Spanner in the works
A tax break isn't everything it is the intergrity and performance of the investment that matters.
Investors that ignore the lessons of the past are bound to repeat them, writes Annette Sampson. "THAT which does not kill us makes us stronger."Friedrich NietzscheSuccessful investment rests on learning from your mistakes, not avoiding mistakes altogether. While it would be nice to say you'd never dropped the ball financially, building wealth is about taking risks - and sometimes getting it wrong.The only way to avoid mistakes is to avoid taking risks completely. And that, arguably, is the worst mistake you can make because you're guaranteeing a below-par return.Over the past couple of decades, a long list of financial products have turned out to be lemons.In every case, there were clear lessons to be learnt, but too often the same mistakes were made all over again. Here are a few of those dud products, and what they should have taught us about investing and managing our finances.ESTATE MORTGAGEJust like a bank or building society, only better. Well, that was the claim and, backed by an aggressive advertising campaign, it sucked in almost half a million investors - many of them retirees who were counting on those promised high returns to live on.Estate Mortgage managed mortgage trusts that it claimed were just like bonds or term deposits but offered much higher interest rates. And this was in the late 1980s when high interest rates were really something. At one stage, investors in Estate Mortgage funds were receiving income payments of 22 per cent - more than 6 per cent above what the banks were paying.But despite all the claims of "high returns, nice and safe", Estate Mortgage was an accident waiting to happen.Many of its loans were secured by overvalued property developments, with the interest often capitalised or added to the loan rather than paid on a monthly basis.Lack of cash flow wasn't a problem as all that advertising was attracting new money to the funds. But, when investors started taking their money out, the whole house of cards came down.Unable to meet redemptions, Estate Mortgage froze its funds and hapless investors learnt that rather than being safe and secure, much of their money was lent out against holes in the ground, which could not be sold for anything approaching the loan value.Estate Mortgage was an extreme example and its former managing director and founder, Richard Lew, and his father, Reuben, were jailed for breaching their duties as company directors. But the pattern of promises of high returns with no risk has been repeated many times since, often with the same dismal results. Westpoint and Fincorp are more recent examples.Estate Mortgage also showed the importance of understanding the assets underlying mortgage loans. While misleading disclosure was a problem for Estate Mortgage investors, many simply invested on the basis of high returns, safe as houses, rather than asking questions first.STORM FINANCIALThe high-profile collapse of Storm Financial was a textbook lesson in the dangers of gearing and one-size-fits-all financial plans. The Storm model was simple - build wealth through borrowing, in some cases gearing up twice by borrowing once against their homes and then through a margin loan.The fallout from Storm is far from over, with court actions still pending against the company's founders and some of the banks that lent to Storm investors. Last week the Commonwealth Bank agreed to increase its compensation offer to investors.Money back is a good thing, but the real lesson is not to get caught in the first place. Gearing substantially increases the risks of any investment and should be undertaken with caution and full knowledge of what can go wrong.TECHNOLOGY FUNDSRemember the technology boom and all those dotcom companies selling on price-earning multiples in the stratosphere? There were plenty of lessons to be learnt from the resulting tech wreck. That when people start to claim that the world has changed, it's time to start worrying. That fundamentals such as whether or not a company earns a profit matter. And that unrealised capital gains can disappear just as quickly as you made them.But the other lesson is that whenever there is an investment bubble, there will be a rush of funds launched to exploit it.The tech boom took off in the late 1990s, but it wasn't until the peak of the market in the months leading up to the April 2000 crash that a rush of specialist funds hit the market.Investors had barely got in before the bubble burst. The Nasdaq Composite Index, where many tech stocks were listed, lost 34 per cent of its value over five weeks. A decade later, units in most tech funds were still worth less than a third of their issue price.You'd think we'd learn. But fad investments still come along to take advantage of heated markets and investors still get sucked into them. Absolute return or hedge funds, resources, emerging markets, high income - they've all had their day, and the product launches have followed.The tech boom also provided a valuable lesson in diversification. As with most lemons, it was the investors who punted big on the "paradigm shift" who fared worst. One of the best anecdotes of the mentality of the time came from a former director of van Eyk Research who's now with fund manager Lazard, Robert Prugue, who was stunned at a Sydney money show at the time by the number of investors there who confessed to selling their broadly diversified share funds to reinvest in specialist technology funds.One investor told him: "It's a no-brainer. I sold my international fund, which had returned a measly 12 per cent, for a tech fund which had returned 60 per cent." Prugue was horrified.What about diversification? No worries, the investor assured him. The tech fund invested in both Australian and international tech shares.CDOsMichael Lewis's bestseller The Big Short probably best details the rise of collateralised debt obligations and the role they played in the global financial crisis. As Lewis so scarily points out, even the Wall Street professionals selling these products often had no idea how they worked. So, what chance for the rest of us?Basically, a CDO was a way of packaging subprime debt (such as home loans to American borrowers who had no hope of paying them back) to sell to mug investors as a high-quality security.Dodgier debt securities were packaged with AAA securities to develop the ideal investment that combined a high yield with the perceived security of a high credit rating. The ratings agencies gave solid ratings to many of these securities without understanding the risks behind them.But with many of these products, it only required a couple of defaults in the lower-ranked securities for investors to lose money overall, due to the high risk of default in some of these securities and the relative "thickness" of the different tranches of debt (or how much AAA debt there was relative to the proportion of low-grade debt).When the GFC hit, investors who had never imagined they were investing in subprime debt found they were losing money. Victims included Australian local governments that believed they had invested in AAA-rated securities.As with many of the engineered financial products that offered a mix of security and high yield and went down with them, the big lesson to be learnt from the CDO debacle is to keep it simple. Or, if you don't understand something, don't invest in it.There's also a lesson in there about relying on ratings agencies to find the risks in an investment. In this case, that didn't happen.TAPsTerm-allocated pensions weren't so much a lemon as a solution to a problem that later went away, leaving many retirees stuck in legacy products that often no longer suited them.They were a retirement income product developed as a halfway house between the old allocated pension (now called account-based pensions, where your account balance goes up and down with the investment market) and lifetime annuities (which provide a guaranteed income for life).These pensions were structured to last for your life expectancy (or longer), but your account balance fluctuated from year to year, which meant your income could also change.The big selling point of TAPs, as they became known, was that they carried a 50 per cent exemption from the Centrelink assets test and were also treated concessionally under the old "reasonable benefit limits" that dictated how much you could take out of superannuation with tax concessions.The problem was that TAPs could only be commuted, or cashed in, under limited circumstances - which didn't include legislative changes to super and the age pension. When the Howard government abolished the tax on super benefits once you turn 60 and retire, there was no need to worry about reasonable benefit limits.In 2007, changes to the Centrelink rules made it easier for retirees to qualify for the age pension and at the same time abolished the concessional assets test treatment for TAPs and other complying pensions. Because there was a cut-off date, many retirees were advised to get in before the rules changed.Once that date passed, however, there was no longer any reason for people to invest in TAPs and fund managers soon stopped offering them.But as one Money reader recently pointed out, those who had already invested were locked in."If your fund - like mine - is underperforming it can take weeks of research to find a fund that still offers these pensions," he wrote. "And then it's very likely you'll discover its returns are no better than those you are - not! - receiving. As far as I can tell, no major funds or funds that are highly rated still offer TAPs."Super is prone to legislative risk - both in the accumulation and retirement phases. Investors had good reasons for buying TAPs, but now find they are locked into a dying product and, from what our reader tells us, the current government is unsympathetic.WHOLE-OF-LIFE INSURANCEAlso known as endowment policies, these combined insurance-investment products have rightly gone the way of the dinosaur. In effect, they were expensive savings plans designed to pay out when you died, or when they matured. In the super market, maturity was commonly at 65.Sold as a "safer" alternative to term life insurance, where you "lose" your annual premium if you don't die that year, whole-of-life policies demanded higher premiums.But investors who wanted out early found their surrender values were often worth much less than they had put in.The main reason for this was that a high proportion of the early premiums went to paying commissions to the highly motivated sales force that sold the policies.The whole-of-life debacle first highlighted the problems of paying commissions on investment products.Many examples emerged of salespeople using unrealistic projections to flog the policies and never contacting their clients again.While the industry has moved on and commissions on the sale of new investment products will be outlawed from next year, conflicts of interest are still alive and kicking. Yes, conflicts now must be disclosed, but "What's in this for you?" is a basic question that should be asked with any recommendation.As the whole-of-life experience showed, circumstances can also change.With any long-term financial product, not just investments, you need to know what it will cost and any other penalties if you need to get out early.AGRICULTURAL SCHEMESFancy a share in an alpaca farm, anyone? What about a viticulture scheme? Jojoba? Ostriches? Avocados? Forest plantations?It's amazing what otherwise intelligent people will and do buy in the pursuit of saving tax. Tax schemes investing in all manner of agricultural products were heavily sold in the lead-up to June 30 in the 1980s and 1990s largely on the basis of high upfront tax deductions. But these deductions were not always allowed and, even when they were, many investments were left to wither on the vine as the promoters focused their attention on flogging new schemes. Costs of the schemes were often exacerbated by commissions of 10 per cent or more paid to the advisers and accountants that sold them.The more recent high-profile collapses of Timbercorp and Great Southern Plantations highlighted the risks of investing in agricultural schemes and offerings have been few and far between in the past few years.But people will always want to find ways to reduce tax.And as the agricultural schemes showed, there will always be promoters devising products to help them do so.If we've learnt nothing else from the tax-scheme lemons it is that a tax break isn't everything. It is the integrity and performance of the investment that matters any tax benefits should merely be icing on the cake.UNLISTED PROPERTY FUNDSWho says lightning never strikes twice?In the early 1990s, investors in unlisted property funds were given a sharp lesson in liquidity when the property market took a downturn, redemption requests took an upturn, and operators of unlisted funds appealed to the government to allow them to freeze redemptions.Major fund provider Aust-Wide collapsed and many other funds were restructured and listed on the stock exchange, with investors hit by substantial losses.It was conclusive proof that you can't make long-term investments and enjoy instant access to your money back - or not on a sustained basis, anyway.Fast-forward to 2009 and, in the fallout from the GFC, investors again found their holdings in unlisted property funds frozen. In some cases, managers had the authority to refuse redemptions to prevent a sale of assets in a falling market in others, high debt levels meant they had fallen below mandated liquidity requirements and so were unable to pay redemptions.Mortgage funds were also frozen during the crisis to prevent a fire sale of assets, highlighting the disconnect between investors' expectations that they should be able to get their money back at short notice (often a selling point of the fund managers) and the fact that any property-related investment should be undertaken for the longer term.Since the last crisis, the Australian Securities and Investments Commission has forced funds to be clearer in disclosing key issues such as how much debt they're carrying (including when and how it must be repaid) and how investors can withdraw their money (including any limitations).