Credit blow-up offers lessons for investors

Shane Oliver

A key lesson for investors from the volatile markets of the past few months is to be sceptical of funds investing in securities that involve a lot of financial engineering to generate returns, according to Shane Oliver, AMP Capital Investors’ head of investment strategy and chief economist.

“It would appear that many investors did not understand the incredible complexity of the some of the (engineered) funds that suffered the heaviest losses on the back of the turmoil in credit markets,” Oliver said at a media conference in Sydney yesterday.

“Mortgages to very low quality borrowers (sub-prime mortgage borrowers) were packaged up into securities (collateralised debt obligations or CDOs) that were sold off in various parcels, some of which came with high risk like equity but with (the highest possible) AAA credit ratings.

“So, due to the magic of modern finance, a portion of something that was regarded as high-risk was able to be marketed as low risk ... to many investors who would not have known what a sub-prime mortgage was and would have thought that a CDO was just another acronym for a senior company executive.”

Oliver said other key lessons for investors are to be aware of and avoid excessive levels of gearing, always maintain a high degree of diversification and understand that there is no such thing as a free lunch — higher returns usually entail higher risks.

He added that the crisis in US sub-prime mortgages is likely to have further to run, although total losses would be small relative to the US mortgage market overall, and thus would not trigger a US recession.

“It is unlikely to threaten the prospects for a relatively mild landing in the US economy and the favourable six to 12 month outlook for equities.

“It is likely to be just another correction in a still-rising trend.”