employees are paid, the taxman gets his cut and the administrators/liquidators get paid, though not necessarily in that order.

Unsecured notes will then normally rank behind debentures. Shareholders will be last, in the unlikely event that there is anything left over after the banks have mopped up.

The main problems, though, with these were in the points raised above. Let's look at them one by one:

1. Financial adviser commissions

I've heard, but I can't pin it down, that in the case of Westpoint, commissions paid to advisers were as high as 10%. This means that for a $10,000 investment, a financial adviser would be collecting a commission of up to $1,000 up front, not allowing for cuts that his dealer group may keep. Not only that, but the commission was paid for by Westpoint themselves, it wasn't recouped from the investor through an "entry fee" arrangement.

Now in all my years of providing advice, it was rare that any product would provide anything up front of more than 4%. And even then, this would normally be recouped via an entry fee, so that the investor essentially paid the fee.

Ostensibly, this means that Westpoint were paying a 10% commission to advisers on top of the interest rate applicable to the notes that they had written. That's some seriously expensive borrowings.

The interest rates were quite high, too. But I'll come to this later.

I can't find any evidence to suggest that Fincorp and ACR were being invested in via financial advisers, so I'll have to assume that his problem was specific to Westpoint.

2. Mezzanine finance and portfolio theory

From what I can tell, advisers appeared to be completely ignorant about the nature of these investments.

Debentures and unsecured notes are medium to long-term instruments that promise a rate of interest paid in regular instalments, together with a return of capital at the end.

This means that they are fixed interest investments, just like bonds and term deposits.

Because the funds were used for what was ostensibly property investments, advisers were not only recommending these to people as part of their fixed interest portfolio, but also as part of their property portfolios.

This is erroneous in the extreme.

Not only that, but it appears that advisers were, in some instances, recommending that investors stick all this part of their portfolio into the one instrument.

Portfolio theory tells us that this is a silly thing to do. For most investors - my guess 90-95% - portfolio theory tells us that diversification achieves a greater return for a given level of risk.

Usually, the risk that is managed through diversification is market risk, however there are other risks out there, two of them being credit risk and interest rate risk. Diversification provides an effective way of managing both of these risks, by "not putting all one's eggs in the one basket".

But if you're going to stick an entire segment of your portfolio in the one asset - your diversification is reduced. And because of this, your exposure to something going wrong is greatly increased.

It's fair to suggest, and studies back up this suggestion, that advisers were really only thinking about their commissions when recommending this sort of product.

Again, I can find no evidence to suggest that Fincorp and ACR's ones were being sold through financial advisers, so this problem appears to be Westpoint-specific.

However, my point about diversification applies to all investors who used this sort of product still stands, and I'll discuss this some more in due course.

3. Financial literacy and retirees

In the case of ACR, I remember seeing advertisements on TV last year where interest rates of up to 9.15% were being offered. I remember at the time breathing a snort of disbelief and thinking to myself, "Surely that can't be sustainable."

And obviously, it wasn't.

However, as I've mentioned before at various spots throughout my blog, the general level of financial literacy throughout the Australian public is not particularly good.

The first thing that anyone should learn before they invest a cent is this old maxim:

"If it looks too good to be true, that's normally because it is."

Anyway, the advertising that ACR was doing was calculated to ensnare retirees. I'm told that Fincorp and Westpoint were doing this too, at various times, but retirees are an interesting demographic.

Why?

A. They're usually cashed up. They've retired from the workforce, and they often have a significant chunk of money to play around with, either in the form of superannuation, or equity in their homes.

B. It would appear that retirees are not particularly financially savvy compared to later generations. This blogger would contend that later generations aren't all that better, but I'll leave that post for another day.

C. Retirees generally like investments that pay regular income.

So it would appear to be a no-brainer - when presented by advertisements showing excellent rates, why wouldn't retirees go in for this hell for leather?

In my book, aiming one's advertising at retirees is only slightly better than how the music industry, alcohol and tobacco companies target their advertising at kiddies.

This doesn't make it any less vile.

