In this article from The IRS Report in November 2008, Chris Gilchrist talks about investment funds.……

If it looks too good to be true...

Not only did AIG, America's largest insurance group, need an $85bn bail-out from the US government, it had also in recent years offered a wide range of investment funds, several of which were extensively recommended by "wealth managers" and private banks. One such was the AIG Enhanced Fund, which was promoted as low-risk, but which in fact sought to achieve higher than money market returns by investing in higher-risk assets such as mortgage-backed securities (MBS).

Now the fund has been closed and write-downs on its MBS and other assets are expected to exceed £100m. Clients have been told they can take half their money now and leave the rest locked in for three-and-a-half years, or take the remainder now but with a loss, expected to be 20-50%.

Over £3bn of the £5.5bn in the fund was raised through wealth managers and private banks, with one high-profile client being Jeremy Clarkson of Top Gear. The average investment in the fund was £750,000. A group planning legal action already boasts several hundred members. The unhappy clients say they did'nt realise...were'nt told...didn't understand. Many blame their wealth managers as much as AIG. Several similar "money market plus" funds in the US have already disclosed losses and face legal action by disgruntled investors. Yet again, the insight of Nassim Taleb (author of "The Black Swan") holds. "Minimal risk" is based on conventional risk models, which vastly understate the true risk of "5-sigma events" or disastrous losses. The promoters are guilty of misleading people, because their strategy assumes you can go on picking up ten pences from the street day after day without ever being hit by a truck.

Since the mid-1990s, we've published many articles on structured products of all types, and our verdict has always been the same: if it looks too good to be true, it probably is. But since there seems to be no way of preventing suckers from believing such claims - even rich suckers - the only solution is much tighter regulation of financial products. Of course the EU juggernaut is lumbering in the other direction, with UK funds already permitted to make widespread use of derivatives and inadequate requirements for reporting to investors. Especially with investment funds, transparency is all-important. My view is that you should only ever buy investments you understand fully. I like fund managers who "eat their own cooking" and have a good slice of their personal wealth invested in their funds. And I like simple low-cost funds such as plain-vanilla Exchange Traded Funds (ETFs). Many of the "absolute return" funds now being promoted by UK financial advisors use strategies that also risk "black swan" wipe-outs. As the legendary Peter Lynch ("One Up On Wall Street") once said: "Never invest in anything you can't illustrate with a crayon".

You can see all of Chris Gilchrist’s articles at www.TheIRSReport.com.

Chris is the editor of The IRS Report every month.

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