Part one: Australia's advice industry
On Monday, 8 December 2008, a series of phone calls were made that changed the lives of 3000 people.
On this day, representatives from Colonial Geared Investments (CGI) phoned clients linked to financial advisory group Storm Financial to inform them their investments were in margin call and their portfolios had been sold.
If this wasn't enough, 450 of the investors were told their portfolios were liquidated due to a shortfall in their loan-to-valuation ratio (LVR), placing them in negative equity, and subsequently facing financial ruin.
On Wednesday, 10 December 2008, CGI's parent company, Commonwealth Bank of Australia (CBA), shut down all Storm index funds, and in doing so pulled the plug on its 10-year relationship with Storm.
Two days later on 12 December, ASIC launched an investigation into Storm, allegedly providing the firm's managing directors with an enforceable undertaking and placing a gag order on its financial advisers. Until this day, the corporate watchdog denies any such undertaking existed.
The following month, on 15 January, Storm founders Emmanuel and Julie Cassimatis were forced to close up shop after CBA appointed KordaMentha as receivers and managers of the business.
The end result, less than two months after the phones of Storm investors began ringing, was that more than $30 million worth of funds were lost, a large portion of Australia's financial services industry realised an exposure to the failed firm, and one of the most aggressive overhauls of Australia's financial advisory industry since 2001's financial services reform was waiting in the wings.
The blame game
News of Storm's failure quickly filtered through the industry. Widespread panic took hold, with blame for investor losses placed on the now tiring shoulders of financial planners.
As Storm's fall came two months after the plummet of global financial markets, and many investors were already suffering considerable losses in their investments, emotional discontent was at a record high, and climbing.
In early January, institutional lenders began distancing themselves from Storm, with Macquarie selling the bulk of its margin lending portfolio, worth $1.5 billion, to Leveraged Equities, a wholly-owned subsidiary of Bendigo and Adelaide Bank.
At the time, fellow Storm lenders CBA and Bank of Queensland went to ground.
Whispers also began penetrating the market that greed was the cause of Storm's failings, with suggestions that advisers were pushing clients into high-risk products in an attempt to claw back lost funds through commission payments due to the global financial crisis (GFC).
On 26 February, the government stepped in, with a Parliamentary Joint Committee launching an inquiry into the collapse of Storm and other corporate failures of 2009.
The committee, fronted by Labor MP Bernie Ripoll, was committed to examine, among other issues, the role of the financial adviser, and any potential conflicts of interest that exist in some financial products and the associated advisory services.
"The collapse of Storm has had a catastrophic effect on thousands of people and has been a major focus of the inquiry, with over 200 submissions coming from former Storm investors," Ripoll said last month.
"Although the committee cannot make judgments about unlawful conduct, there were clearly multiple failures by Storm Financial and some lending institutions.
"By recommending aggressive leveraged lending strategies to elderly people on low incomes, Storm's advisers were not providing advice that was appropriate to their clients' needs."
Industry action
On 1 May, the FPA took a stand for the advice industry and called for an end to commission-based fees. The association proposed that from 2012 fee-based remuneration would become the standard fee model.
"We launched the remuneration policy amidst much controversy and have now finalised this for wealth management products," FPA chair Julie Berry said.
"Risk products remain outside of this policy and will be the subject of further review and discussion. The FPA has led this debate from being a long-winded, emotional and impassioned debate to a reality."
The FPA's proposal was met with much debate. While many within the industry believed the canning of commissions was long overdue, others started banging the drum for consumer choice.
Among the many to oppose the FPA's proposal was federal opposition finance spokesman Joe Hockey, who declared at last month's FPA conference that his party will not support the banning of adviser commission payments.
"The Liberal Party will not support the banning of commissions. We will not do that," Hockey said.
"This is a difficult area to go in, I understand that, and I recognise the good work the FPA has done in relation to this.
"There is a trend away from commissions. This is where financial planners become part of the profession and to become part of a profession does require a higher level of educational standards - I know you've been working on that."
As the simmering debate over adviser commissions or fees bubbled over, the momentum of change continued to move through the industry.
"There is no doubt that as a result of the significant market correction investor and adviser sentiment dropped to an all-time low - and therein investor and adviser confidence equally dropped to an all-time low," BT Financial Group general manager of advice and private banking Geoff Lloyd says.
"It's really been corporate failure, not system failure. So I think everybody involved in the value chain is very disappointed in whenever there is any individual example of where quality of advice hasn't been given.
"I'm not putting that at all in the context of any brand, but there is no doubt, I think, we could have done a better job as a profession."
