Cracking the sads with the media, episode 426: The GFC and superannuation

Those who read this blog will know all about my thoughts on the media. Some of you will also be probably saying, “There’s been a GFC. Why have you been so silent?”

I admit to being busy with other stuff in meatspace, and I haven’t blogged in a little while, so shame on me. But finally, I’m going nuts again, and you can all shut up and read for all I care because there’s stuff that simply has to be said.

The media has been all over superannuation funds for quite some time. True, this is the biggest exposure Australians will ever have to volatile investment markets outside their own home. And yes, for those of you who like to read between the lines (you know who you are) there was a subtle dig buried in that sentence.

Part of the negative press aimed at super funds is simply unwarranted, and here’s the reason why: Chances are big that you need to shoulder what could potentially be the lion’s share of responsibility for that diminishing nest egg.

That’s right folks. You, or at least most of you who are reading, are almost fully culpable. Not your super fund. Possibly your financial adviser, if you have one, but this ain’t aimed at you if you have. That will be the subject of a different post, so if you have a financial adviser, you can consider yourself in the clear. At the moment.

For those of you who don’t use a financial adviser, I suspect that you are having a grand old time criticising your super fund for what is, for most of you, a year and a half of negative returns. Let’s face it; we love to have a go at stuff that shits us. As a nation, we love to stick it up the poms when they’re complaining, but to be frank; we’re a nation of whingers. Possibly even worse than the English.

We’re also a nation that hates to accept personal responsibility.

Put these two traits together, and you’re left with the kind of sensationalist reporting that sees the media (News in particular, but Fairfax is a close second) putting out tripe like this or this and Australians lapping it up like the sheep that that they are.

I’ve said it before and I’ll say it again: Australians are shithouse investors and it’s time that you were all told. As an investor, the chances are that if you’re reading this, you suck.

Permit me to now explain why you potentially suck.

Superannuation is not a type of investment. It’s a tax environment.

John Smith (not his real name) is 58 and recently retired. Naturally, he’s rather upset at his super fund’s return of -20% over the past year. And he’s only in the fund’s ‘balanced’ option.

He spots an ad for an online account in the newspaper paying 4.50% and thinks to himself, “At least this is positive.”

John empties his super fund and sticks the entire amount, lock, stock and barrel into this online account. John is, quite frankly, a goose.

On John’s current marginal rate of tax (30%), the rate of interest becomes less attractive at 3.15%, not including Medicare.

On top of this, John simply doesn’t want to know that he could have invested in a cash option in his super fund which is only taxed at a concessional rate of 15%. He’s that pissed off. In fact, the bank that offers this account also offers an identical account to self-managed super funds, thus yielding a superior return after tax of 3.825%.

And because John is not 60 yet, he’s going to be in for a fright at tax time when he finds himself hit with a tax bill in the tens of thousands of dollars on his lump sum super withdrawal.

Can it get any worse?

You bet. John also couldn’t care less that, had he switched to the pension phase of super, his assets aren’t even subject to tax on their earnings. Holding this online account within a self-managed super fund in the online phase would have yielded the full 4.50%.

Not only that, because John has withdrawn the amount from super he is going to have serious problems if he ever wants to start up a super pension, because he won’t be able to get the whole thing back into super if he tries. Amounts able to be contributed to super in a financial year are subject to contribution caps, which limits his flexibility in this regard.

John might be a retiree, but I have no sympathy for him.

Notice that I haven’t talked about John’s potential exit fees, John’s lost insurance coverage or the likelihood that he’ll miss a market upswing. Well I wasn’t going to, anyway.

You choose your investments (part 1)

Jo Phelps (not her real name) is 40 and a manager with an HR recruitment firm.

About a year and a half ago, she received her annual super statement from her fund. Jo was in the balanced option of her fund which had been performing quite respectably for the past four years posting regular returns of 15%.

Her balanced option is about 70% shares and property and 30% cash and fixed interest.

But when she saw the returns on the fund’s ‘high-growth’ option, her eyes lit up as it showed average returns of 25-30% regularly over the past 4 years. The high-growth option is predominantly shares with a smattering of property. There is about 3 or 4 % cash in the portfolio.

Jo rings up her fund and demands to have a switch form sent out. The staffer on the end of the line helpfully suggests to Jo that she speak to a financial adviser before going ahead with the switch.

