Why Tracker Bonds And Cash Are Not Good For Investors

As someone who is advising investment clients for almost 25 years it never ceases to amaze me when history tends to repeat itself. Not only do we see investment bubbles form and burst with increasing regularity but we also see the emotional reaction from clients ebb and flow as well.

When markets are in the ascendency everyone, it seems, chases the latest investment trend in the same manner as fashion trends exist. In the last decade we have seen bandwagons of technology stock, property and more recently gold. When corrections occur, as they will from time to time, then an overreaction of selling the same assets materialises.

At such times, many investors who are uncomfortable with stockmarket investment but who realise that it is necessary for long term growth prefer to use Tracker Bonds which are linked to stock market indices but which guarantee a return of capital.

Such products usually lock in client monies for a fixed period varying from 3 years to 6 years. The reason for the lock in is due to the fact that between 77% and 92% of the investor capital (depending on the term involved and the prevailing interest rates) is placed on deposit for the complete term of the investment. The balance is then used to pay introducer commission, the cost of buying stock market options as well as the profit margin for the product promoter, usually a financial institution. If the institution is only dealing with, say, an 8% balance (i.e. 100% less the aforementioned 92% on deposit), then it is more likely to embark on extensive marketing in order to draw in a greater volume of funds so as to make the product a profitable business proposition for themselves. There is nothing wrong with making profit providing that the eventual investor is fully aware of what they are doing with their money.

What many investors may not appreciate is while tracker bonds fulfil a reactionary investment need for safety they invariably compromise the client more by ensuring that their money becomes inaccessible for the period of the investment, which can be up to over six years in length. If no growth is achieved on the stock market portion of the tracker bond, then the client receives only that amount which was guaranteed, usually the original investment. Most such investors overlook the fact that their monies actually incurs a loss in value due to inflation in the intervening period. Considering that the long term Eurozone inflation averages out at 2% (if you ignore our recent deflationary experience) then the growth needed just to maintain purchasing parity is actually 2.74% p.a. if allowance is made for DIRT of 27%, which is the tax rate that now applies to all tracker bonds. Over time, these amount to a significant loss in real value.

If these were the only considerations then a relatively submissive investor might dismiss these drawbacks if their main concern is to at least know that a substantial portion of their money is safe. Safety is, like beauty, in the eye of the beholder. All tracker bonds carry what is referred to as counterparty risk, whereby the guaranteed return of capital is available only if the guaranteeing institution is still capable of fulfilling the return of capital. If a financial institution’s trading status is compromised, so too is its ability to give guarantees or, more importantly, fulfil them.

In my experience many investors rarely read the small print of investment brochures or contracts, trusting instead the adviser’s wisdom. A noticeable clause in such documents, for those eagle eyed enough to read them is now, since 2008, the specific reference to this counter party risk. Whether the return of capital is guaranteed by the promoting institution or the bank with whom the monies are actually deposited, there is a real risk that a default by the institution could occur.

This counter party risk is no different than that which exists if a person places money on deposit directly with a bank. While the EU wide Deposit Guarantee Scheme is in place to protect up to €100,000 per person, any excess can be more at risk with one bank than another, depending on the relative banks’ own financial ratings. Generally, the higher the investment rating of the institution, the lower the deposit rate offered. Inversely, those financial institutions that need funds to improve their own solvency and liquidity reserves tend to be higher risks and therefore need to offer a higher deposit rate to attract funds.

In recent times, many Irish people have transferred monies away from the Euro and into other currencies such as Swiss Franc, Norwegian Kroner or Sterling on the premise that these currencies are safer relative to the Euro. In so doing, investors (or more aptly, deposit holders) have already taken substantial risk which can result in substantial losses being incurred if the new currency holding loses value relative to the Euro. In many cases currency losses can arise quite swiftly without any immediate hope of recovery. The recent 8% devaluation of the Swiss Franc by its own Central Bank is a case in point.

The bottom line is that there are no sure bets and everything, even apparent safety, comes at a price.

Why You Should Ignore Expert Advice When It Comes To Investing

Recently while reading the Sunday papers I came across an article which contained summary views from a number of financial advisers and investment managers on what readers should be investing in going forward. The article was typical of what usually appears in the printed media at every year end with a view to what investors should be doing over the coming 12 months.

On reflection, this type of article occurs throughout the year with perhaps more subtle commentary depending on the then current investment conditions. This, of course, is not unique to Ireland and happens in every country throughout the world. Everyone wants to know what the experts think and how one can take shortcuts in making money.

