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Picking the prospects

Do you agree with the opinions voiced by Peter Hargreaves and Kerry Nelson that structured products should not be sold by IFAs?

Dennis Hall: I would go a step further and say that structured products should not be sold by IFAs or anyone else. I too believe these funds are only created because they represent an easy sell and give risk-free returns to the product provider. Everyone else in the chain, right through to the client, carries the risk.

It is the adviser that is left trying to pick up the pieces when the product fails to deliver anticipated returns at maturity, the provider having pocketed his loot and probably hotfooted it to the next area of rich pickings.

Simon Webster: There are a few IFAs who should not be allowed to sell protection, let alone structured products, just as there are some lawyers, accountants and doctors that should not be allowed to practice.

Generally, IFAs are uniquely well placed to understand the concept of risk and reward and, subject to a reasonable degree of technical competence, should be able to advise on risk and reward relating to structured products.

The rule surely has to be that the IFA reads and understands the product literature and develops a means of communicating that understanding to the client. If an IFA does not fully understand the product, then he should not advise on it.

I would like to think that IFAs these days only operate within their abilities and, while acknowledging that some people do not accept their limitations, cutting IFAs out of this market would be ridiculous. Perhaps there is a case for a mandatory exam in this area.

The more interesting issue is that if the FSA is going to allow the distribution of complex products in the personal investment sector, perhaps it should regulate the products and thus prevent those of dubious merit going on sale.

But we could not possibly do that because if some- thing unforeseen happened, the FSA could be potentially liable. It would much rather push that problem on to the profession and continue to be wise after the event rather than risk facing the music itself.

Anna Sofat: No, I do not think that structured products should not be sold by IFAs. However, I do think there needs to be – a: a require- ment of the product providers to disclose key information about charges, parties to the guarantees and the exact nature of the risk involved, and, b: a requirement on the forms to ensure there is a good level of competency for advisers who want to advise on these. At present. these are sold on headline rates and often there is no real understanding of the underlying risk.

Sales of absolute return funds have slowed sharply, according to the Investment Management Association. Has the ban on shorting caused absolute return funds to fall out of favour?

Hall: The shorting ban has no doubt had some impact on the returns of these funds, but the bigger problem has been apparent for some time – too many of these funds have simply failed to deliver an absolute return.

Any fool can make money in a rising market, some even manage in benign market conditions but they have all been caught with their pants down in the past few months. Their shortcomings have been exposed, along with a charging structure stacked in the manager’s favour.

Webster: Leveraging return by trading in derivatives, including shorts, certainly added to fund managers’ ability to achieve returns in falling markets. However, the ban is only on shorting banks, so the whole of the rest of the market is open to this trade.

I do not think the ban has caused absolute return funds to fall out of favour. The fact that they are attracting less money is more likely due to the lemming instinct of many investors, in that they will often not invest until after a turbulent market has stabilised.

They should start to attract funds again over the next few months as it seems a degree of stability is now returning.

Sofat: I think it is just a reflection of the fact that many of these funds have not provided returns in line with expectation and have not been immune to the recent volatility.

It is also a reflection of the fact that the skillset for investing short is very different and many funds do not have two sets of managers to manage the different investment strategies – this has obviously had an impact on the performance.

Legal & General has said it is going ahead with plans to launch an absolute return fund. Is this the right time to be launching an absolute return fund?

Hall: If L&G were to launch an absolute return fund that actually lived up the hype that generally accompanies such funds, now would be a great time. The trouble is that I do not feel they can deliver. But I would be prepared to watch its performance over the next few years, to see whether it was really uncorrelated with the market and if it did deliver.

Webster: The concept of an absolute return in a falling market is attractive, as so many are seeking to cash in the current flavour of the month. L&G’s strong brand means it should be able to take a proportion of this market.

Sofat: It might be a good time if L&G used recent experience to devise a more robust investment strategy.

Timing will really depend on the quality of the underlying proposition and L&G’s expectations of growth. If the proposition is solid and expectations of assets under management are realistic, then I do not think that timing matters.

Schroders recently said that it expects its recovery fund to find opportunities in current market conditions. Are recovery and special situations funds attractive at the moment?

Hall: I am warming to the idea that funds of this nature can find opportunities that would otherwise be missed by broader-based funds and trackers. They are not for the faint-hearted but, as a long-term addition to a portfolio, this would probably provide some stellar long-term returns.

I would probably add private equity investment trusts to this sector as I strongly believe they are poised to hoover up some great businesses at a fraction of their true long-term value.