Jo helpfully suggests to the staffer that she takes her offer of financial advice and sticks it where the sun doesn’t shine, because after all, all financial advisers only recommend stuff with kickbacks for them. “I don’t need a financial adviser,” she casually mentions, “please just post the form.”

The switch was processed and now Jo feels shell-shocked by negative returns of -35%.

Jo would like to know this:

1. Aren’t fund managers meant to see this sort of stuff coming and take action to stop it?
2. I mean, I know that there’s no such things as psychics, but couldn’t they have short-sold or something? and
3. Given that employers have to contribute into superannuation, how come the government can’t guarantee it like bank accounts? I mean really, all Australians should be protected from the downside, shouldn’t they? They guarantee bank accounts; superannuation funds aren’t really that different…

Jo had no idea that a high-growth option could go down as well as up. Mind you, if you’d told her a year and a half ago, I don’t think she would have given a stuff.

You choose your investments (part 2)

Brad Dawes (not his real name) works in a blue-collar job. He’s twenty-something.

When he started with his current employer, he couldn’t be bothered filling out the super forms. He did ask at the time, “So let me get this straight: I don’t have to fill this in. You’ll sort it out for me with this ‘default’ thingy?”

To which the answer was, “Yes”. Natch.

About the only form that Brad filled in correctly was the bank account details for where he wanted to be paid.

The super from Brad’s current job now goes, by default, into the balanced option of the default super fund offered by his employer. Brad doesn’t know how these funds are invested, and really couldn’t care.

Brad’s super is all over the place. All default funds provided by previous employers and all different.

All the negative press about super has Brad looking at the one or two statements (out of the six or so funds he’s ever joined) that he regularly gets. Brad now has the following criticisms of super:

1. I could invest my funds better than my super fund could;
2. What’s with all these fees coming out? This is a scam;
3. What do you mean, ‘Share prices have gone down?’ Isn’t super meant to be invested in property which never goes backwards? (This is Brad’s opinion, not mine)
4. I didn’t choose to have my super here. I shouldn’t suffer as a result.

About the only good thing you can say about Brad is that he’s finally shown some interest (even if only passing) in his super as a result of this.

But he’s dead wrong about not choosing to have his super where it is: He chose alright. He’s also not worthy of sympathy.

Retirees are not always worthy of extra sympathy

Let’s go back to John Smith again. Sorry John, but you’re particularly worthy of some stick.

About three years, John decided he’d retire when he turned 58.

John’s super was in the balanced option, which his super fund recommends for periods of 4-5 years or longer. That’s right: 4 to 5 years minimum.

John consciously chose to leave his super in the balanced option, because, “It’s doing pretty well there.” Unlike Jo, he looked at the more aggressive options and thought that they seemed pretty aggressive for him. That’s OK.

He looked at the less aggressive investment options and was put off by the lesser returns. And I’m sure you can see why.

But, looking at the recommended minimum timeframe on his balanced option, he thought, “Well it’s only a recommendation.”

Fast forward to a year and a half ago. John looked at his super fund again, and he thought the exact same thing.

That’s right. With a year and a half to go until retirement, John completely disregarded the recommended minimum investment periods and consciously chose an investment option suited to 4-5 years or longer.

John is now shitted off with his super fund when really, John should be shitted off with himself.

It’s probably worth mentioning that you should plan your exit strategy from the outset. John didn’t even do this with three years to go.

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So what can investors learn from this?