I'm going to call a halt here - there's plenty more that I'd like to write, but it needs a second part. Stay tuned.

Standard but necessary disclaimer: This is not advice. Only a complete idiot would think that any of this constituted advice. It's not even vaguely reasonable to consider this to be advice. If you are in any doubt as to the content of this, see a good, independent financial adviser immediately. They do exist.

Why AMP got busted

This is something that I didn’t think that I’d re-visit for a little while, however, the whole situation that blew up last week requires some reflection.

For those who don’t know, AMP Financial Planning was pinged in a big way by ASIC for an large ongoing amount of inappropriate advice being given out.

Basically, what was happening was that advisers were recommending that their clients roll over their superannuation to another fund, which was, more often than not, administered by AMP.

This isn't bad in itself.

But they were doing it enough to warrant a second look by the corporate regulator. And they were giving inadequate reasons for such recommendations whenever they did it. Finally, they weren't discussing what it was going to cost clients to roll over.

Now it’s the worst kept secret in the industry that advisers are under pressure to do exactly that – sell the products provided by the company that you represent.

And why not? It’s bleeding obvious to even the most financially illiterate observer that an AMP-branded adviser, or anyone else for that matter, is going to be told to push the products of the hand that feeds them.

But from the other perspective, how many mug investors know that Godfrey Pembroke, for example, is a member of the National Australia Bank group of companies, which also includes MLC? How many investors know that RetireInvest is part of the global ING group?

This blogger was formerly employed by and represented another financial institution which also just happened to have funds management, life and general insurance and banking operations.

Yes. We were told in no uncertain terms that, although we had various products from various providers on our approved product lists, we were to make sure that our first choice was from the providers in our group of companies.

This, when it was painted in such stark language, caused me to re-think my career in financial services.

Now I left the advice business in 2003 when it became clear to me that working for the same company as the product provider caused all sorts of dodgy situations.

My personal experience went something like these:

Story 1:

Boss-man: (at a meeting of advisers in the area/region/zone/district) We need sales to improve. So we’d like you to “churn”.

Adviser 1: Isn’t that unethical?

Boss-man: Other areas/regions/zones/districts are doing it.

Adviser 2: Surely that doesn’t mean that we should.

Boss-man: Look. All you have to do is find some good reasons to get your clients to do it.

Adviser 3: Could you provide us with some written guidelines that illustrate how we can do this ethically?

Boss-man: No. This is simple, straightforward stuff. You should be able to work out how to do this. Or maybe you think that a job here is not for you?

Note that “churning” is a particularly smelly practice that involves swapping existing clients from one product to another for no reason at all other than to collect another fee on the way through.

Story 2:

Boss-man: (at a sales seminar) I’ve brought in a “BDM” to explain to you why you should consider moving your clients in product X to product Y.

BDM: Thank you, Boss-man. Folks, your clients are currently in the equivalent of a Mitsubishi Magna (large-medium family sedan, for those outside Australia). How good would it be if you could move them to a Rolls-Royce?

Adviser 4: Sticking with your car analogy for a moment, what if what they really need is not a Magna or a Rolls Royce, but a Toyota Corolla?

BDM: Who wants one of those, really?

Adviser 4: Isn’t that between us and our clients?

Note that a BDM (Business Development Manager) is a representative of the product provider who liaises with the advisers similar to how a drug company sales representative might liaise with a doctor.

Doctors don’t get sales commissions, though.

But let’s put that aside and look at the argument.

Financial institutions such as life companies, fund managers and banks all rely on a dealership network of sorts to market their products.

“So what?” they say, “Doesn’t Ford and Toyota rely on a network of dealerships to sell their cars? Don’t Telstra and Vodafone relay on a network of dealers to sell their mobile phones?”

This is a valid argument.

If an investor goes into the office of a financial adviser from AMP or anyone else who also manufactures financial products, he should expect to receive advice that products from AMP are the best for him.

And, in some way, shape or form, he will receive a Statement of Advice to that effect. It will say that the product that the adviser is recommending is most appropriate for him for reasons A, B and/or C.

