What are the lessons?

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Preston Brown
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l a b o l G ancial ﬁn What are the lessons?

phenomenon that became known as the GFC?

key lessons the GFC has provided for investors large and small. What triggered the GFC?

This event made investors sit up and take notice, but the signs of instability in the financial system had been there for a

The US Government, wanting to increase home ownership among lower income earners, had encouraged a long period of low interest

Borrowers with poor credit histories and no evidence of income or savings were enticed into home loans (sub-prime mortgages)

1 The dangers of complicated products Banks, finding themselves oversupplied with sub-prime mortgages, packaged them up with

Often these carried high ratings from the international rating agencies, despite their obvious risks.

1 l a b o l G ancial ﬁn What are the lessons? As markets regain their footing and a brighter outlook comes into view, what can we say we ve learned from the global phenomenon that became known as the GFC? This factsheet revisits the events that set off the crisis, examines how the markets have responded and outlines some of the key lessons the GFC has provided for investors large and small. What triggered the GFC? The global financial crisis (GFC) is widely attributed to the collapse of US investment bank Lehman Brothers in September This event made investors sit up and take notice, but the signs of instability in the financial system had been there for a while. Fundamentally it was a case of too much lending. The US Government, wanting to increase home ownership among lower income earners, had encouraged a long period of low interest rates. Borrowers with poor credit histories and no evidence of income or savings were enticed into home loans (sub-prime mortgages) through low honeymoon rates. Meanwhile, around the word people were borrowing more and more for investing often in risky new products. 1 The dangers of complicated products Banks, finding themselves oversupplied with sub-prime mortgages, packaged them up with other debt to on-sell as complex investment products (called collateralised debt obligations or CDOs). Often these carried high ratings from the international rating agencies, despite their obvious risks. Everyone from mum-and-dad investors to large superannuation funds was buying CDOs. And everyone expected house prices and investment markets to keep on rising. The inevitable impact Inevitably, many mortgagees in the US defaulted when their honeymoon rates ended, and house prices everywhere plummeted. The banks, weighed down with mounting debts, simply stopped lending to each other. When Lehman Brothers collapsed, the share markets were engulfed by a wave of selling. This led to a devaluation in all asset classes and the worst financial crisis the world has seen for 60-odd years.

2 Key lessons from the GFC for investors large and small Lesson Number 1: Expect the ups and downs Remember that markets are cyclical and they always recover. Before the GFC, a generation of investors and investment managers, never having experienced a major downturn, probably thought the salad days would continue forever. The financial crisis came on more swiftly and was more pervasive than anyone could have imagined. But markets always recover, and all indications are that we are entering the upward part of the cycle now. At 30 September 2009 the Australian share market had gone up 54.8% since the low point of the GFC on 6 March Lesson Number 2: Stick to your investment plan When something seems too good to be true, it usually is. During the GFC the most successful investment managers survived by sticking to their tried and true processes. Lesson Number 3: Markets are global and emotional With the instant sharing of information made possible by new technologies, investment markets around the world are closer than ever. As part of this we are seeing a new global psychology of share markets and this includes the sharing of emotive, knee-jerk responses to market events or economic indicators. Consumer confidence drives investment markets and economies. In the GFC, American investors led the panic and everyone else followed, and the resulting wave of selling and panic quickly led to the virtual collapse of the financial system. Lesson Number 4: Understand the risks As a result of the GFC, investors now have a heightened awareness of different types of investment risk. For example, they have learned lessons about product risk if you don t understand it, don t buy it and about counterparty risk who lent to the bank who lent to you? Lesson Number 5: Don t panic and beware of switching at the bottom Investors can be their own worst enemies by trading at exactly the wrong time in the investment cycle. The chart below shows how many AustralianSuper members switched their accounts to more conservative investment options in March 2009 when markets were at their lowest point for 60 years. If these members had remained in their original investment options throughout the crisis and resisted the temptation to switch into the more conservative options, they would not have missed out on the large gains that were made after the market hit the bottom. See the chart below which illustrates this. 3,000 2,500 2,000 1,500 1, Number of Members Switches S&P ASX 300 (Australian Share Market) 14/11/08 21/11/08 28/11/08 05/12/08 12/12/08 19/12/08 26/12/08 02/01/09 09/01/09 16/01/09 23/01/09 30/01/09 06/02/09 13/02/09 20/02/09 27/02/09 06/03/09 13/03/09 20/03/09 Week ending 27/03/09 03/04/09 10/04/09 17/04/09 24/04/09 01/05/09 08/05/09 15/05/09 22/05/09 29/05/09 05/06/09 12/06/09 19/06/ This chart compares the recent trend in the number of AustralianSuper members switching their investment options to the price movement in the Australian share market (as measured by the S&P ASX 300 Index). Unfortunately, many members switched their investment options at the lowest point of the market. 26/06/09 Cumulative price change (%) 2

What our investment managers learned Although most experts agree that the lessons of the GFC will continue to reveal themselves over the next year or more, we invited some of our investment managers

This came after 15 years of rising values, and taught us all some fundamental lessons about leverage, liquidity, and counterparty risk, says Matthew Williams, Senior Portfolio Manager at Perpetual

The good news is that our market and economy were well placed to weather the global storm thanks to our strong banks and government finances.