On 17 June, the Investment and Financial Services Association (IFSA) followed the FPA's lead and released a charter to create a fairer and more competitive superannuation system.
Under the new standards, fees for financial advice would be clearly separated from the fees members paid for their superannuation, IFSA chief executive John Brogden said.
"Australians can now 'turn on' or 'turn off' financial advice fees in their superannuation and negotiate advice fees in super with their adviser," Brogden said.
IFSA member companies endorsed the member charter in November after a seven-month member consultation period.
Association members have begun the process of unbundling advice and product costs to empower consumers with greater choice and control in how they pay for financial advice.
For Consultum Financial Advisers head Stuart Abley, the FPA and IFSA proposals reinforced the dealer group's own position to move to a fee-for-service offering. "We're very strong advocates in moving to a fee-based arrangement and have plenty of practices on that journey already," Abley says.
"We're anticipating that the changes will go ahead pretty much in line with IFSA and FPA's agenda, but that includes asset-based fee-for-service arrangements. We are believers of offering a fair bit of choice in how consumers or clients pay for their fees.
"We don't believe there should be just an hourly rate set for a fee. We do believe in choice and we do believe in choice of collection method as well."
Lloyd says BT/Westpac is one institution that has embraced change. "Although I'm very proud of the profession of advice, I think we can use the energy and the focus that has come on the profession and the overall value chain as a great opportunity to continue," he says.
"BT/Westpac, pre the merger, we really wanted to unbundle advice from product and we saw this change coming and very particularly in our organisational design.
"The merger is behind us and now we're focusing on how we can look forward to build an effective regulatory environment - our goal is to have all Australians have access to affordable advice, to significantly raise the quality of advice in Australia and lastly to look to how we can simplify super so more people engage in it."
Further advice snag
The advice profession took another hit in April and May when agribusiness firms Timbercorp (on 23 April) and Great Southern (on 16 May) were placed in administration. Again the issue of commissions raised its head with investors raging. Financial planners were again in the firing line, with authorised representatives dragged behind them.
"Initially when word came out in regards to the collapses of Timbercorp and Great Southern and there was a lot of implications coming up in the media in regards to accountants, we were rather concerned so we did some investigation ourselves," Institute of Chartered Accountants in Australia head of financial planning and superannuation Hugh Elvy says.
"When you look at it, the MIS (managed investment scheme) situation, yes we had members who were actually involved, we don't believe it was a great number but again what we've found in the last 12 months is that the various collapses and downturn in the markets have actually been a real positive for a lot of people because it's meant that they've had to stop, look at their business model, look at their practice and actually review it."
While Elvy says there is no doubt chartered accountants were involved in providing advice on Great Southern products, in context the exposure is quite small.
In July, the retail advice industry took another heavy knock when ASIC gave the green light to its intra-fund advice initiative, enabling Australia's superannuation fund sector to offer single-issue advice to members. The decision left many in the advice industry on the back foot, though the outcome of the Ripoll report was looming for the industry.
D-day
On 23 November, Ripoll delivered his findings after a 10-month investigation.
"As the events of 2008 demonstrated, Storm's model was not capable of withstanding a severe market downturn. Its success was predicated on the market continuing to rise indefinitely," the report concluded.
"The buffer and LVR settings proved to be such that, when the market fell rapidly, there was insufficient time and capacity to put accounts back into order before they fell into negative equity.
"The responsibility for this failure to resolve margin calls may well be shared between several parties, but that does not change the fact that the strategy failed.
"The committee is of a clear view that Storm's aggressive leveraged strategy, in combination with the failure of multiple parties to appropriately monitor and manage margin calls at the height of the market volatility, were of disastrous effect for Storm's investment clients.
"The effects are greatest on those for whom this strategy simply cannot be considered appropriate advice - that is, those who were at or near the end of their working lives, with limited capacity to rebuild from scratch in the event that all their assets were lost and they found themselves in negative equity."
The findings of the report made a lacklustre impression, with Storm Investors Consumer Action Group joint-chairman Mark Weir saying the group was disappointed with the recommendations.
"We did not wake up to a brave new world. It wasn't sort of a big bang projection of any legislative changes, particularly with regard to the projected manner in which client advisers get their fees," Weir says.
"It was more of an incremental approach to change and given that the industry is largely made up of well-meaning and well-intentioned practitioners, to have introduced sudden reform would have been unfair to those in the industry."
As 2009 draws to a close, the physical and emotional scars of the past year will no doubt remain, though it is hoped 2010 will provide a time for healing.