It’s at this point that the uninitiated usually ask “Hang on. If they’re providing advice, shouldn’t they be considering all products equally?”

Well, they should at least be considering a broad spread of products, yes.

Certainly, that spread should be a lot broader than what would be on your typical Approved Product List (APL) for your adviser from the particular dealership that that adviser works for.

Where a financial institution’s argument about being a dealership for in-house products comes unstuck is in the question asked above. And if you muttered "Conflict of Interest" under your breath, give yourself a point.

Does a car salesman for Toyota consider that they are an “auto-adviser”?

Should a mobile phone salesman at a Vodafone branch be considered an adviser?

The answer is a no-brainer. Product advice of any sort requires products from a variety of providers to be considered. At least, if you would like objective advice to be provided, anyway.

The dealership argument is a sound one. However, it is rendered null and void by the fact that the dealers themselves are simply not advisers – they are salespeople.

A financial institution, at this point, will jump up and down and scream, “How, then, do we get our product out there, for Joe Public to invest in/buy/use?”

The answers to this are pretty easy, actually:

1. Produce stuff that is worth it to consumers to use. Concentrate on old-fashioned values like high returns, low fees, simplicity and ease of use and easy to read documentation. There are companies out there who are doing this now, and who do not rely on a network of financial advisers to sell their product.
2. Cut out the middle man and advertise directly to clients. Clearly, you’re uninterested in providing a service that’s worth anything to anyone if your advice network is merely an expensive rubber stamp. Why would, or should, clients accept bits being sliced off here or there if there is no value being provided?
3. Call your network of advisers, “salespeople”. This is just telling it how it is. Why mislead clients further by creating the expectation that they are getting something objective?
4. Put advisers’ APLs into a client friendly brochure. Why continue to be bashful about the fact that advisers are tied to a particular provider? What is it that you’re really ashamed of?

The fact is that AMP got busted. But it could have been anyone.

AMP are to get an enforceable undertaking from ASIC and this will probably last for the next few years at least.

Bravo to ASIC for targetting the dealerships.

It should, of course, be remembered that the advisers are every bit as complicit as the dealership that they represent. Yes, I know it's hard saying no, but if soldiers can be found guilty at war crimes trials for merely following orders, then advisers should, most certainly, not get off lightly in the least.

But it is clear to even the most disinterested of observers that it was AMPFP's internal policies in the first place which has lead to ASIC's action.

Having an interest in the industry, the very important piece of wishful thinking is that the progressive move away from commissions towards fees-for-service should prevent this sort of thing from happening in the future.

Sadly, I'm not positive that this will be the case. AMP will still require sales. So too will other institutions that produce their own products. And thus there will always be some kind of pressure on advisers to tow the line.

But the four points I've outlined above would, at least, make the whole thing a lot more honest.

Disclosure: This blogger owns shares in National Australia Bank Limited.

Standard but necessary disclaimer: This is not advice. Only a complete idiot would think that any of this constituted advice. It's not even vaguely reasonable to consider this to be advice. If you are in any doubt as to the content of this, see a good, independent financial adviser immediately. They do exist.

What the hell is wrong with financial planning? (Part 2)

This is part 2.

Part 1 is here.

In part 1, we looked at some of the issues affecting financial planning in Australia, in particular, the small issue that financial advisers and their clients do not seem to be driving the agenda with regards to financial products.

The points that were raised were as follows:

1. Financial planning licensees and/or fund managers appear to be deliberately and mischievously aiming to discredit the Efficient Markets Hypothesis.
2. Financial planning licensees and their representatives are pushing active portfolio management as a benefit for clients.
3. Financial planning licensees and their representatives appear to also be pushing directly held assets as a benefit for their clients.

This article will look at some more specific problems - some of which follow on directly from the problems we identified in Part 1.

4. Marketing driven investment strategies

In the Fin Review of Saturday, 29 April, 2006, an article appeared that suggested that fund managers and not client needs drive the agenda with regards to clients' investment strategies.

Keith Ambachtsheer, a Canadian, has suggested that things may not be as they appear when it comes to personal investment.