1. You choose your investments. Read the sodding disclosure statements – they may look like slickly produced marketing paraphernalia (and to be honest, most are) – but they have to contain stuff you need to make an informed decision.
2. The default option isn’t some kind of magical tool that posts excellent returns while protecting investors from market downturns.
3. Read the bits about how your funds are invested. Also read the bits about recommended minimum timeframes. If you don’t understand how an investment option works, ask an adviser, ask the fund and if they can’t tell you, steer the fuck clear of it.
4. No one is psychic. Especially not fund managers.
5. Have you switched to cash? You may learn the hard way that markets can rise violently as well as fall. Chances are you’ll miss out and by gee, won’t it be costly?
6. No one rings a bell to let you know that the market has bottomed out. Think of this if you’re attempting to time your way back in.
7. Super investments are taxed at 15 %. Non-super investments are taxed at your marginal rate. This should be a no-brainer but you would be surprised at the number of people who couldn’t give a shit about this.
8. When you next whinge about your super fund’s non-performance, compare it to something that vaguely resembles it. Comparing a balanced option with anything other than a balanced non-super managed fund is only going to make you look like a moron. Even that is pushing it. Do not compare a balanced super option with an online bank account – geez do I have to spell it out?
9. Good, fee-for-service financial advisers are there to help out people who know bugger all about investing. There is a very good chance that you form a subset of the latter half of the previous sentence.
10. I’ve heard people whinge about their super fund’s performance who are in defined benefit schemes. I’m not kidding. If you don’t know what investment option you’re in, or even the fund’s design, find out. Number 3 above should help you.

That’s it. I’ve had a gutful. You can all get stuffed.

Disclosure: This blogger works for a service company that services super funds. He also used to work as a financial planner. And he most likely posted bigger declines in his superannuation balance than the lot of you (if expressed in percentage terms).

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: Brokers get broken

Oh this is a right pickle.

Once upon a time, stockbrokers were venerable institutions with names like JB Were & Sons, Potter Warburg, Ord Minnett and others. They screamed integrity, even if you knew that the way they profited was by buying and selling shares, hence putting them in situations where conflicts of interest can and did arise.

Over time, advising their clients on share trading became much of a side event, as they branched out into areas that could "add value" to their revenue flows.

Derivatives trading became more prevalent. Then full financial planning services. Institutional advice. And margin lending.

About the same time, fund managers, custodians and superannuation funds were finding that they could open up more income flows by lending out their shareholdings to other institutions or investors. The money that flowed from this was valuable.

Why would anyone borrow shares? There appears to be two main drivers for this:

1. Borrowed shares can be sold, thereby covering an activity known as "short selling", which is where you sell securities that you don't possess. You can then buy them back later, which you need to do before passing the securities back.

2. Holders of borrowed ordinary shares can vote on resolutions of listed companies.

The mechanics of stock lending is a weird one to me - and I don't really know the full legal reasons why. When shares are lent, legal title actually passes from the lender to the borrower.

So what actually happens here?

Normally, when title to a security changes hands, there is a Capital Gains Tax (CGT) event. Where stock lending is concerned, for no apparent reason, this rule appears to head straight out the window.

So if the lender is not being pinged for the transfer of securities, one would expect that they have retained some sort of beneficial ownership. In which case, normally, when the shares in question are sold by the borrower - this should give rise to a CGT event for the lender. This doesn't appear to be the case either.

Legal responsibility for the CGT on shares being sold and then bought back would appear, then, to lie in the hands of the borrower. And I'm not really sure how this works, given that what I know of our CGT rules, assets need to be bought before they can be sold.

(Although, it should be noted that most share borrowers fall into the category of "professional investors", in which case, profits retrieved from the selling and buying back of shares would appear, to this observer, to fall into the income category, which makes the whole thing a little bit simpler to work out.)

Which means that ordinary tax laws go out the window a little bit here, and there must be some loopholes or explicit exemptions that are currently in place to facilitate this sort of activity.

But back to brokers again.

Eventually, someone had to connect the dots and work out that margin lending and stock lending could be combined in a profitable way. This would have been a no-brainer for stockbrokers, given that margin lending (or pretty much most lending arrangements for that matter) and stock lending are largely unregulated.

Brokers, who by now had extensive margin lending operations, were changing their arrangements with regards to margin lending subtly. The scope of the change was minor, but a biggie nonetheless: Brokers would assume ownership of the securities outright, rather than merely taking a charge over them.

Then, the broker could on-lend the securities in question.

I don't expect that this is limited to a handful of firms, either. While I have no evidence to back this up, I suspect that the practice is rampant, and it's only some who have been caught doing this.

Consequently, it was only a matter of time before a broker found themselves in hot water over this.

Tricom's problems came to light at the start of this year, when there was a huge slide in the value of stock markets around the globe precipitated by the woes in the US housing and credit markets. Essentially, they had lent out so much of their clients' stock, that when the slide hit and their clients were selling, they couldn't get the stock back in time to enable settlement for the sales made by their clients.

