He who rejects change is the architect of decay. The only human institution which rejects progress is the cemetery. - Harold Wilson
Many portfolio managers, as well as investors, are struggling to make sense of the current investment environment.
Since the credit crunch cut a swathe through financial markets last year, some investment strategies and asset classes investors traditionally thought of as safe havens have been proven to be quite the opposite.
The recent clear out of the credit market and the complex securitisation structures that underpinned some of the fixed interest space, using mortgages at the base, has cast a shadow over how much investors really understand what they are getting into.
"The market has been so good for mums and dads investors that everything they have touched has turned to gold," University of New South Wales associate professor of finance David Gallagher says.
"Growth in asset classes has been phenomenal over the last four to five years. I don't believe those kind of returns are sustainable.
"Investors should back their investment objectives, realise the past few years have been particularly strong, but that markets do go up and down."
According to Adviser Edge research, listed property trusts crashed by over 35 per cent around the world during December and January on fears of a global economic downturn and a number of very large listed trusts being on the verge of bankruptcy.
High-yield fixed interest funds also took a battering in the second half of 2007, with many Australian credit-focused funds going backwards and posting negative returns.
Funds with exposure to the banking sector were the most severely hit as the financial sector globally reacted badly to write-downs on the back of sub-prime losses. Most of the funds in diversified credit, high-yield and multi-strategy income categories failed to achieve a return anywhere close to the cash rate for the year.
"The free lunch offered by credit investing over the last few years has come to an abrupt halt in 2007, although an improvement in market liquidity and stabilising credit spreads means we can only hope that this trend is not set to continue into 2008," Morningstar analyst Sallyanne Cook says. Gallagher says investors need to fully understand their investment objectives and be prepared to invest for the long run.
"Hopefully there is no knee-jerk reaction to the current climate," he says.
"In any portfolio you need a core of high-quality assets and then around the margin, depending on the size of portfolio and the risk-return objective, you can add those niche-type products.
"Ultimately we hope that investors are diversified and that they are in good-quality assets."
Morningstar research shows the safest place to be in 2007 was cash, the UBS Australian Bank Bill Index providing a return of 6.66 per cent compared with the average return of 3.13 per cent for fixed income funds.
Macquarie Adviser Services head of cash sales Grant McCorquodale says with rising interest rates and volatile investment markets, the interest in cash as a depository has increased.
"We have seen a strong move by investors to increase their allocation to cash at this time," McCorquodale says.
"It's perhaps a consequence of the shock and nervousness investors are feeling during these volatile markets that it is now being seen as a yield play.
"The key role of a proper cash management system is to ensure that capital still accumulates so when investments do get made, whether it is this month or in a few months' time, the capital is still there and hasn't been consumed."
New accounts in the Macquarie Cash Management Trust (CMT) grew by 45 per cent in 2007 over the previous year and it now holds $17.6 billion in funds under management.
McCorquodale says investors are starting to understand how important cash-flow management is for maintaining investment strategies.
"The initial step is always to separate consumer cash flow from investment cash flow," he says.
He says this allows the investment cash flow to be identified and used for future investment, rather than being lost to consumption.
"Cash-flow management is core to a successful investment strategy. It's important that investors understand the relationship between the money they are placing into financial markets and the dividends interest coming back to your cash flow," he says.
"For example, if you are taking on a leveraged position you need to ensure there is sufficient cash flow coming back into the system to perhaps fund a gearing position.
"Advisers recognise when a client seeks advice they are saying two things, firstly, that I wish to create wealth, and secondly, that the way I am doing it now might not be working as well as it could." The markets have undergone in some ways a paradigm shift. Property and fixed income, in their many guises, have traditionally been used as not only a diversifier for equities, but asset classes that created wealth in their own right.
The derivative, gearing and structuring tools, which were only the realm of the inter-bank market not long ago, have now found their way to the retail investor.
JP Morgan instalment warrants expert Mark Flynn says while the current environment is quite tough given the market pull back, the opportunity is there for investors to still look at equities that were previously overpriced.
"It's not a time to be jumping in and buying your whole portfolio right now, but it's an opportunity for some people to build a portfolio over the next six months, looking at stocks that may have been oversold," Flynn says.
"With instalment warrants the ultimate bottom line is that you need to have a positive view of the market. It involves gearing and one of the risks of the warrant is that interest costs may out weigh the gain on the transaction."
But the risks of these tools must be understood.
"The underlying risk of instalments is that it has a greater level of leverage than the underlying securities, so you need to manage that risk," Flynn says.
Gallagher says investors must realise that changing investment strategies could end up being a costly process.
"Transaction costs can be quite significant, going in and out of cash, particularly if they are liquidating their assets," he says.
"I'm hoping there aren't unscrupulous planners out there, and I'm sure there aren't, that are using this volatility to get clients to switch in and out of different products and catch a fee for the transfer."