Ambachtsheer, regarded by the Fin as one of the world's leading thinkers on pensions and retirement savings, publishes a monthly letter where he has contends that there may be more than meets the eye on this topic.

In short, Ambachtsheer's contention is that it is not client requirements that drive new financial product innovation, it's marketing.

Now, this is something of a change from what common sense would dictate is the situation.

Financial advisers should normally be recommending stuff to suit clients' needs. The simpler the better, where possible.

Not only that, but terms like "alpha" and "beta" should be meaningful expressions that demonstrate a concept that an adviser might use to address client requirements.

They should not be terms used to flummox clients unnecessarily.

For example - Strategy A has a better alpha than strategy B, all other things being constant. So adviser recommends strategy A.

Why has the adviser chosen this? And what does this mean? And why can't advisers refer to alpha as "outperformance"?

In the Ambachtsheer Letter (#243, dated April 2006), Ambachtsheer bemoans the proliferation of terms that have lost all meaning as fund managers drain all use out of them in order to portray their offerings as being more attractive than others.

The subtext of all this is that Ambachtsheer has strongly indicated that what we in Australia like to call 'Structured Investment Products' are nothing more than cynically marketed dumps for money.

5. A plethora of meaningless terms

Ambachtsheer picks up on just a few terms in the Ambachtsheer Letter that he dislikes.

These are not the only ones.

So many terms without specific nailed-down meanings are thrown around now that we may have actually lost sight of what terminology we should be using.

I happen to work at a master trust. I remember speaking to a former colleague of mine some time ago who told me that the product I work on, "Isn't a master trust. It's a wrap account."

What it actually is isn't important. What is important is that we have all this terminology in the financial world that is defined in quite fluid ways.

And this is simply crap.

The implications of so many words without agreed meanings is that personal investment itself starts to resemble some of the woo that I hate.

The thing about woo, is that pseudo-scientific terms are thrown about, partially to attempt to legitimise and partially to deliberately obfuscate.

And this is not what investment should be about. Investment should be a lot clearer than this and should never be considered even remotely woo-like. It is far too important.

6. Structured Investment Products^®

So what are these "marketing driven investment strategies"?

In the Fin of Saturday 24 June, 2006, reporter Chris Wright wrote an insightful article about the new breed of complicated investment products being promoted by financial advisers.

These started springing up in the nineties and involve much more complicated investing than your average managed fund.

First we had agribusiness schemes which were dodgy in the extreme. It's interesting to note that farmers are blaming these schemes for falling commodity prices.

I might even examine this claim in a future article - it's not as silly a claim as it appears.

These days, Wright writes (couldn't resist!), Structured Investment Products include the following:

• Capital-protected products
• Basket products
• Inaccessible asset classes
• Structured debt products
• Funds of funds

The issuer of quite a lot of these is Macquarie Bank, a company that has made a career out of making things as complicated as hell while stripping out a veritable treasure-trove of fees in the process. And each time they issue a new one, you get the usual positive spin about how "new" and "innovative" each product is.

Sure, some fund managers actually might have new and innovative ways to manage money, but are these methods actually any good?

Richard Capel, an adviser with Capel and Associates is worried that there is a new lack of transparency that is creeping in - the complexity is masking the actual act of investing itself.
Indeed, finding out how some of these work through the promotional material is really, really difficult. Product Disclosure Documents (PDSs), whilst meant to be standardised offer documents under the Corporations Act, appear to be nothing more than slickly produced sales tools.

The average PDS for a complicated investment is so opaque that you can't find out a lot of information. And the fees are quite high, despite what the fundies (fund managers, I mean) say.

Peter Lucas, executive director of the financial products division of Macquarie Bank says this:

"I understand the perception you've got there, that there are hidden fees and high fees. [But in many products there isn't a fee.] I can, hand on heart, say investors are not paying an MER on the Nikkei product [invested in via the ReFleXion product]."

Lucas is being economical with the truth when he says that investors are not paying an MER. What he is expected to disclose at this point if he is in any way, shape or form a good bloke is that the Nikkei product does not magically run itself. Somehow, somewhere the investor is paying for this. And common sense dictates that Lucas should mention precisely where this is.