Part two: Investing after the crisis
Out of the past 12 months, March was probably the most important period. It marked the end of market paralysis and money started to flow back into the system.
Gwydion Williams made an interesting point in his otherwise uninspiring socialist pamphlet "Adam Smith - Wealth without Nations".
"It's an odd truth that scientists were able to predict the future development of the supernova that exploded in 1987, and track it as it has developed more or less as expected, whereas the drastic stock-market collapse of the same year was a surprise, predictable only on the commonsense logic that overvalued stocks must crash eventually. Much the same was true with the 1998 Asian crisis," Williams wrote.
We can now add that the same was also true for the global financial crisis (GFC) of 2008. Although a number of people, including the bright minds of the Bank of International Settlements, had pointed out the dangers inherent in the carving up of risk through financial engineering, nobody predicted the exact start of the GFC, or the severity with which it was going to hit global markets.
Despite of all the world's technological achievements, the course financial markets take remains a mystery, and crises keep creeping up on unexpected investors.
National Australia Bank chief economist Alan Oster is frank in his admission that he did not see the crisis coming.
"I've been in the forecasting game for 30 years and I haven't seen anything like it. I don't think anybody alive has seen anything like this," Oster says.
"I hope I will never see it again."
His explanation for the difficulty in predicting crises is simple and logical.
"I don't think you could ever forecast anything like that, because systemic shocks are by definition unprecedented. You can't use average behaviour on something that is systemic," he says.
In a similar fashion, nobody can accurately predict when a crisis will end. Yet, looking back over the past 12 months, March was certainly a good month.
In ancient Rome, when life was still closely tied to the seasons, the beginning of a new year started in March, the first month of spring.
As far as Australian investors are concerned, 2009 may as well have started in March, as this month marked the end of the collective paralysis and stock markets started to move up again. Since then the ASX 200 Index has gained 50 per cent.
Although it is hard to call the end of the crisis - and there are certainly still enough people who believe more trouble lies ahead when stimulus packages are withdrawn - the months after March have offered enough reprieve to give an insight into the extent the crisis has impacted on the investment industry.
The lucky country
Although Australia did not escape the GFC, it certainly has done better than most Western economies.
"We didn't have a technical recession," AMP Capital Investors chief economist Shane Oliver says.
"We had one negative quarter [of gross domestic product growth] in the December quarter of last year. Over the year as a whole the economy has actually expanded, whereas all other advanced countries have gone backwards."
The limited rise in Australian unemployment figures during the crisis is another good indication of the health of our economy, Oliver says.
"Whereas our unemployment has gone up from 3.9 to 5.8 per cent currently, in other [economies] it is headed up to 10 per cent - currently over 10 per cent in the US and close to 10 per cent in Europe. There is no doubt that Australia has performed better than any other country," he says.
The reasons for the stability of the Australian economy are diverse. Economists suggest strong exports to China, a shortage of housing, a solid regulatory framework, and a quick government response in the form of a stimulus package have all contributed to stability.
But this should not lead people to believe Australia is bulletproof, Oliver says. "I don't think that Australia can sit back and relax because all that has happened is we survived this particular crisis," he says.
Redemptions
The impact of the crisis on Australia might not have been as severe as it could have been, but it certainly has left its traces and, occasionally, scars.
The sharp drop in share prices was a major problem in itself, but not a unique event in itself. What was unexpected was the blow out of fund redemptions.
The fear-fuelled flight to cash by retail investors caused redemption requests to spike to abnormally high levels, and systems were not ready for this mass migration of money. It forced a number of fund managers to put restrictions in place, while others had to shut down their funds entirely.
BT Investment Management had to close down its BT Global Return Fund, which was managed by US fund-of-hedge-fund manager Grosvenor Capital Management.
"We had a relationship with Grosvenor and we did have to terminate that fund and return that money to clients," BT Investment Management head of multi-strategies Robert Swift says.
"We have now given back 75 per cent of the capital to clients. I think we dealt with a difficult situation relatively well."
Swift says the closing of the fund was the biggest challenge he and his team had to face during the crisis, but the collapse was largely symptomatic of the problems of the wider hedge fund industry.
"The reason that Grosvenor got into a jam [was] that their underlying managers themselves were relying on other funds of hedge funds for their capital," he says.
"Many of these managers had lock-ups and were invested in illiquid parts of the capital structure, so when the demands simultaneously hit for the cash it was inevitable that some of the underlying managers said 'sorry, we can't do that'."