Babcock & Brown s stock went from $6 to $34 and clients were asking us, why don t you own that? Many companies such as that were purely reliant on asset inflation fuelled by increasing levels of debt.

3 What our investment managers learned Although most experts agree that the lessons of the GFC will continue to reveal themselves over the next year or more, we invited some of our investment managers across a range of asset classes to discuss the lessons so far. Australian shares The Australian share market plunged more than 50 per cent between its peak in November 2007 and March This came after 15 years of rising values, and taught us all some fundamental lessons about leverage, liquidity, and counterparty risk, says Matthew Williams, Senior Portfolio Manager at Perpetual Investments. The good news is that our market and economy were well placed to weather the global storm thanks to our strong banks and government finances. The good news is that our market and economy were well placed to weather the global storm thanks to our strong banks and government finances. MATTHEW WILLIAMS Senior Portfolio Manager at Perpetual Investments. Williams says a lot of very popular companies during the boom had excessive debt as part of their business model. Babcock & Brown s stock went from $6 to $34 and clients were asking us, why don t you own that? Many companies such as that were purely reliant on asset inflation fuelled by increasing levels of debt. Their businesses were not sustainable. Now we see clients are looking for a more back to basics approach to investments. Strong market returns leading up to the GFC led to more complex, esoteric, and leveraged products. Simple, conservative and common sense investing are coming back into vogue. International shares International shares were probably the first asset class to suffer extreme losses as a result of the GFC and world markets lost around 46 per cent of their value before beginning their recovery. The crisis showed the degree of potential systemic risk across global markets today, says Kurt Umbarger, Portfolio Specialist at T. Rowe Price. Your ability to invest in very far flung places around the world today is much greater and markets are more connected to each other, in a way that they weren t necessarily in the past. When investors panic all together it impacts all markets around the world. And in this case the perceived higher risk markets suffered the most. So although emerging markets weren t at the centre of the crisis, they sold off much more heavily than developed markets. That was purely based on people s perception of risk. What we have learned is that even a very highly diversified US or European-based company can be affected by a downturn in emerging markets. If they do business on a global stage, with a portion of their market growth anticipated to be in emerging markets, even though they might have 80 per cent of their revenues coming from the developed world, their stock can still be much more negatively impacted than you might expect. Umbarger says that as people rushed for liquidity during the GFC every asset class came under abnormal pressure. When investors panic all together it impacts all markets around the world. And in this case the perceived higher risk markets suffered the most KURT UMBARGER Portfolio Specialist at T. Rowe Price Usually different assets perform at different parts of the cycle, and we call that correlation, he says. During times of great stress, when people really don t want to take any risk at all and they want to own cash, that affects every asset at once. 3

Property Property can be either listed on markets, or unlisted (directly owned).

The important thing to remember is that direct property, unlike listed assets, is very illiquid, says Pepicelli.

the GFC has highlighted the need to keep it simple ROB PEPICELLI Manager, Strategy and Capital Markets from (ISPT) During the GFC credit was hard to get, and also

What the GFC has highlighted is just how much the property asset class relies on the debt market and being able to fund investments at a reasonable cost,

Whilst a lot of other groups have borrowed to finance as much as 50 or 60 per cent of their portfolios, ISPT s largest fund has had debt in the region of between

As soon as you get banks seizing up or lending at a high cost, that can erode the equity in any fund very quickly.

purpose debt is meant to serve, which is really to be at the margin and not to be the primary way to achieve returns.

like residential electricity, water and other essentials remains constant even during a downturn. People will continue to shower, cook and watch TV.

seaports may lose income. This is because when a city is in an economic downturn, people travel less and businesses run down their inventory of goods and products.

when people believe there is going to be an extended low level of economic activity, the value is affected KYLE MANGINI Head of Infrastructure and Specialised

