TWO weeks ago, we did our first article on safety explaining how to assess the viability of your bank or investment house. Last week, we spoke about the softer side of the equation by evaluating the expertise that you are relying on and how to gauge a comfort level with your advisor.

After the recent tumultuous changes in our local capital markets, investors are hungrier than ever for alternative investment products that can provide a safe haven for their funds with reasonable returns. With a growing number of financial institutions launching unit trusts, pushing mutual funds and structured investment vehicles, how can you assess the safety and quality of these products? Here are some key questions to ask:

1. What is the Investment Strategy? The first concept to have clear in your mind is the investment strategy of the product under consideration. The investment strategy/ philosophy should tell you the basics of the asset classes, credit quality and geographic concentration that the product focuses on. More importantly however, it should tell you why and how the product makes money. For example, does the investment strategy focus on under-priced assets in order to realise capital gains as the primary source of return? Or is the strategy to “buy and hold” assets with returns coming primarily from the coupon income of underlying investments? Is a quantitative investment strategy using complex algorithms and models being employed?

2. What are the Underlying Assets? Every “investment product” must be made up of different assets. You should know what these assets are and be comfortable with their risk profile. For example, if the product is made up primarily of equities, the investment manager should be able to explain the rationale for each equity purchase and why the company is a good buy. Similarly, if there are large real estate holdings in the product, the manager must explain how the real estate asset will be used to generate a return, who manages it, and what kind of returns it has generated in the past. Very frequently, long term investors get into real estate investments that fail due to poor management and oversight. The liquidity of the underlying assets is also very important as this will affect the ease with which they can get access to their funds when they need them.

3. What is the track record of the investment manager? What kind of returns has the investment manager generated on the product under consideration? Do they have any other products that have performed well or poorly? Very often we may be presented with the successful products but always ask the investment manager if the sample you are being shown is representative of all their products and if any less stellar performers were omitted. The time period over which the returns have been earned is also very important as an investment may have performed very well over the last year but rather poorly over the last three, five or ten years. It should also be remembered that past performance is no guarantee of future returns.

4. How are the incentives of the investment manager structured? How is your investment manager compensated? Far too often, large investment managers receive the majority of their remuneration through fixed annual fees that are levied on the size of assets under management. They therefore are not incentivised to maximise returns as they are receiving income whether or not the investors make a return. It is important to ensure that majority of your investment manager’s compensation comes in the form of performance fees and that sufficient “clawback” provisions are incorporated to ensure that if investors lose money, managers must work to make it back before they can receive any further compensation.

Long-term investor representatives that are held accountable and liable for the performance of funds under their purview such as Pension fund trustees would be well-advised to ask more questions and seek to understand the instruments and structures that are proposed by their investment managers. Additionally, it is critical to ensure that your investment manager’s objectives are clearly aligned with yours.

Marian Ross is a business development officer at Sterling Asset Management. Sterling provides financial advice and instruments in US dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at https://www.sterling.com.jm Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm