Victoria Kelly examines how the credit crunch has affected investors' perception of risk and asks exactly how safe are so-called low-risk investments
Investors' perception of risk has changed significantly over the last 15 months as the credit crisis has worked its way through the global financial system.
Banks and building societies, the traditional guarantors of low-risk investing such as cash deposits and guaranteed funds, have been shaken to their core by a breakdown of confidence in lending markets and poor consumer sentiment.
The list of high-profile banking casualties has grown alarmingly long. In Europe, a string of institutions including British former buildings societies Northern Rock and Bradford & Bingley, Glitnir Bank and Landsbanki in Iceland, and Belgian banks Fortis and Dexia have been forcibly taken under government control. Meanwhile in the United States, investment bank Lehman Brothers has collapsed along with Washington Mutual, while Fannie Mae, Freddie Mac and AIG have all been nationalised by the US government.
The upshot of all this is that many financial institutions no longer offer the same level of security to low-risk investors they once did. With more banks expected to collapse, deciding where to invest money has become more risky, at least in the short term.
Gavin Haynes, investment director at IFA Whitechurch Securities, says it has become increasingly difficult for advisers to assess risk as the financial crisis has deepened.
"The credit crunch has certainly changed people's perception of what is low risk," he says.
"When we are rating clients' risk profiles between one and 10, number one has always been cash. But now we are having to dig deeper than that and look at the underlying institutions."
Finding a cash account backed by a stable institution is one way to address the problem. Another is to make sure client money is placed in a jurisdiction that offers a compensation scheme in the event of the bank or building society collapsing. Anglo Irish Bank, for example, currently offers an attractive headline rate of 7.21% on its sterling 12-month-notice offshore Privilege Fixed Interest Account. The account is based in the Isle of Man (IoM), which means savers have added insurance if Anglo Irish were to go bust because the account is backed by the island's Depositors Compensation Scheme. The amount of compensation deposit holders are eligible for was recently revised upwards from a maximum of £15,000 to £50,000.
For clients with cash deposits that exceed a jurisdiction's compensation limit, however, a compensation scheme can only go so far to cover losses. The Isle of Man is also something of an exception among the main offshore jurisdictions with regard to compensation. Other financial enclaves like Jersey and Guernsey will not reimburse depositors if a bank goes bust, although this is currently under review (see news, page 5).
Bob Parker, chief executive officer at Dubai-based IFA Holborn Assets, says at times like this advisers need to find clever ways to mitigate risk for clients. Redistributing a large cash deposit among several different accounts based in jurisdictions that offer compensation is one option, he says. This will diversify a client's cash holding and reduce their exposure to the risk of an individual bank defaulting.
"If you have got £350,000 in HSBC, for example, get it out and spread it around," he says.
Exchange traded funds
There are other ways for low-risk investors to access a cash-type investment without opting for a deposit account. According to Marco Montanari, head of fixed interest exchange traded funds (ETFs) at Deutsche Bank, replacing the core cash component of a low-risk portfolio with a money market ETF is becoming increasingly popular.
Montanari says money market ETFs offer more interesting returns than current sovereign bond yields, which have fallen recently as investors have sought safety in government-backed securities. He also says the money market ETFs offered by Deutsche Bank are less volatile than their money market fund equivalents because they track overnight interest rates, which effectively smoothes interest rate volatility.
"ETFs offer investors a very safe legal framework," Montanari says. "They are Ucits III compliant and so can only hold up to a maximum of 10% counterparty risk."
As an illustration, Montanari says that at present Deutsche Bank's European money market ETF, the Eonia ETF, is collateralised entirely through European sovereign bonds and has no counterparty risk. Deutsche Bank also offers a US dollar money market ETF and a sterling money market ETF.
"It is important in these kinds of markets for clients to have products that are fully collateralised with a secure underlying investment," he says.
Another area where counterparty risk is playing an increasingly important role in determining returns is structured products. Again, instability in the financial sector has prompted a reappraisal of the security of structured products, many of which are backed by banks and building societies and are marketed as low-risk. Investors can no longer take for granted that the institution guaranteeing the product will be able to honour the terms of the contract at the end of the plan's lifespan.
A number of structured products have already been hit by the problems in the banking sector. The demise of Lehman Brothers has seen certain plans offered by Meteor Asset Management and others affected negatively, while, more recently, the value of Close Investments' Japanese Accelerated Return Fund II fell significantly after two Icelandic banks, Glitnir and Kaupthing, hit the ropes. Around 30% of the fund's net assets are backed by the two banks.
Daniel Boyce, an analyst at WINS Research, says if a bank looks likely to default, the value of a structured product will fall even though the terms of the final payout remain the same.
"This is because there is now a greater chance that any returns you are supposed to get - say, according to the movement of an equity index - may not be paid because the bank might not be around when the product matures," he says.
But a collapsed bank is not always bad news for structured product investors. For those in products that are guaranteed by banks or building societies that have been nationalised, it can be good news. This is because a government is now providing the guarantee, which in today's environment can offer the best security.