4 Property Property can be either listed on markets, or unlisted (directly owned). We asked Rob Pepicelli, Manager, Strategy and Capital Markets from Industry Superannuation Property Trust (ISPT) about unlisted property and the GFC. The important thing to remember is that direct property, unlike listed assets, is very illiquid, says Pepicelli. It can t be cashed up quickly, and should be considered as part of a long-term strategy. the GFC has highlighted the need to keep it simple ROB PEPICELLI Manager, Strategy and Capital Markets from (ISPT) During the GFC credit was hard to get, and also expensive. Funds that had borrowed large amounts to buy their properties were the hardest hit. What the GFC has highlighted is just how much the property asset class relies on the debt market and being able to fund investments at a reasonable cost, Pepicelli points out. Whilst a lot of other groups have borrowed to finance as much as 50 or 60 per cent of their portfolios, ISPT s largest fund has had debt in the region of between eight and 15 per cent over the last five years, he explains. As soon as you get banks seizing up or lending at a high cost, that can erode the equity in any fund very quickly. I think the GFC has highlighted the need to keep it simple, and the low cost of freely available debt for such a long period of time made people forget the purpose debt is meant to serve, which is really to be at the margin and not to be the primary way to achieve returns. Infrastructure Part of the reason infrastructure is considered a dependable asset in any investment climate is that the income on certain infrastructure assets, like residential electricity, water and other essentials remains constant even during a downturn. People will continue to shower, cook and watch TV. However, as Kyle Mangini, Head of Infrastructure and Specialised Funds at Industry Funds Management (IFM), points out, other assets like airports, toll roads and seaports may lose income. This is because when a city is in an economic downturn, people travel less and businesses run down their inventory of goods and products. Mangini also points out that emotion has affected the value of all assets, including in the infrastructure area. when people believe there is going to be an extended low level of economic activity, the value is affected KYLE MANGINI Head of Infrastructure and Specialised Funds at IFM What was unexpected for us was the impact on the values of those assets that are associated with confidence about the future, like airports and roads he explains. That applies to both listed and unlisted funds. For assets that have a 50 year or 100 year life, one year or even two years of reduced usage won t make a difference to their value. But when people believe there is going to be an extended low level of economic activity, the value is affected. This is why infrastructure has been more volatile than anticipated. Mangini sees opportunities for astute buyers in this situation. The pendulum has swung from a tremendous amount of liquidity, debt and equity capital available, to a situation where it is scarce, he says. This means that all investors in the infrastructure sector can now be extremely selective about the assets they choose. 4

5 Cash and fixed interest The cash and fixed interest asset class invests in products like bonds, basically an I.O.U. from the government, bank or private company because you have lent them money, generally at an agreed fixed interest rate. When you invest in this asset class you are the lender. Government bonds performed particularly well during the GFC as people flocked to their stability and liquidity, but there are other areas of loans and credit markets that were quite impacted by the downturn. Richard Quin, Director, Credit Investments Group at Credit Suisse Investments (Australia), manages funds in the relatively higher risk area of credit. He says that the biggest risk within that section of the asset class is in fact liquidity. Even though I wrote a paper in early 2008 warning about valuation and liquidity levels in some less liquid investments, we never imagined the extent of the liquidity crisis in the last quarter of 2008, he explains. The ability to be able to readily sell an asset is tremendously important. Investment managers who invested in small illiquid markets without a number of different investors were unable to provide liquidity and locked investors in their funds. In times when everyone is trying to sell at once, bonds drop in value on the open market, which means their yield or interest rate increases dramatically. Quin says Credit Suisse was able to take advantage of such opportunities. When the market is illiquid and prices are very cheap, a lot of people decide not to invest. The gap between the economic value of an asset and the market value was massive in some areas RICHARD QUIN Director, Credit Investments Group at Credit Suisse Investments (Australia) When the market is illiquid and prices are very cheap, a lot of people decide not to invest. The gap between the economic value of an asset and the market value was massive in some areas, he says. Quin says the GFC also underlined the importance of making sure an investment is valued correctly, and understanding the broader marketplace. We avoided sub-prime debt in our portfolios, he explains, mainly because the worst case scenario anyone could imagine for housing markets was a very small fall of two to five per cent. People believed that housing in the US would not fall in value. Going forward, Quin says that as systemic risk starts to abate, you will again see good returns from credit assets and asset classes performing at different times in the cycle, which is good for those with very diversified investments, like AustralianSuper. More information is available AustralianSuper provides members with a range of information about investments, for all levels of interest. These include e-investment bulletins, monthly and quarterly investment updates, detailed fact sheets and web seminars presented by our Chief Investment Officer Mark Delaney. All can be accessed through: The AustralianSuper website or by subscription to our monthly updates. Visit to subscribe. Or call and speak to one of our Customer Service Team. This document is of a general nature and does not take into account your personal objectives, situation or needs. Before making a decision about AustralianSuper, consider your financial requirements and read our Product Disclosure Statement, available at or by calling AustralianSuper Pty Ltd ABN AFSL , Trustee of AustralianSuper ABN Industry Superfund logo used with permission of Industry Fund Services (IFS).This consent had not been withdrawn at the date of publication. 5

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