(Unless, of course, Wright or a sub-editor at the Fin has selectively edited him)

What Lucas fails to realise, or realises too well, is that a product like Macquarie's ReFleXion is too bloody complicated by half.

And there is no track record in the same way there is with a conventionally managed Managed Fund. Capel alludes to this:

"I wonder whether these structured products will work as intended?"

Wright includes some wisdom at the end of his article from Warren Buffett, the Oracle of Omaha - he (Buffett) follows a strict maxim that he never invests in companies that he cannot understand.

Wise words indeed.

Financial advisers have lost sight of the little people. Their clients.

They've been blinded by the dog-and-pony show being thrown at them by cashed up institutions and are willing to buy these claims that their clients will benefit without due examination.

Advisers need to understand that their clients are people, too, and would do well to heed Buffett's advice on these matters.

And advisers should also be unafraid to bring this to their clients' attention. It is very much the exception that clients, given the choice, would not wish to know how their money is invested.

Advisers don't appear to know this, but they are there to keep institutions honest. Failure to exercise this power means that institutions will continue to walk all over the average investor.

Disclosure: This blogger owns shares in Macquarie Bank Ltd.

Standard but necessary disclaimer: This is not advice. Only a complete idiot would think that any of this constituted advice. Are you an idiot? I didn't think you were. If you are in any doubt as to the content of this, see a good, independent financial adviser immediately. They do exist.

What the hell is wrong with financial planning? (Part 1)

Financial Planning is an industry well short of maturity in Australia.

It can be considered an infant industry - hey, it's only been going since the late eighties in Australia. Financial Planning was the logical successor to the Life Insurance Advice industry, which needed room to grow.

Like all infant industries, Financial Planning is temperamental, emotional, irrational and lacks a substantial degree of theory behind the practical... and its practitioners, likewise.

This blogger happens to be a former financial adviser, and still works in close proximity to the financial advice industry. So he's allowed to bag it.

Once upon a time, financial advisers in Australia were accorded a social status marginally below that of Real Estate Agents and Plaintiff Lawyers and marginally higher than that of sufferers of Hansen's disease.

Now, thanks to a raging bull market, clients think that financial advisers can do no wrong.

And it's being reflected in society's opinion of them, showing that their popularity has increased.

But is the industry resting on its laurels?

This blogger has noted in the past that the FPA very much appears to have favoured its licensee members, and not the public interest when it has been making policy.

For example, the tectonically slow pace of reform on adviser commissions appears to be moving in the direction of a model rejecting commissions. It is clear to even Blind Freddy that commissions for advisers is a blatant potential conflict of interest, however, the FPA could not spot a conflict of interest if it swung a cricket bat up between its legs.

Given the slow pace of policy reform from the industry's key body, which represents the vast majority of financial advisers and advice houses, what is in the offing is a potential powderkeg of recriminations and finger-pointing once the next bear market hits.

We're already seeing this in a lightweight form with the Westpoint fiasco. What would happen if the shit were truly to hit the fan?

The irony is that the whole Westpoint thing could easily have been avoided if financial advisers had stayed true to the old maxim "build and diversify".

Clients who have been burnt appear to have one thing in common - their adviser recommended that quite a large portion of their portfolio went into just this asset.

If their advisers had been a little more diligent, there would have been substantially more attention paid to a client's diversification profile.

Or, to put it another way, I find it very, very difficult to believe that all clients who were burnt required all their property portfolio to be managed by the one very small company.

But the financial planning world does some funny things these days.

Lets look at some areas that are contentious.

1. Rejection of the Efficient Market Hypothesis (EMH)

This appears to be a recent thing and appears driven by a desire by dealer groups to use products other than index funds.

Put simply, all forms of the EMH suggest that it is impossible for anyone to expect to outdo the market consistently (on average).

Which means that, if the EMH holds, a fund that approximates the index - such as an index fund - is going to represent the best bet over the medium to long term.