Boyce says that in the case of the Japanese Accelerated Return Fund II, the nationalisation of Glitnir and Kaupthing should help investors, although at the time of going to press it was still uncertain whether Kaupthing would honour its guarantees.
He says: "If, for example, the Icelandic government nationalises the banks and commits to honour all their bonds, the value and price will instantly rise significantly because payout of any returns is much more likely."
With government guarantees currently offering the best option, Boyce believes investors will increasingly demand structured products backed by secure government assets.
Boyce says: "The main effect of what has happened recently is it will improve disclosure. The time when investors did not know who exactly was guaranteeing their returns has passed, and products will have to be much more explicit."
Flight to bonds
The current trend for investors to seek security in government-backed investments has not been confined to cash deposits, ETFs and structured products, however. Government bonds have also enjoyed a flight to safety, prompting global government fixed interest to rally.
In contrast, investors have shunned corporate and high-yield bonds in the last year, fearful of the extent of the credit crisis contagion, which has caused credit spreads to widen. The ensuing volatility seen in non-government bond markets has been more akin to that of equity markets.
This is backed up by figures from Morningstar, which show that in the third quarter of this year the average fund in the European Government Bond category gained 4.2%, whilst the average European High Yield Bond fund lost 4.6%, in local currency terms. The story is repeated in the sterling and dollar fund categories.
Whitechurch's Haynes says investor aversion to riskier corporate and high-yield bonds means many funds now look attractively priced.
"Corporate bond funds are looking exceptionally cheap and some are offering exciting yields," he says. "We think the negative scenario is already priced in."
Going for gold
One asset that is free of counterparty risk and has historically been seen as a safe haven in times of economic turmoil is gold.
Gold prices have risen steadily since 1999 when the gold price hit lows around $250 an ounce, a point that was cemented in economic history after British Prime Minister Gordon Brown - then Chancellor of the Exchequer - sold a large chunk of the UK Government's gold reserves at the bottom of the market.
This year the price of gold has been very volatile but has averaged around $900 an ounce. Although more recently the price has fallen back after hitting an all-time high of $1,030 earlier this year, average prices remain significantly higher than in 2007, when gold averaged $700 an ounce.
Evy Hambro, manager of the BlackRock Global Funds World Gold fund, says a simple supply and demand imbalance continues to push gold prices upwards.
"What is really driving gold prices is the medium to long-term fundamentals of supply and demand," he says. "Gold production has been declining steadily since production peaked in 2001. This year there will be sharp falls in production as many of the gold mines mature and are no longer able to produce at the same levels."
Hambro also says central banks, which have been bulk gold sellers since 1999, have in the last three years been selling less from their reserves, which is reducing the amount of gold on the market.
Despite this, demand remains high, mainly from the jewellery industry but also increasingly from investors who are buying gold as a secure asset in times of economic instability. Gold is seen as a low-risk safe haven because unlike banknotes it holds its pricing power over time, although some question its suitability as part of a low-risk portfolio because it is volatile.
Hambro says the most significant demand in the last six or seven years has come from the launch of gold ETFs. These allow investors to approximate investment in physical gold.
"This has resulted in a huge amount of people investing in gold who previously didn't," he says. "That continues to be a very strong source of demand as people become fearful of what is happening in markets."
In the balance
Although the credit crisis has changed the short-term outlook for traditional low-risk areas, advisers remain adamant it should not alter how a low-risk portfolio is constructed.
Haynes says: "The rules haven't changed. It's about putting together a balanced portfolio. But people have to realise that volatility is exceptionally high at the moment and so they have to be prepared to invest for the long term."
This volatility can make it difficult for advisers to manage client expectations, especially those close to retirement or with a short-term investment horizon.
Tim Rainsford, international manager, personal financial planning at IFA The Fry Group, which has offices in Asia and Europe, says advisers need to manage client expectations by making the risks of each investment clear at the outset. Also, risk is highly subjective so an individual assessment is vital, he says.
For Rainsford, a typical low-risk portfolio will consist of the standard range of asset classes, such as cash, bonds, equities, property and commodities, but will also include funds that use hedging techniques to smooth volatility. These include hedge funds and funds that take advantage of the flexibility of Ucits III, which allows the use of derivatives. If effective, they can help advisers manage client objectives.
There are other risks apart from short-term volatility and counterparty risk that low risk investors need to consider.
Rainsford says inflation and longevity risk can affect how asset classes are perceived and used in a portfolio. An individual's investment horizon in particular will affect how different asset classes are used.
"Timescale will feature in the whole portfolio equation, so equities may be deemed in fact lower-risk than cash on a long-term basis because the risk of inflation reducing the purchasing power of the latter," he says.
Yet the overriding message remains the same: diversification is paramount if a client's long-term objectives are to be met. Even very low-risk investors cannot rely on the security of cash alone to secure their financial future.
Rainsford concludes: "Despite the current turmoil in markets, investors seeking income and/or capital growth have to accept that their current or future income needs will have to be drawn from a portfolio that has some breadth in terms of asset diversification, because low-risk or 'safe' investments are unlikely to deliver real returns over the long term."
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