Adventurous Investor

June 28, 2013 6:02 pm

I confess, Co-op hybrids were a mistake

The key is to learn from blunders

The American lawyer and polymath Edward John Phelps famously said that “the man who makes no mistakes does not usually make anything”. It’s the same with investment – everything you do carries risk, and occasionally things will go wrong.

Having an adventurous bent probably increases those risks still further, but for me the key is to learn from those mistakes, understand what happened and sense what they tell us about the future.

So into the confessional I go. “Forgive me Father, but I bought hybrid securities in the Co-operative Bank, thinking it to be a mutual with solid principles and solid finances, and considering the coupons on the old Britannia permanent interest-bearing shares to be most attractive . . .”

I must point out that I didn’t go into this with my eyes shut. I’ve always been fairly cautious about these income-producing instruments, largely because when push comes to shove, the issuers can and will stop the coupon payments (remember Northern Rock and Bradford & Bingley ) and then try and “renegotiate’’ with investors the value of the structures. Investors need to understand the creditworthiness of the issuer and all hybrids are absolutely not created equally.

All my friends in the City used to chuckle mercilessly whenever I mentioned the Co-op Bank, especially after the Moody’s downgrade in May. They’d mutter darkly about “more to come” and “trickling out the bad news”. They were right, and my holding in the 13 per cent subordinated bonds (CPBC) has taken a hammering.

Lessons to learn? That mutuals are not always good, and investors need to think long and hard about the reliability of a great brand name. That sometimes even a substantial brand is just too small to play in a big boys’ game. Action to take? None, for now. I’d rather take my chances in the restructuring, details of which will not be forthcoming until October, than sell at a big loss in the market now. Elsewhere in the pibs and prefs market, my guess is that outfits like Nationwide and Coventry are still first-rate bets, despite the former’s run-in with the Prudential Regulatory Authority over leverage ratios.

My next confession relates to stock market-listed closed-end funds. This is an area where good ideas can go bad very, very quickly, especially if the underlying assets are in relatively illiquid assets. Take PSource Structured Debt. I talked about this very niche fund a few years back as part of a wider discussion about the merits of using complex structures to invest in loans to small and midsized US companies. This doesn’t need to end in disaster and listed funds with similar mandates such as Carador Loan Income fund have gone on to produce excellent numbers. But PSource has officially gone wrong in a very major way, voluntarily winding up with a closing price of less than 1p.

If it looks too good to be true, it probably is; beware illiquid assets; and try to back managers who will proactively cut costs and help out suffering investors, rather than just help themselves to fees

- David Stevenson

I was originally attracted by the huge discrepancy between net asset value and the share price, which suggested possible value. Instead it proved a value trap. Those assets were fairly illiquid and are proving difficult to sell, but the real humdinger for me is that the fund managers continued to pocket their fees for managing the fund into oblivion – and are now being incentivised to sell the remaining assets.

My learning points here: if it looks too good to be true, it probably is; beware illiquid assets; and try to back managers who will proactively cut costs and help out suffering investors, rather than just help themselves to fees.

My last admission is more of a warning. I’ve mentioned the rise of low volatility index tracking exchange traded funds a number of times in this column. The idea is deceptively simple and involves screening an index like the FTSE 100 for the most volatile stocks, and then excluding or minimising exposure to them. The net result is that in the past you’ve received better returns than you would have got from the whole index (especially in the UK, where a big chunk of it is accounted for by oils and miners).

Just before the most recent correction began, minimum volatility started to break down and generate inferior returns. Analysts specialising in smart beta strategies scratched their heads, trying to work out why. Their conclusion (comprehensively explained in a series of articles on the ETF-focused online publication Index Universe) is that low-volatility ETFs are stuffed with defensive stocks such as utilities and pharmaceuticals which underperformed for a while as investors rotated into riskier cyclicals.

This doesn’t mean that low volatility is a bad idea, but what these numbers do tell us is that, like any actively-managed fund, they may not perform equally well in all market conditions. As markets correct, defensive may well come back into favour, but if they go all “risk-on” again, then expect cyclicals to do better – in which case indices such as the FTSE 250 may be a better short- to medium-term bet.

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