Financial

It is quite possible that we shall look back on the current credit crunch as the moment when the USA’s dominance in the world’s capital markets finally ended.

The biggest financial institutions in the world have spent the last few years busily taking on a great deal more risk than they understood in the pursuit of profits.  There is nothing wrong with a company making profits, that is why they exist, but many years of profits are being wiped out in one fell swoop.  It is safe to say that most shareholders would have foregone some of the profits of the past in order to preserve more of their capital value, had they but known.  Only, they could not have known because the finest minds available to the likes of Citi Group and Merrill Lynch at incredible cost did not know that their money-making schemes were so fundamentally flawed.

Of course, had these banks adopted a more cautious approach, their executives would have been pilloried and then sacked or the bank would have fallen prey to a takeover, such are the demands of shareholders.  We sow what we reap.

Now, these great institutions, and others, have had to go cap in hand to China and the Middle East for capital.  When the dust has settled, much of the intellectual capital within these firms will partly belong to their fiercest rivals, sold on the cheap.  Oh, how the mighty have fallen.

Whilst we in the UK are in the throes of Retail Distribution Review by our Regulator, it is interesting to see that Australia (apparently, home of the Wrap) is facing up to similar issues.  The Australian Securities and Investment Commission found in a survey last year that consumers were six times more likely to receive bad advice when an adviser had a conflict of interest over remuneration, even if it was disclosed, and that most investors were unable to tell when they had received bad advice.  Now, you could dismiss this on the grounds that Aussie investors must be considerably less sophisticated than their British counterparts but I would not be too complacent as the average news bulletin in Australia carries much more financial news than those in Britain.  Clearly, the existence of commission has a hugely detrimental effect on the quality of the financial advice received, a fact not lost on the British Financial Services Authority, the Government, the Consumers Association and some financial advisers.

“The question remains as to whether full disclosure is enough to deal with the potential conflicts of interest associated with commission-based fees, or whether there is merit in the industry moving further in the direction of offering advice on a fee-for-service basis.’

It is all getting a little hairy in the markets at the moment; all major markets posted significant falls yesterday and the news may not be much better today.  Are we witnessing (or, for those of us with investments, experiencing) the final act in the credit crunch tragedy or merely another scene?  Also, what course of action should a rational investor take?

No one can be sure where this crisis is heading; quite a few problems have been brought to the fore but there may be more to come.  It is almost laughable now that, only a matter of weeks ago, our august politicians were focused on the rate of tax paid by Private Equity to the extent that they restructured our entire tax system in an attempt to penalise them.  Meanwhile, in the real world, things were going pear shaped.

Poorly diversified investors may have the least comfortable experience, particularly those poor private investors who held significant chunks of Northern Rock stock for no real reason.  Also, those with too large a proportion of equities may find themselves ruing their lack of investment spread and property looks set for a difficult period.

What is holding up?  Well, the bond markets, unloved of late, may find themselves viewed more favourably (especially government and high quality) and commodities may continue their climb.  But it seems, oddly enough, that emerging markets may emerge (pardon the pun) the real winners from this period of instability.  A year or so from now, they may look quite grown up, while some of the racier classes of investment, such as private equity, may look a little discredited (another pun?).

As ever, the advice to any investor is to ensure that you are properly diversified.  Do not get drawn into this year's must have (or have not) sector and only invest if you have a long term outlook.

Is the stock market, as a whole, an inherently riskier place to invest money than the residential property market?  Now, I am not for one second suggesting that either is an appropriate place to put your money, although one or both may be, I am just opening up the discussion.  I am also considering the property market in investment terms rather than housing terms, no share portfolio will keep you dry through the winter or give you somewhere to show off your latest plasma TV.  These thoughts are probably, therefore most applicable to excess property investment, by which I mean a second property, a buy-to-let property or a house larger than your requirements, which you hope to sell to fund your retirement.

Firstly, what do we mean by risk?  It is, I suggest, unlikely that the stock market or the property market will drop in value to zero.  It is, of course, possible to make a bad choice of investment.  Some companies will go bust and some properties may become worthless, perhaps because of flooding or encroachment by the sea.  Now, you would be daft to buy a property without insuring it against these risks but most people will buy a share in a company without any corresponding insurance against loss (i may cover how another time).  This, then, starts to colour our view of the relative merits of the investments; we take more risk with our stocks, for some reason, than we do with our real estate.

The world of professional investors usually expresses risk in terms of the volatility of returns.  An investment which can deliver high returns with periodic big drops in values is considered to be riskier than an investment which is more steady in its delivery, even if they end up at the same spot.

So, how does volatility compare?  My main concern here is one of information delivery.  If you valued your share portfolio every year, it may not look particularly volatile and, indeed, in most years it would have gone up in value, probably even in 1987.  This is where the stock portfolio is at something of a disadvantage when compared against property.  You see, property is not valued by anyone, let alone the market (as distinctly opposed to an estate agent or even a surveyor) in anything like real time.  Depending on how often we move, a property may only be market valued, i.e. bought, once every seven years.  We may read in the press about the general sentiment but no one is able to rub our noses in its value in real time, minute by minute.  If you own a stock portfolio, you can watch it go up and down every minute of the working day, responding instantaneously to investor sentiment, and it can be frightening for some.

Also, I have referred to a stock portfolio as opposed to one stock, mostly, as it would not be rational to hold only a couple of different shares.  Diversification is easy with shares, not so with property as it is expensive and slow to sell, amongst other things.  

What of the returns?  Well, ignoring income form dividends or rent, which I gauge to be similar after costs, I think property and equities have probably delivered similar capital growth.  If you take into account transaction costs and the difficulties of diversifying across a number of properties, it may well be that a property portfolio has lost ground to a share portfolio.  What, though, will the next twenty bring?

This is quite a difficult question to answer. The problem is that if we did not have the current system, we would not invent it today. Twenty-five years ago, the insurance industry sold huge numbers of life insurance and insurance-based investment products with opaque terms and conditions for extremely high upfront commission payments and plenty of non-cash added benefits to the advisers and sales teams. The products attracted tax breaks on the contributions, there was very little competition and even less freely available information for investors. The sale and marketing of these products and the activities of the ‘advisers’ was all but unregulated. Happy times for the insurance companies! This got the insurers and their salespeople firmly addicted to the drug of commission.

In the late Eighties, the problems started or, depending on your point of view, things started slowly to improve. Firstly, many of the tax breaks that the insurance based products (other than pensions) enjoyed were withdrawn. The withdrawal of Life Assurance Premium Relief should have stopped the whole industry dead in its tracks, but it did not. Given the shot of added adrenaline which the tax relief on contributions had given, the insurance industry had designed a raft of very profitable products (for them and the sales people), which they had come to enjoy selling. Given the tax relief, even an expensive product (expensive mainly because of the commission) could deliver a seemingly respectable return.

Just because this perk had been removed did not mean that the insurers wanted to stop manufacturing and marketing these products and they needed to proffer a large slice of commission to ensure that they were sold. This set the scene for another fifteen years of truly awful product sales.

The second problem to arrive shortly after the withdrawal of LAPR was the notion of regulating the activities of financial advisers. This caused consternation amongst the industry and many envisioned the final departure of their gravy train. In fact, very little changed. The insurance industry regulated itself and turkeys do not vote for Christmas. All that was required was a more formal sales process and reams and reams of small print. Business as usual.

Amid an increasing clamour for change, nothing really happened until the end of the Twentieth Century. The first major change was the advent of statutory regulation. The old guard with the suspicion of vested interests were swept aside and in came a more professional approach to regulation and one much less inclined to hear the financial industries view.

The second significant event was the introduction by the Government of the Stakeholder Pension with its charges capped at an unheard of 1% per annum. In itself, this would not have caused the insurers or the advisers much of a problem; there had always been cheaper, better products available, they had just skilfully avoided selling any of them. What really caused the rot to set in was the insistence by the regulator that any reasons for the sale of a more expensive product must be adequately documented. This meant that the Compliance Officers of the sales and advisory companies took fright and sales of more expensive pensions dropped off, much to the benefit of the public. The problem was that there are very few, genuine, reasons to recommend a more expensive product over a cheaper one, excepting commission. Cheaper products pay less commission and, all of a sudden, the chickens came home to roost.

Commission took a violent downward turn as the insurance companies realised that they would make no money themselves if they gave away upfront the next twenty years of revenue to secure a sale. This meant that the commission junkies were suddenly deprived of their most important drug. Ever adaptable, except when it comes to the business model and client offering, they turned to different products. Many became mortgage brokers (at that stage, largely unregulated) and many sold reams of sophisticated and risky tax products, often without any experience, technical support or Professional Indemnity Insurance (all another story).

In truth, that industry has withered on the vine but insurance companies still need to shift their products through advisers and the advisers are still reliant on the insurance companies’ commission.

The third major change was the widespread adoption of the internet. Suddenly, clients had access to more information and broke the grip which the insurance companies and the advisers had on it. This placed clients in a stronger position and led them to expect a very different experience.

In many ways, change has been slow and much of the industry limps on as before. Clients, however, have never had it so good. If they are minded to look, there are a few advisers working with a different business model offering their clients a very different proposition.

Fee Based Solutions was amongst the vanguard of this movement and we believe that our experience in the realm of Fee Only Advice and our attitude to our clients positions us perfectly to help our clients to ensure that best possible outcome from financial planning.