Tricom is still in business. They've since been bailed out by a lot of their owners and clients. Which makes them incredibly lucky.

More worrying was the problems caused by the collapse of another stockbroker not long after. Opes Prime collapsed after similar problems, however Opes Prime's problems were far sillier.

Opes Prime already were exposed to completely ridiculous practices that they'd put in place where they were accepting small listed companies as security for margin loans. This is not normally done.

Normally, margin lenders won't accept shares for security if they lie outside the ASX100, or maybe the ASX200 at a pinch. Opes Prime appeared to accept shareholdings in micro-caps, which was phenomenally silly.

Malcolm Maiden, in The Age described Opes Prime as the "margin lender of last resort".

Indeed, Marcus Padley said somewhere that the value of shareholdings outside the All Ordinaries Index posted as security came to in excess of 65% (if my memory serves me correctly) of Opes Prime's total book. Unbelievable!

Anyway, compounding this was the insistence of Opes Prime to take advantage of lax stock lending laws to move shareholdings between accounts in order to avoid making margin calls on clients' accounts. This was dangerous stuff, and eventually, the losses were going to be big.

ANZ Bank got dragged into this, as they were Opes Prime's principal financier, and held title themselves to much of Opes Prime's stock. How they did this, I'm not really sure. Opes Prime would have been extraordinarily stupid to have allowed ANZ to have ownership of the shares in question, given their practices.

At the end of the day, both the ASX and ASIC have come under heavy fire for allowing situations like Tricom and Opes Prime to happen. I'm not sure why - they couldn't really have prevented this, anyway. I'll talk about this some more in a few moments.

As a postscript to this, broking firm Lift Capital have just gone under, after inappropriate margin lending arrangements with three of the company's directors sent this firm under.

So the question remains - why is only investment covered by the financial services provisions of the Corporations Act? Why isn't lending?

This is more a gripe than a question that I'm going to attempt to answer today.

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.

Dikkii's financial tips #6: Risk and inflation

Welcome to Dikkii's financial tips.

This is a series where I attempt to provide some sort of guidance to financial matters without breaching the Corporations Act by actually providing advice.

It's actually been quite some time since I last posted an update in this series, and since then, I've rejigged the order of my planned modules just a little.

So before I get too far into this series, I thought I'd touch on the single most important concept for any investor.

Risk.

Risk is such a fundamentally important subject, I reckon that it should be added as the fourth R in primary and secondary education. It is that important.

And sadly, a lot of the time, investors just don't get the whole risk thing until it's too late.

We're hearing a lot about risk at the moment.

Take the current credit crunch in the States, for instance. Risk existed there before the crunch just as much as it does now, even if a lot of professional investors failed to properly account for it. The whole concept of sub-prime lending revolved around lending money out to a demographic that was horribly risky in the extreme. So when it all went pear-shaped, there was suddenly a wailing and a gnashing of teeth that told the world that a whole bunch of financial journalists really dropped the ball on this one.

Prior to that, in Australia, we had issues with mezzanine financing when four medium to largish property developers went belly up leaving a whole heap of investors out of pocket.

And, although gaol is certainly beckoning for at least one of the miscreants who ran the show at one of the property developers in question, we don't appear to have learnt our lesson.

So let's have a look at risk, as it relates to investing. Back in the day, risk was really only discussed with my clients while they did their own self assessment as to where they thought they placed themselves on a basic risk profile.

This was a process, I felt, that was open to all sorts of biases and error. I'll go into this some more in a later post when I get round to looking at risk profiling.

Risk is a huge area. I'm sure that it's possible that you could get a subject stream out of it at university, but I'm really going to discuss one risk area in this post.

Specifically Investment Risk. And only the major ones that cover personal investment.

Investment risk really covers a broad area in itself, so I don't see how I'm going to give it justice here, properly, but today, we'll look at some risks that you really ought to be aware of before you go ahead with any type of personal investment plan.

Let's get started.

1. Market Risk.

Market risk is, ironically, the most understood of all investment risks by mug investors. In a nutshell, market risk is the risk that your investment value will suffer due to adverse market movements.

An example of being adversely affected by this risk might be this - you might have bought 100 shares in XYZ Company for $10 each, making a total investment of $1,000. If the share price drops to $9 per share, then you have, on paper at least, suffered a loss of about $100.