The problem with the EMH is that some of the underlying assumptions have not been researched thoroughly enough to be able to even underpin the hypothesis itself.

Naturally, this means that the EMH will probably remain a hypothesis for some time, yet, as a way to test it has not been found.

(Ironically, this often leads to claims by Technical Analysis proponents that the EMH is pseudoscience. Honestly, what planet are these guys from...)

It does appear that a systematic campaign to discredit the EMH is being waged by fund managers and advice houses and, sadly, this appears slanted towards selling non-index products that charge higher fees and pay higher commissions.

And perform worse, more often than not. Oh yes. The stats are available.

2. "Active portfolio management"

Following on from point one is a new twist which is one that, financial advisers are pushing active portfolio management more and more.

This appears to coincide with a rise in fee for service advice.

This, sadly, appears to be a downside in the move to more objective advice. It now becomes in the adviser's interest for a client to not be a "set-and-forget" client.

More and more opportunities will arise to "add value" to a client's financial planning requirements.

Add value. I cannot stand that term. Whenever I hear it, I see several shades of red. It is a cynical term that means, "What can we cross-sell?" And it isn't the client who benefits, it is the adviser.

What I don't get, is that they're "adding value" in contentious areas.

Why aren't they doing stuff that they traditionally haven't touched which they need to do? Such as budget planning? Debt management? Bank account shopping?

If financial advisers are going to continue to call themselves this, they need to be able to justify this title with some more extensive work.

Otherwise, hey. Why don't we just call them "investment advisers" cause that's all they appear to do.

Back to active portfolio management, though.

The most annoying thing about his is that it is a straightforward example of financial advisers not heeding their own advice. Financial advisers tell you to hold your investment for a suggested time horizon. What kind of example is a financial adviser giving when they tell you to drop an investment and switch into another?

I recently spoke to a former colleague of mine and asked him, "What benefit is to be gained by doing this?"

His answer told many stories: "You've got to be seen to be doing something."

Seriously, this is no way to do business.

Let me make this perfectly clear.

A. Financial advisers do not have to be seen to be doing anything. This is a stupid rule perpetuated by stupid American management consultants.

B. If a financial adviser makes a recommendation which they then vary a year later, they at least should have the decency to say that they made a mistake the first time. Then, they should count the "mistakes" that they made. Do they outweigh getting it right? If they do, why should they think that they're any good?

C. Will incurring unnecessary Capital Gains Tax (CGT) events every year really help their clients?

How on earth advisers can advise with conviction if they keep changing their minds is beyond me.

3. A move towards directly owned assets

This one is a direction that I figure that financial planners had to go in eventually.

However, some advisers have gone well beyond what I would consider prudent in recommending these.

Basically, a managed fund allows someone to benefit from either a portfolio that replicates an index, or is managed by a fund manager who has a reasonable degree of skill in excess of the average schmo.

Either way, there are economies of scale cost-wise that the average investor cannot hope to replicate.

Also, in the case of active fund management, you are piggybacking off some of the brightest fund management sparks in the world.

Currently, advice houses plug direct ownership as a way that an investor can keep their costs down and their investment performance up.

This is a furphy. And I'll tell you why.

No adviser who is this good as a stock picker will be a financial planner.

The other small issue is that most client's diversification profiles do not lend themselves to direct investment.

The thing about clients' risk profiles is that they specify a maximum degree of risk that is acceptable to a client.

Clients then look at the maximum return that they are willing to aim for given a certain degree of risk.

For about 90 to 95% (my guess) of clients, lower amounts of risk for higher returns are achieved through diversification.

Advisers are supposed to take all of this into account.

Of course, beyond a certain amount of diversification, that higher potential return for a given level of risk becomes hard to come by.

Some have said that this level of diversification can be achieved by purchasing as few as 15 assets per asset class.

But you still have to pick them. Could you?

At the very least, it is said that at extremely low and high risk profiles, diversification becomes less effective.

But then as I pointed out before, 90 to 95% of people lie in between.

(Hell, if purchasing the family home is considered to be an investment decision, most Australians who own or are paying off their houses have what could be considered to be one of the most inappropriate investments ever)

The only thing I can conclude from the push to directly owned assets is that it is another "value add".