There is a saying that those who can, do. Those who can’t, teach. While this is extremely unfair to those in the education sector, the principle when it comes to advising others about monetary matters boils back down to the fact that if you could be so sure of your investment outlook why would you share it with others? Just say nothing, take your own money, put it into the markets and make yourself a fortune. There would be no need to have clients. All one would have to do is just make money for oneself.

The truth, however, is that nobody actually knows what the future holds in any sphere of life. Otherwise we would all have crystal balls and be heading to the bookies to make money. Even the really smart investors such as Warren Buffett and Anthony Bolton had their own fair share of poor stock choices and these individuals were a rare breed out-thinking, more than most, markets over a longer term but rarely, if ever, getting it right in the short term.

Then why is it that such commentators can get coverage so easily? Partly because such pieces help to give readers a variety of financial perspectives and partly because everyone is, at heart, a little greedy and wants to find out what they might be missing out on. In recent time the Celtic Tiger showed up Irish greed in property and contracts for difference by people who could afford neither the expenditure nor the risk. Further back in history one can find similar greed a la the Dot Com Bubble, the USA Savings & Loans Crisis, the South Sea Bubble and even the Tulip Bulb collapse. Add in the many con-artist schemes that attract the “suckers” and it is easy to see how greed can be exploited.

This avarice is also evidenced by the public focus on investment performance league tables of unit funds. Investment companies, in turn, make hay out of highlighting their top of the table status in order to promote their funds. When they underperform they sidestep the issue by explaining that their funds are primed for growth in the near future when some different circumstances may arise.

So what is an investor to do?

One aspect that all reasonable and experienced investment advisers will agree on is that broad diversification will assist in smoothing out volatility in performance of individual assets or asset classes, while time will assist on recovery of underperforming assets provided that they have not been overly encumbered by borrowings.

This approach has been proven to be enhanced by the process of rebalancing individual portfolios. In this respect it is interesting to see that some Irish investment companies are now promoting this process as the new way forward when, in fact, it has been an acknowledged approach for decades.

 The key for personal investors, however, is to match risk with reward or more specifically define what reward is needed before taking risk. Over a long advisory career I have seen many investors let greed get the better of them in pursuance of higher returns than those needed to achieve their personal objectives. These objectives, quite often, amounted to merely having sufficient funds in their old age to enjoy a quality life. By compromising the objective with higher risk, many have fallen short of their eventual needs and in some cases wiped out a lifetime of earnings from hard work.

In a nutshell, any investor should start by ignoring the experts. Figure out what is important to you and your family’s future and then work with a financial planner who is capable of determining what investment performance is needed. Then and only then, should you start by constructing an appropriate investment portfolio while at the same time bearing in mind that no adviser or fund manager is the font of all knowledge.

Get Rich Quick – How to spot a scam!

One of the advantages of the Celtic Tiger, apart from everybody more or less carrying on as if the good times would last forever, is that investors learned that greed does not pay. Sooner or later, there is a price to pay. For those that can restart their lives eventually there were a few lessons to be learnt, the least of which was realising that if something looks too good to be true, it ALWAYS is!

So what should investors seeking high investment returns be wary of? The answer is the length of the proverbial piece of string. We could be here all day going through every con artists approach but their main tactics can be summarised as follows:

