Storm Financial’s formula for investment success was fundamentally flawed, and should have sent warning signs to investors with even minimal investment skills. MICHAEL LAURENCE asks long-time investor specialists how to identify investment advisers that should be avoided.
The stories from clients of Storm Financial have been heartbreaking.
Take Phil Green, who has an income of just $50,000 a year yet owes $1.5 million in investment loans.
Or retiree Gary Dietrich, who now lives in a caravan parked in his son’s backyard after accepting advice from Storm Financial to invest the proceeds from the sale of his joinery business into the market plus another $1.1 million in borrowed money. Gary and his wife Pauline have lost their Townsville home along with their geared portfolio.
Or the 68-year-old local farmer who told The Chronicle in Toowoomba he had lost $3.4 million after borrowing heavily to invest in shares. He is now in the process of applying for the aged pension, but was remarkably philosophical about his predicament. “We’ve been up dry gullies before,” he told the paper.
The experiences of these three investors alone illustrate basic flaws in Storm’s advice. The apparently standard strategy recommended by Storm to many of their clients of double gearing – that is, borrowing against a family home to buy shares and then to borrow again against those shares – is truly a high-risk practice that would suit very few investors, particularly retirees and lower-income earners.
To make matters worse, in November last year as share prices continued to plunge, Storm advised their clients with margin loans to sell out of their index share funds and to put whatever remained into cash. This crystallised their losses. In January, Storm entered voluntary administration.
Many Storm clients appear to have placed a huge amount of trust in their financial adviser. Quality financial planners can make a highly valuable contribution to the financial well being and financial education of their clients. But the choice of the right adviser is one of the most important decisions that an investor can ever make.
SmartCompany asked four veteran investment specialists to give their pointers to help investors identify financial planners who should be avoided. Significantly, these specialists spoke freely after being assured that they were not being asked to comment about what may or may not have occurred involving Storm Financial.
ONE. Stay away from an adviser recommending double-jeopardy borrowing: This typically involves borrowing against your family home to buy shares and then taking a margin loan against those shares.
Paul Resnik, principal of the Paul Resnik Consulting Group and co-founder of investment-risk profiler FinaMetrica, suggests that if this double-borrowing strategy is recommended to you then the only response is to “run like mad”. Resnik describes himself as an investor advocate.
“This strategy is for those few that have no alternative way of building wealth only when all the more sensible alternatives have been found wanting,” he says.
TWO. Be cautious about an adviser who recommends any type of aggressive borrowing: This is, of course, is related to the first point. Dominic McCormick, chief investment officer of Select Asset Management, says aggressive investment borrowing suits only sophisticated investors who make up a tiny minority of investors.
Resnik says any investment borrowing should pass what he considers the three primary laws of gearing; the lowest possible interest costs, the longest possible time before the money is repayable, and investment in a diversified portfolio of “appropriate growth stocks” if investing in shares.
Peter Thornhill, long-time share investor and principal of personal finance education firm Motivated Money, describes excessive debt as “absolute madness” for investors. “This is fundamental; debt is a killer.”
Thornhill personally has geared into the sharemarket for many years but he keeps his borrowing under careful control. “Debt is a very effective way of creating debt; but an investor’s debt should always be modest.”
Noel Whittaker, veteran investment adviser and prolific author of some of Australia’s best-selling personal investment books, becomes concerned when advisers suggest aggressive borrowing to their clients. “Always remember the golden rule of borrowing; only borrow when you need to,” he says. Whittaker is also a director of large Queensland-based financial planning group Whittaker Macnaught.
Whittaker, who a few years ago co-authored a book with Paul Resnik – Borrowing to Invest – the Fast Way to Wealth? – is convinced that aggressive borrowing can be justified only if the investor has plenty of other non-geared assets.
If your adviser advocates heavy gearing of your investments, Whittaker says you should always understand why. “Under law, an adviser has to justify [to their clients] why a strategy is recommended.”
THREE. Realise that an adviser is not up to standard if recommending heavy borrowing on the eve of retirement or when your business is struggling: “This is fundamental,” Whittaker says.
FOUR. Don’t seek advice from an adviser who advocates margin lending without fully explaining its risks: It is generally better to use margin lending as the last resort, Resnik argues. “Surprise loan-to-value ratio changes [the amount outstanding on the loan as a ratio of the prevailing share price], margin calls, and redemption delays [not all units in managed share funds are necessarily sold immediately upon request] are all inevitable when markets are volatile and heading south,” he says. “It’s better to use borrowings secured against a home or a low-cost personal loan.”
FIVE. Watch for advisers who may receive higher rewards for poor advice: McCormick says investors should understand how their advisers are remunerated. And he is emphatic that investors should, in turn, know if their adviser could receive incentives for possibly giving the wrong advice.
For instance, McCormick points out that advisers who charge commissions based on a percentage of invested assets will receive more by getting their clients to excessively gear.
And he explains that advisers who arrange for their clients to take a home equity loan to invest and then to take margin loans to further gear could be receiving a succession of financial rewards – commissions on the home-equity loan, commissions on the initial amount invested, commissions on the margin loan, and then more commissions on the extra amount invested.