Stockbrokers have been doing this sort of stuff for years - and clipping the ticket every time a trade is executed.

Financial Planners now are doing it as a value add - hey, this fee for service thing really pays off.

It requires more intensive maintenance, more work, more transactions, and, not surprisingly, more Statements of Advice.

And you can be sure that some clients who use these services would, of course, be better off buying and holding an index fund.

What is going on?

The above are only some of the questionable tacks that financial planning these days has embarked on.

In Part 2, we'll look at someone who believes that he has the answer as to why this revolution is going on, and who stands to benefit.

Standard but necessary disclaimer: This is not advice. Only a complete idiot would think that any of this constituted advice. Are you an idiot? I didn't think you were. If you are in any doubt as to the content of this, see a good, independent financial adviser immediately. They do exist.

Scrapping Superannuation - An "Argument" For

Australian readers would know that compulsory superannuation exists for a reason.

For those of you reading from outside Australia, compulsory superannuation is an enforced savings regime for all employees with significant tax benefits attached to it.

At Deakin University's School of Law, two of the academics there, Mirko Bagaric and Rami Hanegbi, have suggested that it might be a good idea to scrap this system.

Mirko Bagaric, you might recall from early last year, was the sensitive soul who suggested that torture should be made legal.

Thanks to such flagwaving American propaganda as 24 and NCIS, we now have a population in Australia ready to embrace the no nonsense, "It'll never happen to me, only the bad guys," world of legalised torture.

I'll leave Bagaric's torture proclivities for another day.

Bagaric and Hanegbi (B&H) have moved in this recent stroke of genius that scrapping this will be the kind of thing that makes Australian society a much better place to live.

Let's look at their arguments one by one:

1. B&H contend that:

The superannuation juggernaut that was introduced in 1992 by the federal government against alarmist predictions that we can't afford to sustain an ageing population needs to be halted.

Let's look at this one right here. Hysterical use of words like "juggernaut" and "alarmist" are, well alarmist in the extreme. I so wish I had another word to use right now.

It works kinda like this - when one uses that term "juggernaut", the automatic vision is of a huge vehicle out of control and destroying everything in its path.

What's doubly ironic is that the authors then go on to use the word "alarmist" which implies that every word of warning related to this is exaggerated.

You can see the unintended consequence of having these two rippers of words in the same sentence.

Anyway, the word "alarmist" is used far too often these days - and usually only used by those with some agenda to push.

The most obvious example of this is the anti-Kyoto lobby.

Science has known for years that the Greenhouse effect is a legitimate environmental concern. Yet you chat to anyone who stands to be affected by applying some environmental standards and this quickly becomes "alarmist nonsense".

Anyway, our point with regards to this statement of B&H's (hmm, sounds suspiciously like a packet of cigarettes, doesn't it?) is that there is a hard sell at work here. For what reason that may be we'll have to see if we can nut it out.

2. B&H make the next rash statement:

The main winner from this meddling, coercive policy the superannuation industry which makes hundreds of millions of dollars annually charging us fees for money we are forced to hand over and public companies in whom fund managers are effectively forced to purchase shares due to an absence of other investment vehicles (thereby artificially driving up the value of stocks).

Whoa. Stop right there. B&H are literally accusing fund managers of paying over the top for investment assets.

If an investment that you or I see does not represent value for money, we don't invest in it, do we? A point that B&H appear to have not the slightest bit considered.

Fund managers do a similar thing. They leave their funds in cash. Of course, B&H won't be pointing this out.

It's here where B&H show their true colours. "Meddling, coercive policy," to appeal to free-marketers before bringing it home with a tirade against the fees that the superannuation industry charge.

I think I see where they're going with this.

3. The cards come out here:

The Government should cease the policy of compulsory superannuation and allow us to access the approximately $600 billion that we have been forced to hand over
during the past 14 years.
Provision should be made for our old age by
abolishing the erroneous notion of retirement and a providing a non-means-tested
pension to all Australians.