Webster: The market is way below the 6,999 reached on December 31, 1999. Many would agree that equities are highly undervalued, so an actively managed fund, structured to take advantage of recovery, should form a part of the portfolios of many investors.

Sofat: Yes, I think both categories are well placed to take advantage of anomalies in pricing. Currently there are many companies with solid balance sheets and good cashflows but where the price is at historic low valuations – these funds can take advantage of these companies, irrespective of sector or size.

Have you been surprised by the speed with which many with-profits funds, including those run by Legal & General, Norwich Union and Standard Life, have cut their bonus rates?

Hall: I have been surprised how slowly with-profits have reacted to the recent market falls and it is not just their equities that have suffered as the property component of the funds will have been suffering for over a year and the riskier end of their bond exposure too.

Of course, a more immediate response can be applied using market value adjusters but market sentiment has been negative for some months and bonus cuts are easier to swallow than MVAs, which feel so penal.

Webster: No. Big insurance companies never give money away and always want to prop up their balance sheets. This is why with-profits is increasingly unpopular in the IFA community and why we have only ever sold a handful of such plans.

Sofat: Market shifts have been swift this year and with-profits funds do not operate in a vacuum so, no, I am not surprised.

I think that the companies have also learned from the last bear market and are responding quicker to ensure the underlying fund is not adversely affected. Last time, many companies continued paying bonuses which were unsustainable over the longer term.

What are you advising clients to do with any new monies being invested?

Hall: For most of 2008, we have been holding money back in cash, either through a diversified spread of bank and building society accounts, or one of a small number of money market funds that we feel comfortable using.

We are starting to believe that certain asset classes hold some attraction to investors based on very high yields – closed-ended property funds for example. But we are in no hurry to get our clients’ funds invested and are suggesting a series of phased investments over the next 12-18 months.

Webster: We run a series of risk-rated balanced portfolios with higher equity and emerging market content for aggressive investors, and more cash and bonds for the risk-averse.

Like everyone else, we are actively seeking out funds that could bounce back over time.

For our braver clients, we like the financial sector as it is hard to fall off the floor and, given the huge increase in lending margins and the fact that most write-offs have already happened, future profit potential in that sector is attractive.

Sofat: We are advising that it is an excellent time to invest in equities for the longer term and, as usual, designing diversified portfolios. We are also looking at funds with good dividend stream for clients needing income.Continued on p52Continued from p51 I would go a step further and say that structured products should not be sold by IFAs or anyone else. I too believe these funds are only created because they represent an easy sell and give risk-free returns to the product provider. Everyone else in the chain, right through to the client, carries the risk.

It is the adviser that is left trying to pick up the pieces when the product fails to deliver anticipated returns at maturity, the provider having pocketed his loot and probably hotfooted it to the next area of rich pickings.

Simon Webster: There are a few IFAs who should not be allowed to sell protection, let alone structured products, just as there are some lawyers, accountants and doctors that should not be allowed to practice.

Generally, IFAs are uniquely well placed to understand the concept of risk and reward and, subject to a reasonable degree of technical competence, should be able to advise on risk and reward relating to structured products.

The rule surely has to be that the IFA reads and understands the product literature and develops a means of communicating that understanding to the client. If an IFA does not fully understand the product, then he should not advise on it.

I would like to think that IFAs these days only operate within their abilities and, while acknowledging that some people do not accept their limitations, cutting IFAs out of this market would be ridiculous. Perhaps there is a case for a mandatory exam in this area.

The more interesting issue is that if the FSA is going to allow the distribution of complex products in the personal investment sector, perhaps it should regulate the products and thus prevent those of dubious merit going on sale.

But we could not possibly do that because if some- thing unforeseen happened, the FSA could be potentially liable. It would much rather push that problem on to the profession and continue to be wise after the event rather than risk facing the music itself.

Anna Sofat: No, I do not think that structured products should not be sold by IFAs. However, I do think there needs to be – a: a require- ment of the product providers to disclose key information about charges, parties to the guarantees and the exact nature of the risk involved, and, b: a requirement on the forms to ensure there is a good level of competency for advisers who want to advise on these. At present. these are sold on headline rates and often there is no real understanding of the underlying risk.

Sales of absolute return funds have slowed sharply, according to the Investment Management Association. Has the ban on shorting caused absolute return funds to fall out of favour?

Hall: The shorting ban has no doubt had some impact on the returns of these funds, but the bigger problem has been apparent for some time – too many of these funds have simply failed to deliver an absolute return.

Any fool can make money in a rising market, some even manage in benign market conditions but they have all been caught with their pants down in the past few months. Their shortcomings have been exposed, along with a charging structure stacked in the manager’s favour.

Webster: Leveraging return by trading in derivatives, including shorts, certainly added to fund managers’ ability to achieve returns in falling markets. However, the ban is only on shorting banks, so the whole of the rest of the market is open to this trade.

I do not think the ban has caused absolute return funds to fall out of favour. The fact that they are attracting less money is more likely due to the lemming instinct of many investors, in that they will often not invest until after a turbulent market has stabilised.

They should start to attract funds again over the next few months as it seems a degree of stability is now returning.

Sofat: I think it is just a reflection of the fact that many of these funds have not provided returns in line with expectation and have not been immune to the recent volatility.

It is also a reflection of the fact that the skillset for investing short is very different and many funds do not have two sets of managers to manage the different investment strategies – this has obviously had an impact on the performance.

Legal & General has said it is going ahead with plans to launch an absolute return fund. Is this the right time to be launching an absolute return fund?

Hall: If L&G were to launch an absolute return fund that actually lived up the hype that generally accompanies such funds, now would be a great time. The trouble is that I do not feel they can deliver. But I would be prepared to watch its performance over the next few years, to see whether it was really uncorrelated with the market and if it did deliver.

Webster: The concept of an absolute return in a falling market is attractive, as so many are seeking to cash in the current flavour of the month. L&G’s strong brand means it should be able to take a proportion of this market.

Sofat: It might be a good time if L&G used recent experience to devise a more robust investment strategy.

Timing will really depend on the quality of the underlying proposition and L&G’s expectations of growth. If the proposition is solid and expectations of assets under management are realistic, then I do not think that timing matters.

Schroders recently said that it expects its recovery fund to find opportunities in current market conditions. Are recovery and special situations funds attractive at the moment?

Hall: I am warming to the idea that funds of this nature can find opportunities that would otherwise be missed by broader-based funds and trackers. They are not for the faint-hearted but, as a long-term addition to a portfolio, this would probably provide some stellar long-term returns.

I would probably add private equity investment trusts to this sector as I strongly believe they are poised to hoover up some great businesses at a fraction of their true long-term value.

Webster: The market is way below the 6,999 reached on December 31, 1999. Many would agree that equities are highly undervalued, so an actively managed fund, structured to take advantage of recovery, should form a part of the portfolios of many investors.

Sofat: Yes, I think both categories are well placed to take advantage of anomalies in pricing. Currently there are many companies with solid balance sheets and good cashflows but where the price is at historic low valuations – these funds can take advantage of these companies, irrespective of sector or size.

Have you been surprised by the speed with which many with-profits funds, including those run by Legal & General, Norwich Union and Standard Life, have cut their bonus rates?

Hall: I have been surprised how slowly with-profits have reacted to the recent market falls and it is not just their equities that have suffered as the property component of the funds will have been suffering for over a year and the riskier end of their bond exposure too.

Of course, a more immediate response can be applied using market value adjusters but market sentiment has been negative for some months and bonus cuts are easier to swallow than MVAs, which feel so penal.

Webster: No. Big insurance companies never give money away and always want to prop up their balance sheets. This is why with-profits is increasingly unpopular in the IFA community and why we have only ever sold a handful of such plans.

Sofat: Market shifts have been swift this year and with-profits funds do not operate in a vacuum so, no, I am not surprised.

I think that the companies have also learned from the last bear market and are responding quicker to ensure the underlying fund is not adversely affected. Last time, many companies continued paying bonuses which were unsustainable over the longer term.

What are you advising clients to do with any new monies being invested?

Hall: For most of 2008, we have been holding money back in cash, either through a diversified spread of bank and building society accounts, or one of a small number of money market funds that we feel comfortable using.

We are starting to believe that certain asset classes hold some attraction to investors based on very high yields – closed-ended property funds for example. But we are in no hurry to get our clients’ funds invested and are suggesting a series of phased investments over the next 12-18 months.

Webster: We run a series of risk-rated balanced portfolios with higher equity and emerging market content for aggressive investors, and more cash and bonds for the risk-averse.

Like everyone else, we are actively seeking out funds that could bounce back over time.

For our braver clients, we like the financial sector as it is hard to fall off the floor and, given the huge increase in lending margins and the fact that most write-offs have already happened, future profit potential in that sector is attractive.

Sofat: We are advising that it is an excellent time to invest in equities for the longer term and, as usual, designing diversified portfolios. We are also looking at funds with good dividend stream for clients needing income.

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