I know that many people who will steer clear of the stockmarket for this reason - yet strangely, they don't appear to see it as an issue in the property market. Odd, but I put this down to heightened transparency and liquidity in the stockmarket. If properties were traded on an open and transparent exchange, I think it would be a different story.

Market risk is managed through diversification. One ideally wouldn't just own shares (directly or beneficially) in XYZ, they'd own shares in plenty of companies.

This, of course, does not mean that you're immune to overall market movements. We can manage this a little better by diversifying between markets. This is the reason why people often have property and fixed interest portfolios in addition to shares. And cash - which is not subject to market risk.

Also, market volatility tends to smooth itself out over the longer term. So examine your investment time horizon, and ensure that your portfolio is not inappropriate.

2. Credit Risk.

Credit risk is fairly straightforward in theory. Basically, it's the risk that if you lend money to someone, they're either not going to meet their interest payments, or possibly not pay back some or all of your initial principle.

In practice, it's a veritable nightmare. Credit ratings for some institutions can change overnight, and when someone goes belly up and is unable to pay their investors, you just want to be sure that you aren't going to lose your life savings.

Credit risk affects cash and fixed interest investments, but not property, shares or much else for that matter. But this doesn't make it any less of a concern.

Again, credit risk is best managed by diversification, both by having a diversified portfolio of cash and fixed interest investments, and diversifying into different asset classes such as shares and property.

Credit ratings are certainly useful, but at the end of the day, 20 AAA-rated fixed interest securities are better than one. This is a false dichotomy, (though still a valid statement) but I'm sure that you understand why I'm not mentioning any other possible scenarios, of which there are many.

3. Currency Risk

I just love this one. Where you have an investment in a currency denominated in anything other than the one that you're used to, currency risk is the risk that the exchange rate changes and your investment reduces in value as a result.

Here's a good example. The Australian dollar has appreciated markedly against the US dollar over the past three or four years. Consequently, anyone in Australia who invested in a US dollar denominated asset at the start of that period might be looking at paper losses, if they convert the current value of those assets back to Pacific pesos. Assuming, of course, no (or a small amount of) capital growth in the US dollar value of the asset itself.

There are actually quite a number of ways that investors can use to guard against currency risk. Diversifying your asset base (I know I sound like a broken record here, but chant this one like a mantra, kids) is one. If you have international assets in your portfolio, don't just have ones from one country. Have many from many countries.

It would be rare for investors to have only international assets dominated in currencies other than their own. Most of an investor's portfolio will be denominated in their own currency. This is further diversification.

Lastly, where foreign exposure exists, do be aware that currency hedging exists. This can be offered relatively cheaply - quite a lot of international equity funds have a hedged version and an unhedged one. The hedged version will normally be slightly more expensive, fee-wise, but for additional diversification, you could very easily have some of your international exposure in a hedged portfolio and the rest in an unhedged one.

Note that when people talk about "hedge funds", it doesn't normally relate just to currency hedging, or international equity funds that use currency hedging.

4. Liquidity Risk

Liquidity risk is another that has reared it's ugly head throughout the sub-prime lending and mezzanine finance crises.

Basically, this is the risk you take that you will not be able to cash in your investment quickly either at the end of your investment horizon, or at any other time for that matter. Such as emergencies.

Liquidity risk pops up in a lot of places. Thinly traded shares in small listed companies are heavily subject to it - when you want to sell, will there be a buyer? Term deposits - you can't normally access these until maturity. Superannuation is another - it's no good if you're trying to get access before retirement. Residential property can have settlement periods of up to 180 days.

The best way to manage liquidity risk is to explore each of your assets in turn and know how liquidity risk might affect them. And then come up with strategies to avoid the risk itself taking into account your own personal circumstances.

For example, you could possibly choose to buy shares in blue chip companies that are heavily traded and minimise your exposure to smaller capitalised companies. Use term deposits for money that you know that you definitely will not need until maturity. Use superannuation for money that you know you definitely will not need until retirement. Selling a residential property? Try to negotiate a shorter settlement period if you need the cash, and so on.

The rule of thumb is to know the asset, and how it fits in with your overall plans for the money invested.

And did I say diversify? This helps, too.

5. Inflation

Well, inflation is a right bastard of a thing.