Here we are. Pensions for all. You mad, crazy, greedy schmucks.

What's the bet that they have parents in retirement with investment properties who are unable to draw a pension as a result of unfavourable means testing?

It's the old, "Let me at my super. After all, it's my money," combined with, "Can I have a pension? I swear I didn't just blow all my super at the races."

Towards the end of the middle bit, they just quote mindless statistics that don't necessarily defeat their argument. They don't, however, support their argument, either.

In fact, the use of these stats in the middle is so frighteningly inane, so bizarrely irrelevant, that I wonder how the hell these guys ended up as academics in the first place.

Have a read of this:

As a result of these new efficiencies [technical advances/workplace efficiencies], a government paper in 2003 projected that gross domestic product growth per capita in the next few decades to be between 1.5 per cent and 2 per cent. This will ensure that in the future, despite a smaller percentage of the population being in the workforce, total income per capita will remain similar to what it is today.

Or this:

Moreover, while in the foreseeable future there will be proportionality more dependent old people, the community will make enormous savings by not being required to fund the education of the proportionality fewer young people.

You get the idea? Yeah, me neither.

At no point do they address the original intentions of compulsory superannuation or means-tested social security pension. In fact, they appear to be absolutely oblivious as to why these things exist at all.

Lets' look at why they exist.

Compulsory superannuation exists to repair a situation that was identified in the 1980's. Our population is aging, and we aren't saving enough money.

So, as we are not going to have enough money to retire on comfortably, the Hawke/Keating governments legislated compulsory super into existence.

As we can't save properly, it is legislated that employers contribute an additional 9% of our salaries into super.

Not a bad solution as solutions go - It's only 9%.

And the pension - this is meant to be a safety net for those who cannot save for their retirement.

Why is it means tested?

This is so that only those who actually need it get it, and not those who don't.

Quite responsible, don't you think?

Anyway, B&H appear to think that this should all be abolished and replaced with non-means tested pensions for all. I smell the foul stench of Larouchians.

Here's a few good reasons why this should not even be thought about.

1. The government is about to venture into virgin territory as a saver. Prior to the creation of the concept of the Future Fund, it has mostly been a borrower. Given this appalling fact, the very thought that the federal government should be looking after our retirement savings is a little bit scary.

2. Financial Planners and, increasingly, Fund Managers are plugging diversification between different fund management styles. (I support this, as there is not a shred of evidence that one fund management style is best. I say this as an proud index trouser-wearer.) How is having just the one fund manager, the federal government, going to support this?

3. Why should we all receive the same benefit in retirement? Isn't this straightforward communism?

4. I find it fun managing my retirement savings. What is going to replace that?

5. You say that I don't have a life 'cause I'm into investment and personal finance. Yeah well, what are you into, stamp collecting or something?

6. B&H claim that quite a lot of families can't afford the extra amount that ends up going towards superannuation. Talk about an appeal to the lowest common denominator. Let's take a person earning $40,000 per annum. How in the name of FSM (may we all be touched by His noodly appendage) is an extra $69 per week going to do anything at all?

7. A Pension is meant to be a safety net. Given that under B&H's recommendations, everyone would be getting it, (pension that is) will we go on to complicate matters further by putting a saftey net under the safety net?

8. Speaking of safety net, how is the pension meant to operate as one if everyone gets it?

9. B&H plug a civil libertarian argument on compulsory super. Coming from someone who supports torture (Bagaric), I find this more than just a bit insulting.

10. They actually say this in the article:

Coercive laws are legitimate only where a government can demonstrate that it will encourage compliance with fundamental moral norms that affect the wellbeing of others or where they will promote the welfare of each individual. This test has not been satisfied in relation to compulsory superannuation.

We can all conclude from this that Sony's attempts to destroy Western civilization's braincells with their insidious Playstation are most certainly working.

B&H's recommendations are so far out there that they don't stand repeating. And it's not even creative out-thereness. This is purely reactionary propaganda spewed out by someone who is not disclosing a conflict of interest and arguing from authority.

B&H might be law academics - they're certainly not business ones. 1 star.