1. Anybody who suggests that they have a risk free investment offering is probably lying. Even cash in a bank carries risk. Just ask the many thousands who withdrew money from the Irish banks in recent months because of the fear of a bank collapse.
2. Someone who has says that they have the magic touch and produces consistent returns even when the markets do not facilitate such investment performances.  This is usually reinforced by them stating that their approach and knowledge is proprietary and will not be disclosed to third parties. All regulated investment companies will never make such claims - this is why they always advise that past performance of investments are not an indicator of future performance.
3. If someone is promising high investment returns, then why do you actually need private investor monies? If the deal is that good any self respecting fund manager would jump at an opportunity of getting an investment that gets higher than normal investment returns. The reason why any fund manager might not invest is because the proposed investment carries far too much investment risk for the relative return or because the promoter of such a "great deal" knows that it would not stand up to scrutiny.
4. In my experience the offer of an unusually high rate of return is usually the most consistent hook used by scam artists and preys, in particular, on either people's greed or a desperate attempt to make up losses from another bad investment. Indeed, it is somehow sad to see certain individuals get conned several times by the same type of scam because they find themselves in desperate straits in the first place.
5. Any investment adviser that maintains direct custody of client assets is potentially suspect. Unless there is an independent, third party, custodian to maintain control over client assets, conmen can easily compromise such monies. Large, well recognized custodians are to be proferred as they make a serious business out of providing independent trustee services. Furthermore, in the event that they fall short of their fiduciary responsibilities it is quite likely that they will have large professional indemnity insurance cover that will pay out to cover any unanticipated losses.
6. Auditors have a similar capacity to either enhance or destroy a scam artist's reputation. In the USA for example, one of the reasons that the Madoff fraud remained undetected for such a long period of time was due to the lack of a credible auditor. In Madoff’s case his company was audited by a tiny accounting firm with only a few employees, something which was totally disproportionate to the funds of $50 billion that Madoff was supposedly managing.
7. Financial Cons only exist because either the investors or their advisers are not thorough enough in their due diligence process and therefore do not ask the right questions. Sometimes this is because all parties rely on the reputation of one or more of the promoters. Sometimes this reputation might have been earned historically but the same circumstances may no longer apply. Sometimes the con artist relies on investors desire to be with the incrowd and creates a further lack of due diligence by individuals assuming that if it is good enough for "so and so" then it's good enough for me!  These type of investors are just easy targets for scurrilous scam artists. In many cases, pride often prevents them from telling others if they find out later that they have been stung!

Finally, if you are considering an unregulated investment vehicle, the best approach before you might invest is to engage a capable professional in order to carry out due diligence. This individual should be someone who has the experience, knowledge and skills necessary to analyse any such investment scenario. A fee paid for such work in advance of any potential investment might save a lot of money later on if the investment turns sour!

How Safe Is Safe?

In the last 12 months the question that I get asked most frequestly is: " Is my money safe?" There is no doubt that that the level of distrust and incredulity that is directed towards banks has turned a once sacred cow into a national pariah. And from that, depositors now fear for their own account balances like never before. The ongoing, but necessary, rationalisation and merging of the whole banking system has only served to feed these concerns.

Ironically, the more that Irish depositors withdraw from local banks in order to protect their own vested interests of personal money, the more the national interest gets compromised and requires further bail-outs. This has become a vicious circle which has fed on itself and will quite only stop feeding once a sense of calmness settles on deposit holders, particularly private account holders.

If you are one such person, then perhaps now is the time to take stock and in particular to identify what protection is in place for your money.

As I write, there are two levels of protection afforded to Irish retail depositors, as distinct from institutional or corporate. These protections are the Deposit Guarantee Scheme and the Eligible Liabilities Guarantee Scheme.

The Deposit Guarantee Scheme is operated by the Central Bank of Ireland and extends to particular retail deposits held with banks, building societies and credit unions that have been established and authorised to trade in the Republic of Ireland. Other EU countries have similar schemes covering their deposits held with banks established in that State. The EU limit on all such schemes is €100,000 per depositor or €200,000 per couple and covers the sum total of all deposits held with an institution. This scheme is open ended and has no particular time limit. The scheme covers:

• current accounts;
• demand deposit accounts;
• term deposit accounts;
• notice deposit accounts
• share accounts with building societies and credit unions.

Retail investors are defined as one of the following:

1. private individuals, sole traders, partnerships
2. small companies, which meet at least two of the following requirements:
   1. a balance sheet total of less than €1.9m
   2. turnover less than €3.8m,
   3. average number of employees less than 50.
3. charities,
4. voluntary organisations,
5. credit unions, in respect of deposit they may hold with other financial institutions.
6. trustees of Small Self Administered Pension Schemes.

The scheme does not protect what might be called ‘professional’ investors, such as deposits held by pension funds other than SSAPS, life and general insurance companies, investment funds, large companies, etc. Importantly, any amount the depositor owes a bank is not deducted from the deposit amount to determine the amount of compensation a depositor can get in the event of the bank being unable to repay its depositors.

However, all of the Irish banks and building societies covered by the Deposit Guarante scheme are also covered by the Eligible Liabilities Guarantee Scheme, which covers retail deposits for the excess, if any, over €100,000 per depositor - see below.

I would add that a depositor with more than €100,000 to invest (or €200,000 for joint accounts) can split their deposits over a number of different institutions to benefit from the €100,000 limit with each institution.

