KEY POINTS:
The conventional wisdom is that retail investors should keep up with the latest financial news but, these days, Mum and Dad could be forgiven for giving the finance pages a wide berth. The past year has seen an unprecedented run of bad news from the local retail investment
scene.
First, it was the turn of the finance companies to go bust, with about 15 having turned up their toes so far.
Investors are worried who will be next but the goods news is that there aren't many left.
Then Blue Chip, the world's most inappropriately named property investment company, got into trouble, taking with it the retirement savings of hundreds of investors.
At the same time, global stockmarkets are lurching from crisis to crisis, residential property sales have hit a brick wall and the credit markets, which were not so long ago falling over themselves to lend money, are today closed for business to all but the highest-rated borrowers.
How that much bad stuff could happen to retail investors in civilised New Zealand will no doubt be the subject of much discussion, but the fact that higher-risk products pay the most commission should be a prime suspect in any investigation.
The most recent disaster involves so called "structured credit", which this column has been flagging as an accident waiting to happen since 2005.
Structured credit usually refers to collateralised debt and loan obligations (CDOs/CLOs) and was initially sold to retail investors as a relatively low risk way of earning a bit extra on your cash than you would otherwise get in the bank.
What wasn't always so clear at the point of sale was that these products invested in ultra complex financial instruments, which no one fully understood, and whose main feature was to combine high risk with, at best, mediocre returns.
The fees and overheads built into some of these instruments meant that much of the upside accrued to the originators and Mum and Dad were left with the risk.
New Zealand retail investors have embraced structured finance in a big way, with about $1.8 billion invested. Since May 2007, when the credit crisis got under way, New Zealand Mums and Dads have lost an estimated $450 million on products with a CDO-based exposure.
Structured credit has been marketed in New Zealand via unlisted unit trusts and trusts which are listed on the stockmarket, with one or two of the latter performing particularly badly - the Fortress Notes issue from Macquarie has lost about 90 per cent of its value.
With names like "Diversified Yield Fund" and "High Yield Cash Fund" these instruments were marketed as being lower risk than a property or share fund, yet have managed to lose more than one-third of investors' money.
NZ Funds Management has closed the High Yield Cash Fund to new investment and, while investors in the $220 million Super Yield Fund can still get their money out (the fund is 30 per cent invested in cash), the notice period has shifted from four to 63 days.
This sort of policy u-turn is normally invoked where there is a lack of depth and liquidity in a market.
So what should investors in these funds do? For what it is worth, there is speculation by experts writing in the London Financial Times that things could get worse in CDO land, that many banks and institutions have either got skeletons in the closet and are hoping for the best or, due to the complexity of the products, don't have a firm view of the size of their losses.
There is some suspicion that fund managers are still in denial by pricing CDOs on the basis of what their computer model says they should be worth rather than what they could be sold for. Certainly changes in the macro-economic environment augur badly for credit - people and companies will find it harder to service their loans.
The question is, is that already in the price of the CDOs? NZ Funds advises that instruments in its funds are valued at the price they can be sold for and current spreads over low risk bonds are as much as 8 per cent, which certainly discounts a lot of bad news.
In deciding what to do, Mum and Dad need to understand the strengths and weaknesses of the vehicle within which they are invested.
Unit trusts like those managed by ING and NZ Funds can be problematic: When someone wants their money out of an unlisted vehicle, the fund manager has to sell something from the fund's portfolio for cash to fund the redemption. If an open-ended fund or unit trust has invested in illiquid assets, and Mum and Dad want their money out, the option of selling down the portfolio to fund the redemption might not be available.
In such situations, managers typically sell what they can and keep what they can't, potentially affecting the balance of the portfolio. Back in 1990, when the unlisted property funds had to suspend redemptions because they couldn't sell the underlying property, one cynic labelled the redemption facility as "an umbrella which you can only use until it starts raining".
In the US and Europe, many hedge funds investing in CDOs have suspended withdrawals completely. While no manager wants to take this sort of action, the dilemma is that if the fund remained open and it turned out the prices were optimistic, every time an investor redeemed units at a high price he or she would be doing so at the expense of unit holders who didn't sell.
With a listed fund, the fund manager's management of the portfolio is independent of the supply/demand position of the fund's units. What happens in practice, however, is that if people try to aggressively sell their shares on the stockmarket the listed fund goes to a big discount to asset value, thereby magnifying the impact of the loss. The market position of many of the listed structured credit funds is dire - frequently lots of sellers and no buyers to be found.
Investors with exposure to CDO-based funds should speak to their advisers to ensure that their exposure remains appropriate in terms of their risk profile and income requirements.
* Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.