A changed industry
The woes among hedge funds have led to some significant changes in this industry.
Investors have called for the end of the black box strategies, where they get only limited insight into the actual investment process practised by a fund.
They now demand transparent strategies. But perhaps a more dramatic change is that they are no longer prepared to pay for simple market exposure, also known as beta.
"Most hedge funds would be net long in the market. If the market goes up they look like geniuses, but most of that comes from market exposure and they would have economics that would enable them to be paid, when in fact it works out you could buy beta in futures and bond futures. You can buy beta for almost nothing," Swift says.
"Beta is a good thing; generally you want an exposure to market risk. It is just that you shouldn't pay a lot for it."
As a result, clients are now demanding different pricing models for returns that are achieved as a result of a manager's investment skills and returns that are achieved through market exposure, a development also known as the separation of alpha and beta.
This will lead to more fund managers introducing performance fees, in which most of their remuneration comes from beating the benchmark.
"The quid pro quo for the manager is that they get the certainty of those assets, because one of the problems of the industry is that there is a lot of money flying around and allocations come and go and that makes it difficult to invest," Swift says.
Stick to your guns
Colonial First State (CFS) head of FirstChoice Investments Scott Tully agrees redemptions were the toughest issue to deal with during the crisis and CFS was also forced to terminate one of its funds, the CFS Income Fund.
However, Tully says the lack of liquidity in the market also led to significant problems in executing investment processes.
"The main challenge was ensuring we could rebalance our funds," he says.
"To stay in line with our strategic allocations we had to sell bonds to raise capital."
The struggles with redemptions and problems caused by a lack of liquidity sparked a rethinking of CFS's investment processes, but ultimately the decision was made to stick to the existing strategy, he says.
"We were very careful not to react to something that was a very infrequent event," he says.
Good models are built on averages, not on extreme anomalies. If CFS had overhauled its processes and, for example, scaled back its exposure to equities, it would not have benefited from the rebound in the markets since March, he says.
Disillusion with a safe haven
Another nasty surprise of the crisis was that some fixed income allocations experienced heavy declines, leaving financial planners and their clients equally baffled as to why this traditional safe haven failed.
"When the GFC hit, the defensive assets that were supposed to protect them went down and didn't behave as they should have," Kapstream Capital founder and director Kumar Palghat says.
"The only thing that did not fall was sovereign bonds."
Palghat says this sparked questions about the true correlation among the different asset classes.
"Clients now look at how to construct their portfolio so that the defensive part really acts defensive," he says.
The problem with a number of fixed interest funds was that as the boom years continued, some managers took on more corporate loans, or credit, in their portfolios.
However, as the crisis hit, these loans turned out to be heavily correlated with equities and followed their decline. After all, corporate failure would also mean credit investors would lose out.
Institutions are now looking to split the various fixed income asset classes into categories such as government bonds, emerging market bonds and credit. And as often happens with innovations in the funds management industry, this development may trickle down to the retail industry.
Yet the collapse of credit also provided opportunities. Kapstream was one of the fixed interest managers that did not fall for the temptation to prop up returns by adding irresponsibly high amounts of corporate debt.
As a result it has done well during the crisis. "We had only three months of underperformance and the biggest one was just 18 basis points," Kumar says.
As a result, the Challenger-backed firm has continued to see inflows and built up its funds under management since its establishment in 2006 to $700 million.
Simplicity
The heavy decline of investments, unexpected behaviour of some asset classes and the freezing up of funds created an environment of scepticism among investors, and this was followed by a push for simple and easy-to-understand products.
Exotic is out. There is no more demand for products with three-letter acronyms that rely heavily on financial engineering.
Schroders Australia chief executive Greg Cooper sees the move to simplicity as a vindication of the company's investment approach.
"If anything, the GFC was a proved-right thing for us last year," Cooper says.
"We have been saying for years that there was too much complexity in the system."
He says there should be more attention on the end result that investors are looking to achieve.
"If a manager outperforms by 5 per cent, but the market is down 25 per cent, that is not really that useful for a client in achieving their CPI (consumer price index) plus 5 per cent objective. At the end of the day, if you aggregate things up, you can build a better alignment between a manager and their clients," he says.
He says he feels there is still too much complexity in the industry due to the large number of managers, offering too many products. This unnecessary level of specialisation does not assist investors in achieving their goals, he says.
"I would argue that over the last decade the number of managers has gone up threefold, but the amount of talent hasn't gone up threefold. So net for clients there is less talented people per manager out there," he says.
