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Don’t fall into asset trap

It's important to not fall into asset trap

Without experience, it is easy to fall into the trap of trying to reduce risk by adding more assets to a portfolio, without deeply understanding the links between the individual components.

In any professional undertaking, there is a base level of knowledge that you need to know just to get started.  This base knowledge is often taught in segments or subjects, and so at the time of learning, the components seem discrete from one another.  This is true of economics and finance where the characteristics of bond, equity and property assets are carefully considered on the one hand and the benefits of diversification on the other.

Without experience, it is easy to fall into the trap of trying to reduce risk by adding more assets to a portfolio, without deeply understanding the links between the individual components.  Daily we see very basic examples of this – a new client will present with an existing portfolio that includes several managed funds.  They’ve been told the portfolio is diversified because the funds are run by different fund managers, but they don’t realise that the underlying assets in all the funds are more or less the same.  A portfolio containing say, the Perpetual Australian Shares Fund, the AMP Australian Share Fund and the Colonial First State Australian Share Fund is for example hardly diversified at all.  That’s not to say you cannot build a diversified portfolio using funds, but to do that you really have to know what the underlying assets are, and how they interact.  An adviser who knows that is starting to add some value.

The origin of the Global Financial Crisis (GFC) lay in home ownership policies in the USA which made it very easy for people on low incomes to buy houses.  This was seen as a ‘social good’ that could be funded by the private sector (and also some government-related entities).  Using a process known as securitisation, the loans underlying the house purchases were packaged up and sold, enabling more loans to be made with the proceeds.  Securitisation is a very common practice and a great tool if managed well.  Making sure that the package of loans is very likely to be repaid is paramount.

With the ‘socially good’ government policy in full swing, more and more loans were written to people on low incomes.  Financial products known as Collateralised Debt Obligations (CDO) were developed to provide exposure to different levels of risk within the securitised pool of loans.  The securitisation market went into overdrive – until people began to default on their loans.  The value of the securitised loan packages and CDOs, which were held as investments by many financial and other institutions, began to fall. This damaged balance sheets and rendered banks and other financiers unable to lend.  They rapidly started calling in loans, even loans to sound companies.  Before long it was a tsunami of grief, resulting in a collapse in asset prices as investors large and small ran for the door.  At the time I recognised the problem with CDOs (we never bought any), but I did not comprehend just how widespread the carnage would be when it all went wrong (thankfully we did recognise just how undervalued assets became, and on account of that we got out of the hole relatively quickly).

The lesson from the GFC is that seemingly unrelated assets (e.g. residential real estate in the USA; Australian equities) can become related through means that are not obvious at first blush.  In the case of the GFC, it was debt that bound everything together.

Last week Greensill Capital was in the news for all the wrong reasons.  Greensill is a huge provider of debtor financing, which means that it lends money to businesses on the back of invoices.  This process used to be called debt factoring, and it can be a useful tool for businesses providing goods and services to get paid quicker than they otherwise would.  But now Greensill is in administration and parts of it are being liquidated.  The reason – insurers that effectively underwrite the value of the loans Greensill made refused to renew the policy.

Now, this would not matter if it was a one-off event, but insurers all over the world are fighting for survival anyway.  That’s because the very low (indeed, sometimes negative) interest rates earned on lower volatility assets like bonds means that the assets that underpin insurance policies are not growing in value.  At the same time policies of Western Governments (including our own – witness the results of the Hayne Royal Commission), encourage litigation and complaint, massively increasing the burden on insurers.  The result is that insurers are withdrawing from insurance markets and refusing to insure some customers.

The Greensill loan book is valued at about $US143 billion.  Losses on that will spread far and wide.  If it’s a one-off, it might be contained.  If it’s not, it could lead to a global failure of insurance markets that will bring financial markets undone.

Please note this article provides general advice only and has not taken your personal, business or financial circumstances into consideration.

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Originally Published – Thursday, 18 March, 2021
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