The Eligible Liabilities Guarantee Scheme was introduced on 9^th December 2009, and guarantees certain deposits held with banks covered by the scheme (called the ‘covered institutions’) as follows:

• the excess, if any, over €100,000 of deposits which are covered by the Deposit Guarantee Scheme, and
• the full deposit amount, without limit, for other deposits not covered by the Deposit Guarantee Scheme and which are covered by the Eligible Liabilities Scheme.

At this point in time while the Deposit Guarantee Scheme is openended, the Eligible Liabilities Guarantee Scheme only extends to 30th June 2011. It should be added that, any deposit term that commenced before 30th June 2011 will be covered up to a maximum term ceasing at 30th June 2016. Interestingly, any fixed term deposit account opened with a bank before a bank joined the ELG scheme is NOT covered by the ELG scheme and may only be covered (if a retail depositor) by the DGS.

Finally, the operation of the ELG scheme is subject to ongoing approval by the European Commission, in accordance with EU State aid rules. The next review is on 30^th June 2011 and the Commission could extend it at that date to 31^st December 2011.

Foreign owned banks may be accepting deposits in the Republic of Ireland either through ownership of a separate bank established and authorised here (e.g. KBC Bank Ireland plc, which is 100% owned by KBC Bank) or through a branch established here (e.g. Rabobank operates here as a branch of its Dutch bank) or operating on a cross border basis (e.g. Investec Bank plc operating from the UK). The foreign banks which operate as separate banks established here are covered by the Irish Deposit Guarantee scheme, up to €100,000 per depositor. None of these foreign owned banks are part of the Irish Government ELG scheme.

The Six Deadly Sins Of Investing

I have been helping clients make investment decisions for almost 25 years and it never cases to amaze me how the adage of  "plus ça change, plus c'est la même chose" still applies - the more things change, the more things stay the same.

In all this time I have experienced the investment stresses of the USA's Savings and Loans crisis of the late 1980s, Black Monday in 1987, the  Russian Financial Crisis in 1998 followed closely by the Long Term Credit Management collapse, the Technology Bubble bursting at the start of this Millenium and for good measure 2 Iraqi wars and an ongoing war in Afghanistan.

Add in the unfortunate recent experience of the Japanese Tsunami and the Libyian crisis, not to mention the Eurozone bailout problems, and one could be forgiven for thinking that one should never invest. There is too much uncertainty in the world!

Well guess what, there always was and always will be!

Going back to the Black Monday Crash in 1987 one might remember, if you are old enough, that the Dow Jones Index fell by 22% alone on that day to close at 1,738.74 only to recover the total losses within 18 months. As at Friday 8 April 2011, the Dow Jones index stood at 12,380.05, an annual compound gain of 8.4%. A tremendous gain especially when you consider that the Dow Jones reached 14,156 in October 2007 before falling to 6,626 in March 2009 and then recovering to current levels.

The moral of recognising such volatility is that no-one can predict the markets - there is no crystal ball! Yet despite this, investor behaviour, both individually and collectively has not changed and investors continue to lose substantial monies by continuously committing the six deadly signs of investing. These are:

1. Being Overconfident. Investors thinking that they can outthink the market. They never can and never do. Otherwise everyone would be rich.
2. Having an Hindsight Bias. It's easy to see patterns in hindsight, therefore you can predict the future. Wrong! The global investment mangement industry is populated by some of the smartest people ever to live and yet they cannot see patterns. If they could invent a see through process then nobody would make money as there would be no risk premium available in markets to take advantage of.
3. Having a Familiarity Bias. By concentrating investment in a few well known stocks or assets gives some investors a sense of being in control and therefore comfort. I wonder how much comfort recent investors in Irish banks now feel?
4. Regret Avoidance. "I won't make that mistake again" or "It'll be different this time" Short term investment is no different than placing a single bet on a particular number on a roulette wheel. It becomes speculation and in chasing a stock gain, heavy losses usually follow.
5. Self Attribution Bias. If an investor is fortunate enough to make a gain, there is a tendancy to take the credit as being their skill in stock picking. If a loss is incurred, then it wasn't their fault, it's the market's and everybody got caught out!
6. Extrapolation. Why do investment companies attach wealth warnings that past performance is no guide to future performances. It's because they know that investors chase markets after the fact. They get in after markets rise considerably only to see them fall considerably, then exit when they fall considerably only to see them rise.

And what is the answer then? Simple. Stay invested in a well diversified portfolio consistent with your risk tolerance once you have enough cash for current and emergency expenses. 8.4% p.a. over a 23 and a half year period didn't happen by stockpicking. It happened as a natural consequence of markets doing what they do. Time, not timing,  is King!