The risk here is a simple one, but overly conservative investors don't understand it very well at all, based on my experience.

Its best explained like this: Imagine that you buy $100 worth of groceries today. If we assume a rate of inflation of 3% per annum, this means that those same groceries will cost $103 this time next year, and about $106 in two years time.

Thus, if we invest in a bank account paying 4% during that period, the return on your funds as measured by the buying power of that money is going to be greatly reduced by that rate of inflation in the meantime. Add in the impact of taxation, and you stand to go backwards, not in dollar terms, but in purchasing power terms.

Again, diversification is the key here. Historically, cash and fixed interest investments have been heavily subject to inflation so it pays over the medium to long term to diversify into investments that have the potential to provide capital growth, such as shares and property.

In the short term, you may have no choice but to accept "losses" caused by inflation. Growth assets are generally considered hot potatoes in the short term.

6. Opportunity Cost

Let's say you invest in shareholding A over a period and that asset returns 6% consistently over that period.

But at the end of that period, you find out that you could have invested in shareholding B instead, which returned 7%. It may be ludicrous to suggest that you could have known about this at the start of that period, so let's just use a statement uttered by sensible investors everywhere whenever they hear about this:

"No one is psychic."

Needless to say, there is no way that you can control for what is, essentially, speculation in hindsight.

Accept your opportunity costs with good grace, and wish investors in shareholding B good luck. You didn't "win" today.

7. Interest Rate Risk

Interest rate risk is simply what might happen due to a rise in interest rates.

Fixed interest is really susceptible to this. Imagine that you have a portfolio of bonds. If interest rates were to rise unexpectedly, this has the disadvantage of making bond yields go up, which really means that your bond portfolio has just decreased in value, all other things remaining constant. In this context, this is another type of market risk.

Indirectly, this can also affect shares and property - companies will find it harder to remain profitable if the cost of their borrowings increases. Property becomes less attractive to buyers if their interest bill is higher.

Conversely, cash becomes more attractive - if interest rates increase, the income from cash investments will normally increase. Likewise also, international assets should increase in value in domestic pricing - all other things remaining constant, a currency's exchange rate with the rest of the world should go up if the central bank of that currency raises interest rates.

Diversification ensures that some of the risk that interest rates might increase is absorbed and also turned to an advantage in spots. Of course, knowing your assets helps as well.

And if you're invested via a gearing strategy? Well, I think you can work out what's going to happen in this scenario.

8. Reinvestment Risk

Reinvestment risk is the risk that your investment might come to an end sooner than you expect.

A good example is if you provide a mortgage to someone to invest in a property, and they pay it back sooner than what you expected. You then have to go ahead and reinvest the money again elsewhere.

Sometimes this can happen with other assets - a company you hold shares in might, for example, be subject to a takeover bid for cash, and you then end up receiving cash for your shares if the takeover is successful.

This can cause problems from a tax perspective.

Diversifying your portfolio will minimise the impact of such events when they occur.

9. Manager Risk

Your investment is subject to decisions made by the manager responsible for your investment's performance.

A good example of this might be where a managed fund (or mutual fund, if you're reading this from North America) that you invest in might suddenly terminate due to a decision by the manager of that investment. You might then find that they've redeemed your investment and you then have to do something with the proceeds of that redemption. This particular example is also a good example of reinvestment risk.

Another one is where the manager changes the methodology by which a particular fund invests. This happens occasionally, and can make it somewhat annoying when you have invested in a particular managed fund for a particular reason - say, for example, the managers's particular investment methodology.

This makes diversification imperative - if your reasons for investing in a particular asset evaporate overnight, or you end up receiving the proceeds of a forced redemption, this can play havoc with your own personal tax planning, particularly if you're relatively highly exposed to that particular asset.

Different fund managers of different management styles is usually considered prudent and is an excellent example of further diversification.

10. Fee Risk

Financial advisers who work on a commission basis will never discuss this risk.

Fee risk is basically the risk that any fees that you incur will reduce returns, and may even reduce the capital invested.

It's best to manage this risk through crunching some numbers yourself to see how exposed a position you find yourself in. I normally suggest taking your amount invested and working out a years worth of fees based on that figure. And then shopping around.

You would be surprised at the figures that you may end up obtaining.

