My lesson learned from Elders hybrids

Know what you’re getting into, know what your advisor knows, and what’s in it for them.

PORTFOLIO POINT: A small amount lost on Elders hybrids carries a valuable lesson. Know what you’re getting into, and make sure your advisor knows as well.

This week our family took a loss on a small hybrid investment and it made me recall the mistakes that led to that investment and the lessons I learned.

Before I take you through the journey, let me start by emphasising one point –‘Don’t blame your advisor. Blame yourself’.

That’s a lesson that is sometimes hard to accept, because when we make investment mistakes it’s all too easy to blame the person who told you to make the decision.

As more and more Australians take control of their finances through self-managed funds, how they work with their advisor will be very important to the financial fortunes of a large portion of the nation, including many Eureka readers.

I have had a self-managed fund since 1978. In those days self-managed funds were very rare and Treasury was trying to stamp them out and would constantly change the trustee rules. But I stuck with it.

At the time a lot of our fund’s money was managed by carefully selected large institutions. I got to know a number of the people in those funds and we picked out certain areas where the particular institution had real talent.

One of my institutional executive friends decided to jump ship and join what became the Australian arm of Lehman. Now, at the time, I had no idea of the risks that Lehman was taking and the dangers faced by anyone dealing with it.

I might add that neither did the institutional executive who shifted across. He was an honest person who didn’t appreciate the risks.

But not long after his transfer we were discussing his new role and he was introducing me to what appeared to be the delights of hybrids. He also suggested that I might like to place money with its professionally managed debt funds. The returns looked extremely good. It was these funds where many local councils invested money and lost so heavily. Something told me to be wary about these funds because I didn’t understand exactly what was being done to achieve the high returns. When anyone offers you a security, whether it be shares or hybrids or some other package, ask how the money is being made. And if there isn’t a good answer, be very wary – especially if the returns are high. High returns usually mean that they are taking big risks.

But one of the hybrids my adviser friend suggested was Elders. It seemed inconceivable to me that Elders would get into serious trouble, so our family took up a small holding in the Elders hybrid. (I applied for more but the rush for the security was so great I was thankfully cut back) It wasn’t long before Elders got into serious trouble and went very close to going broke.

I learned that when a company hits deep problems the hybrid security has virtually no standing. The only hybrid ‘security’ that counts is that the hybrids will continue to be paid interest so long as shareholders get dividends. Shareholders like dividends.

Once the shareholder dividends stop, so does the hybrid income. But, unlike shareholders, the hybrid usually has no other powers. They must just wait it out and hope. So you must be very careful to make sure that hybrid investments are in companies that are likely to continue paying dividends.

Shareholders take the upside but the hybrids have no upside apart from high income. As Elders shows, they clearly have a downside risk. If a company performs well they often buy back their hybrids and you miss out on the high secure yields.

I should have sold the Elders hybrid stock but it was not a large investment and I committed the ‘sin’ of not taking a loss. I will leave discussion of that ‘sin’ to another day.

What we have seen in Elders is that there is now a demand for the shares and RuralCo wants to acquire the company. Under its proposal, Elders hybrids will get an offer above the market but at a substantial discount to par value.

The problem with hybrids is that they have no votes and no clout in these takeover situations. Control comes with shares. So the shareholders will get a return even though the hybrids take a big loss.

The RuralCo/Elders merger negotiations are going to hit the headlines for the next six months and I want to comment on them. I hate commenting and being forced to put a note down at the bottom of the article that I own securities in this particular deal. It takes the shine off your commentary. So our family has sold the Elders hybrids and we have taken a loss. Once again this was a mistake that I made – I certainly don’t blame the advisor. This particular person had a good understanding of big institutions and pool funds but he had moved out of his comfort zone.

Understand the skills of your advisor – it will soon become apparent where those skills lie. In this particular case he was in a totally new area and we were venturing into securities where I did not have anywhere near sufficient knowledge.

Secondly, make sure that what the advisor is telling you is in accord with what you want to do. In this particular case, gaining higher returns from interest-bearing securities was in line with what I was after. But all too often advisors direct you towards securities where they are either familiar or where they get considerable commissions.

It’s always worth taking an extra 24 hours and thinking about what the advisor is telling you to do. Does it really suit your priorities?

Finally, be very wary of advisors who take over-riding commissions on your entire portfolio. Advice should be paid for on an hourly basis or on a commission over a particular deal, as is the case in broking.

In today’s world where returns are lower, over-riding commissions of 0.5% or 1% on portfolios are extraordinarily expensive and totally unnecessary because a good advisor can be obtained on a much cheaper basis. But I can’t emphasis enough that you need to understand the skills of your advisor and the products the advisor is suggesting to you.

If it is all too hard, then stay with safe vanilla products. In the case of equities, there are investment companies like Australian Foundation Investment Company that are available. In the case of interest-bearing securities, term deposits still represent safe returns.

In the case of hybrids, I would stay with the big four banks. It is possible that their dividends might get into trouble in a very severe economic downturn. But a lot of other things will also be in trouble if that takes place.

When you are being offered securities you don’t understand and that carry great risk, certainly limit them to small portions of your portfolio if you take them up at all. And that is, of course, where I am thankful. I might have made a mistake with Elders, but the amount of money was small.

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