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Damage assessment

Given the events of the last two weeks, how much blame lies with the ratings agencies which seemed to give Lehman Brothers, AIG, Merrill Lynch and HBOS a relatively clean bill of health?

Urquhart Stewart: The whole purpose of these agencies is to rank and rate what they put their names to. They seem to have joined in the industrywide mesmeric attitude that there was apparently no risk. Frankly, they have failed abysmally and ruined their credibility. Thus, it will take some time to rebuild it. There is not much we can trust if their ratings are just rank.

McDermott: The ratings agencies have had a major part to play in the downfall of many financial institutions since the beginning of this crisis. Initially, Wall Street firms took on risky mortgages from the lenders and packaged them into bonds. These were given a risk rating by agencies such as Fitch, Standard & Poor’s and Moody’s and sold to pension funds and other institutions. The ratings agencies helped to keep the market performing by seeing that these bond offerings got attractive ratings to enable them to be sold, providing new funds mortgage originators to make new loans to increasingly unsuitable borrowers. For this practice, I find them particularly culpable.

Yearsley: The speed at which some of these financial institutions have collapsedor have been taken over has caught many in the market by surprise. Therefore, it is difficult to pin blame on the ratings agencies for not responding earlier. However, you have to wonder whether the credibility of the ratings agencies will suffer as a result of the last 12 months and the seeming failings in analysing financial risks properly.

Does the state of world equity markets offer a buying opportunity for new money being invested or should any new funds be placed in a safe haven until market volatility calms down?

Urquhart Stewart: The question to ask yourself is will the world look better in five years? If the answer is yes, then we should continue to drip feed client money back into a broadly asset allocated portfolio. Now is the time to benefit from pound cost averaging. If you try and time this market, you are quite likely to miss it. I think in five years time, you may well look back at today and think that this was a time of quite good value.

McDermott: In hindsight, the market trading between 4,500 and 5,300 will be looked on as a very attractive point of entry but that is taking a long-term view on equities. In the short term, until the credit crisis can be stopped or at least its virulence dampened by significant government intervention, investors can expect a continued period market volatility and more frayed nerves.

Yearsley: I think markets do look historically cheap at the current time. However, that does not mean that they will not get cheaper. Unfortunately, with the high level of volatility, it is easy to get on the wrong end of a 4 or 5 per cent swing. On the other hand, you can buy into markets such as Russia which is not unduly affected by the credit crunch and currently trades on a price/ earnings ratio of about 5. If you can ignore volatility, then now is probably a good time to invest. However, most investors would probably sit this out and wait until calm returns to the market.

With everyone from the Prime Minister to the Archbishop of York condemning the actions of short-sellers, do you think regulating short-selling is in the best interests of the UK equity markets?

Urquhart Stewart: This shows a total lack of understanding about short-selling. It is easy to characterise greedy short-sellers when it is a perfectly Continued on p48legitimate investment management tool. Short-selling did not undermine HBOS significantly, it was the market selling in fear of another Northern Rock and the failure of the shares not being suspended in such a volatile market. What they should be looking at is the management of trading in the market to ensure that stocks are suspended when they become too overheated.

McDermott: It is easy for public figures to mount their various soap boxes when we are in the midst of a crisis but one must still be awfully careful not to find the nearest scapegoat. What is at the very heart of the crisis is the safety and soundness of the financial system. Short-selling may have provided some of the gas to a well-lit fire but to say it is the chief instigator behind our economic problems is a red herring. The real issue was excessive leverage.

Yearsley: There did appear to be a bandwagon forming last week to see who could condemn the short-sellers the loudest. If instruments are created that mean you can benefit from a falling share price, then investors will take advantage of this. There could feasibly be a case for suggesting that naked short-selling is more tightly controlled but I am not convinced that full -scale regulation is required. The adage “a sledge hammer to crack a nut” does spring to mind. Shorting and hedging have been with us for hundreds of years, so of course they should not be stopped. This is a classic case of shooting the messenger. They are not the source of the current problem.

Does short-selling damage the long-term performance of equity markets?

Urquhart Stewart: No, in fact, the opposite. It can help with price formation (and puncturing bubbles) and add liquidity to enable more people to trade. However, the misinterpretation of short-selling does damage the reputation of investment markets in the popular world.

McDermott: No, a lot has been made of aggressive hedge funds undermining the equity markets. While the vulture-like mentality of some short-sellers taking advantage of major banks creaking may have undermined floundering institutions such as Lehman Brothers and provided the final nail in the coffin, it has been the irresponsible packaging of mortgage debt that has been the main driver of the crisis.

Yearsley: I do not think short-selling damages the long-term performance of equity markets. I do think share price falls can be exaggerated by short-selling but they are falling for a reason, namely, that the market does not think those companies are particularly good. As part of a balanced portfolio, shorting can provide long-term benefits and also provide a positive result in a down market, thus providing more money to invest in the long term in the market if desired.

Some providers of structured products with backing from Lehman Brothers, such as NDF and DRL, have had to issue warnings to investors to expect significant losses to their investments. Should advisers who have sold structured products prepare themselves for misselling claims if investors lose money?

Urquhart Stewart: There will undoubtedly be claims and advisers must look back to what they advised their clients about these facilities and the risk attached to them. Unfortunately, many such packaged products have been sold on the basis that these are complicated structures which us mere mortals could not possibly understand. Let that be a lesson to us all not to be patronised by pompous investment bankers.

McDermott: Since the fallout from the precipice bond scandal, all advisers should be fully aware of market risk. In the case where an adviser has actively promoted one of these structured products, a client should have been fully informed of the potential risk, including counterparty risk. If the adviser has not given full disclosure in terms of degree of risk involved, then the adviser must be prepared to face claims of misselling.

Yearsley: I think advisers who have sold many structured products backed by Lehman Brothers should prepare themselves for misselling claims. That is not to say the claims will be successful but that will not stop claimants making a case. I also think the companies that provided the products in the first place may receive a flood of complaints and calls for compensation. The problem with structured products has always been that the capital guarantees are only as good as the guarantor. In the case of Lehman Brothers, that now appears pretty worthless.

Evidence Based Investment Solutions is a non-profit group of eight IFA firms which have banded together to promote the benefits of passive investment. They believe investors would be better off putting their money into low-cost funds such as index trackers and non-commission-paying institutional funds. Do you agree with the philosophy?

Urquhart Stewart: We at 7IM have been pioneering this for a while and were the first todevelop a full multi-asset range of risk-rated passive portfolios. The breadth of exchange traded funds and other passive instruments has vastly broadened our capabilities for better constructed passive portfolios. Their original design was aimed to keep active managers honest and to challenge their rising charges – something which many UK managers should learn from. In a period of lower growth, these lower cost and flexible portfolios will become more important.

McDermott: I have never been against passive funds. Indeed, they can provide a low-cost option to those entering the market. However, for a more sophisticated portfolio, we will always back active managers. History has shown that approximately one-third of active managers will beat their passive counterparts. Given access to the right research, an investor can easily see which managers are likely to perform over the long term and deliver returns that outweigh the savings associated with passive funds.

Yearsley: I have to be honest and say I do not agree with EBIS. I am a firm believer in active management. Over time, I believe that the quality active manager can and does add value and outperform over an index. The trick is identify them. Yes, there is the cost involved but I believe there is an opportunity cost in being in passive over active. I think the disadvantages of passive investing are obvious in that even if you believe a sector such as banking is going to continually fall, you are stuck with it. At least active managers have the choice of whether or not to invest in a particular sector. Some might get it right, some might get it wrong but the key is they have the choice.

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