The good news is that your fees might actually be reduced by a market downturn. Of course, we're talking in dollar terms. In percentage terms, they may actually increase as a result.

In addition, fees serve to exacerbate negative returns. Know your fees and how to minimise them.

11. Personal Events Risk and Property Risk

No discussion of risk would be complete without discussion of this. These are the risks that something might happen to you, or your personal property.

This might not directly impact your investing, but can certainly indirectly impact, particularly if you find yourself having to draw on your investments to fund an unexpected personal event.

Always ensure that you have adequate insurance in place covering personal property such as home and contents cover and comprehensive vehicle insurance.

Legal liability insurance is always good - in today's litigious society, you may need it when you least expect it.

Likewise you can't put a figure on the usefulness of private health and term life insurance. Mortgage protection and credit card cover is useful, but not as cost effective nor does it cover for as much.

Travel insurance is something that you should never leave home without.

Lastly, ensure that you have a valid Will and Enduring Power of Attorney in place, or at least accessible if anything happens to you. An Enduring Power of Attorney (Medical Treatment) or its equivalent is also a good idea.

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This list is by no means exhaustive, so don't rely on it being a be all and end all. For more information regarding the risk that you're facing specifically, your adviser should be able to tell you more details.

Just remember, that if you know your risk and how you're managing it, then the return side of things - the sexy bit - should be easier to manage.

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Dikkii's financial tips index

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 sub-prime mortgage meltdown

As Michael Bains might say - "Silly humans!"

Sub-prime mortgages were something on my radar, until one of my Facebook buddies (and former primary schoolmate) posted this on my FunWall.

I hate FunWall, but I love this. This says all you need to know about the whole stupid mess - and how financial engineers can sell anything.

And it's hilarious, too.

Personally, I think that there should be arrests to come out of this, but we won't see any. Enjoy.

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.

Total carnage

July and August 2007 is proving to be one serious downer for investors, and this blogger, if he didn't exactly tip it, certainly knew that fall-out was imminent.

So far, in Australia, as we speak, markets are down about 12%, and it looks like it's going to continue for some time. The story is similar around the world.

So what's causing it this time?

When the markets had their last major quiver, back in March, this blogger tipped that it would pass and that things would soon be back to normal again, soon.

The reason for the volatility in March was a slide in the Shanghai Stock Exchange, and, as tipped by this blogger, there was absolutely no reason why this should have been seen to have had the major impact on markets that it did.

This time around, I'm tipping that markets around the world will have more lasting problems, and the impact from these will be a little more heavily felt.

Allow me to demonstrate.

The first thing that should be realised, is that this little bit of mayhem is being caused by problems in the US housing sector created by too much money being lent to people who shouldn't have been allowed to borrow in the first place. In delightful understatement, these are called, 'sub-prime' mortgages.

Lenders in the US were bundling up their loan books and then on-selling them on to the market in securitised packages. This had the double impact of raising further money for lenders to continue their risky activities, and re-locating the credit risk on the money lent to the new owners of the loans in question. The most common arrangement was called a collateralised debt obligation, or CDO.

This is not a new practice. Lenders have been doing this for some time. And not just lenders of 'sub-prime' mortgages.

A lender in Australia, RAMS, recently floated on the Australian Stock Exchange (ASX). RAMS floated at a share price of about AUD $2.50 back in July. RAMS' share price is now around AUD 89c and there is nothing that their management can do about it.

RAMS is not really exposed to 'sub-prime' activity (which is called 'non-conforming' in Australia). However, RAMS needs to be able to on-sell it's current mortgage book, otherwise, it will not be able to continue to lend money out to people.

And if no one is willing to buy RAMS' current crop of mortgages from them, then RAMS is going to have to discount the whole package until they can find a buyer. Hence the fall in RAMS' share price.

RAMS will have trouble selling the current lot of mortgages because the institutions that buy this kind of security from them are now reconsidering if this sort of security is worth the risk. And that is regardless of the quality of RAMS mortgage book - mortgages of any type, hell, fixed interest of any type is now being re-assessed across the board and investors are now expecting higher returns for the risk that they're taking on.

Anyway, RAMS investors really have to ask themselves could they have foreseen this? I don't believe that they could.

But this whole meltdown doesn't just end with the lenders, folks.