Depending upon the circumstances, McCormick says that the most appropriate advice for some clients may be to pay off the remainder of their home loans rather than to invest in the sharemarket.
However, McCormick emphasises that some advisers are remunerated on a fee-for-service basis. And, of course, because some advisers may have a financial incentive to give the wrong advice doesn’t necessarily mean they do so. “Some advisers can still deal with conflicts and give right advice,” he says.
As Thornhill emphasises, high commissions paid to financial planners and for use of investment platforms mean that many investors have to rely on capital gains, not income, from their share portfolios. “That doesn’t work when share prices are tanking.”
Thornhill firmly believes that an adviser’s remuneration should be based on services provided. “Commission on assets under management is a definite no- no.
“And if you are asked to pay upfront commission of 7% of the amount invest, you should laugh as you walk away,” Thornhill adds.
As Whittaker says, advisers are legally required to disclose their remuneration to clients in a statement of advice (SoA). But he stresses, these statements are typically about 90 pages long. “And the bigger the document, the more someone can hide.”
He says clients should ensure that they can either understand the amount of fees they are being asked to pay or have the fees explained to them.
A smart idea, SmartCompany suggests, would be to check the charges being quoted with several advisers to ensure the amounts are reasonable.
SIX. Stay away from an adviser who doesn’t take your personal tolerance to risk into account: Investment strategies should be carefully tailored for each investor’s circumstances, yet some advisers appear to use the same strategy regardless of the investors’ ages, financial positions, income and, crucially, their personal tolerance to risk. Resnik says a warning sign is when an adviser tells clients that he is personally using an identical investment strategy to them.
McCormick says most financial planners would, correctly, give investment advice to clients based on three to four categories from conservative risk profiles to aggressive risk profiles. And then they provided additional particular advice to each client about such matters as tax and estate planning.
“To advise all clients to adopt an aggressive strategy would be very dangerous,” McCormick says. And, alternatively, he would also be concerned if all of a firm’s clients were advised to have all-cash portfolios.
SEVEN. Be suspicious of an adviser who doesn’t discuss the worst-case outcome from a recommended strategy: Resnik says an adviser shouldn’t only concentrate on the possible upside. Your portfolio should be stress-tested to measure how you would cope if markets and interest rates really turned against you.
EIGHT. Stay away from an adviser who is not educating you about your personal finances and about investment markets: Thornhill says an adviser’s first responsibility, in his opinion, is to educate clients – not to buy and sell investments for them. “We can transact ourselves on the internet for next to nothing.
“Advisers are there to give us the knowledge to make the best quality investment decisions,” Thornhill says. (Also see the next point about strategic advice.)
“An adviser should be explaining in very simple terms to match your knowledge,” he argues. “There is nothing complicated about investing. It is a very straightforward, rational process.”
He believes that a vital piece of investment education that advisers should provide is about the danger of moving from shares into an all-cash portfolio after the market has sharply fallen.
Apart from selling out at depressed prices, Thornhill says investors will miss out on valuable dividends, which he believes won’t fall as low as interest rates being earned on cash. “Our asset values [in share portfolios] may have halved, but our dividend income hasn’t. “
He says advisers should ensure that their clients understand why share prices rise and fall. In turn, this will help them make the right decisions in bull and bear markets. And advisers should explain to their clients the difference between investing and speculating.
McCormick agrees with Thornhill that one of the basics that advisers should be teaching their clients is how to go through a severe market downturn.
NINE. Expect a quality adviser to provide excellent strategic advice: Thornhill says this advice should not only deal with the investment markets and about selecting investments, but such issues as tax and superannuation (including making contributions within the annual limits) to name just two.
Whittaker agrees. Rather than quickly zooming in on investment products, advisers should be discussing personal finance issues that were relevant to their clients’ circumstances.
He says such issues may include the tax treatment of your superannuation savings in the event of your death, powers of attorney, whether to have a binding death benefit nomination for your super, whether to change to an interest-only home loan upon reaching 55 or 60 (depending upon your date of birth, your super may then become accessible if your job is lost), the advantages of salary-sacrificed super contributions, and whether to take transition-to-retirement pensions upon reaching 55.
Whittaker describes some of these issues as “no-brainers” that advisers should be discussing with their clients.
TEN. Don’t think your adviser is necessarily giving the right advice just because you have had a long relationship: Some investors may have had success in the investment markets by following the advice of the same adviser for many years. Nevertheless, investors should never relax their scrutiny of that adviser. Try to ensure that the advice remains of the highest quality and is still appropriate for your changing personal circumstances.
A trap is not detecting that some advisers may be simply telling you what they think you want to hear. “Many advisers are no bloody smarter than their clients,” Thornhill says. “And their guidance is nothing more than a shallow reflection of their clients’ prejudices. They go out and attract greedy or ignorant people.”
ELEVEN. Stay away from an adviser who promotes an allegedly world-beating investment model or trading model: “Walk away from such advisers [or any other spruikers],” says Thornhill. “Chances are you are being sold a pup. In 43 years of investment, I have never seen a model that works. If it seems too good be true; it is.”
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