The debt securities sold by the lenders have been traditionally bought by fund managers for their mortgage and fixed interest portfolios. Normally, these are considered defensive assets - all other things remaining equal, mortgage and fixed interest funds are recommended as short to medium term investments within a portfolio, and form the defensive part of most Australians' superannuation funds.

But investment in CDOs is crystallising risks far riskier than what would normally be considered prudent.

So mortgage funds and fixed interest funds are going to take a hit. This is bearable. At least I would have thought.

But it turns out that quite a lot of buyers of these investments are a different type of fund manager again.

Hello, hedge funds. Fancy seeing you here?

Hedge funds, in their never-ending quest to satisfy investors seeking lower risks and greater returns for their investment whilst at the same time kicking a shitload of fees in the direction of fund managers have had their snouts in the trough for some time.

This was apparently a no-brainer for your average inscrutable hedge fund manager. Borrow at standard rates and invest in a fixed interest security paying well more than your standard mortgage or fixed interest rate of return. And then do it again. And again.

The end result of this was that some hedge funds, in their search for endless returns were geared several times over mainly as a result of idiotic risk assessments that had these sub-prime mortgages being seen as relatively low-risk, when the reality is substantially different.

So much money was whizzing round the economy and inflating asset prices that when the housing price crunch set in in the US last year, there was going to be problems. Bear Stearns was the first company to feel the heat and have advised that the investors in two of their hedge funds are unlikely to get anything back.

In Australia, we heard problems initially from Basis Capital, a fund manager whose products were actually rated AAA from Standard and Poors. Not long after this, Macquarie Bank have advised that some of their hedge funds are suspending new investment and redemptions, because they are having a hard time valuing their portfolios.

So what for the broader market?

Well a lot of the sell-off that we are seeing has to be driven by hedge fund activity. Hedge funds own other assets and it makes sense that they simply have to liquidate large sections of their portfolios just in order to ensure that their offerings are sufficiently liquid when the investors come a calling.

On top of that, because hedge funds are so opaque in their operation, investors in the broader market simply don't know the level of exposure of other businesses.

One municipal council in Sydney is facing losses of up to AUD 60c in the dollar due to some unwise investment in CDOs directly.

And all this is contributing to an environment where borrowing is going to be so much harder in the months ahead - which stymies investment by you, me and businesses. About the only people who should be rubbing their hands together with glee are going to be the banks - their main lending operations come from quality mortgages, and they don't relay on sourcing cheap funds by way of securitisation to do it.

This is going to be nasty, folks. For me, what makes matters worse is that all my money is currently invested and I don't have any more to plough into what appears to be a corrected market. And for most Australians, superannuation returns will be the worst this year that they have been in quite some time - probably about 7 years.

On the plus side, it does appear that that Australian stock market has fixed up the serious over-valuation that has been identified for some time by financial journalists. It means that some rationality has returned to the table.

But things may actually get worse before they get better. This is not like March, folks.

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 3)

This is part 3

Part 1 is here.

Part 2 is here.

It is with great displeasure that I announce that Bridgecorp has gone under.

This, sadly, means that a fourth major mezzanine financier has gone to the wall, and appears to have taken with it about AUD $25 million of investors' money.

I don't really want to add much more to this. It's a sad tale, and I don't know much about Bridgecorp's circumstances. Suffice to say, there can't be much more carnage on this front.

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 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.

Frustration

Here's the story.

Late last week, my online stockbroker sends me an email to say that they would be handling the upcoming float (IPO) of a particular company whose business model I respect greatly and would very much like to own shares in.

I immediately rang my margin lender and asked if they could approve me investing in the float. They said that they would pass on the pdf copy of the float prospectus to their risk area and let me know in the next working day or so if this would be OK.

On Tuesday of this week, the company in question started getting applications via an electronic form online at my stockbroker's website.

Still no word from the margin lender.

I learned today that the electronic application facility for this float had closed - a mere 48 hours after being opened - and the company has indicated that the float has been, from what I can tell, massively oversubscribed.

And still no word from the margin lender.

So I've missed out on what I think might have been the float of the year due to my margin lender's tardiness.

Now I'll have to invest the hard way when the company lists in May.

I am so totally not happy.

Disclosure: This blogger wishes!

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.