Off the Rails

Over the years there have been many schemes which offer investors a steady rate of return irrespective of whether actual profits or losses are being made. These are collectively called Mark-to-Model schemes, as they base their performance on a model, not a market. Why don’t people who create such schemes use market prices? Well, because such prices don’t exist!

The last few years have at times felt like watching a train crash, not so much in slow-motion but in freeze frame being advanced just one frame at a time. We are referring, of course, to the proliferation of the aforementioned mark-to-model investments whose popularity has been just one side-effect of the financially repressive zero interest rate policies (ZIRP) that have pushed investors towards assets that would not, and should not, usually feature on their financial radars.

There have already been some sad cases of these Mark-to Model funds causing clients heartache. However, it seems as though there is a huge gathering of momentum now towards a catastrophic meltdown in this sector.

The problem is not the underlying assets themselves (which is why all sorts of mark-to-model basket cases will now come out and loudly proclaim why they are so different) but rather the use of an accounting method which is sometimes signed off by big name auditors whose only remit is to check that the fund’s internal model has been followed, however daft it may be, and not to comment on its basis in reality – or not, as the case may be. This form of accounting publishes prices that are hugely at variance with the realizable value of the underlying assets. The more opaque the underlying assets, the greater the scope for mischief before the discrepancy is realized. We warned about this in International Adviser in April – http://www. international-adviser.com/profiles-and-analysis/analysis/why-its-important-to-know-your-models

Mark-to-model funds can come in various different forms; however, they all have some common features:

– Unquantifiable assets

The reality of these schemes is that they are built on assets which are practically impossible to quantify, such as life expectancy, future property prices or future share prices.

– Valuation Gaps

Given the difficulty of valuing assets, if the realisable market value of the underlying assets falls below the price reflected in the fund model a valuation gap develops. This means that the full assumed value of each investor’s assets does not actually exist and cannot be realised. Funds which use artificial pricing to average out market fluctuations over time are particularly vulnerable to:

1. Major corrections (when the investment may have to be rebased – i.e. written down by 50% or more);

2. Suspensions (which disguise the fact that the asset value is significantly lower than stated).

Comparing a student accommodation fund today to the European property sector average, a significant correction may be necessary to correct the value gap that has developed since 2010 alone.

Of specific concern is that following the 2008 global crisis, one example, the Brandeaux student accommodation fund, was unable to pay requested redemptions. Instead of writing down the fund price in line with realisable asset values, they chose to suspend redemptions. Brandeaux has just had to suspend all of its funds quoting a liquidity crisis as being the reason.

– The myth of liquidity

Some schemes promote how liquid they are. The reality is that the underlying assets are in fact illiquid. Selling a house or a share in a real estate portfolio at a profit is not easy in a bear market. Insurance-based schemes are even less liquid: a collection of insurance policies does not actually have any tangible value.

Investors who try to withdraw when the actual performance falls below the model performance may find that the assets are insufficient and they are either prevented from doing so by a suspension of redemptions or are paid a much lower amount virtue of a discretionary reduction, known as a Market Value Adjustment (or MVA). In a sustained period of negative performance, where the fund’s asset become increasingly divorced from the quoted model-based performance, such suspensions or write-downs tend to become inevitable.

Investor Protection

As many mark-to-model funds are set up as offshore and unregulated investments, they are not normally covered by the Financial Services Compensation Scheme (FSCS). In these cases, investors are unlikely to be compensated if the fund goes bust. In fact the Financial Times reported last month that, “Financial advisers will no longer be able to recommend risky, unusual or complex funds to ordinary investors following a ban by the UK’s new financial regulator.”

It is a cause of huge regret for us that our warnings are now coming to pass with so much money still trapped in such investments, whether in trade endowment policies or life settlements (http://www.international-adviser. com/news/products/managing-partners-suspends-redemptions), Australian mortgage funds (http://www.international-adviser.com/news/products/lmim-situation-severe-as-investors-face), resort developments (http://www. international-adviser.com/news/harlequin-admin-report-shows-86m-owed) litigation funding (http://www. international-adviser.com/news/products/axiom-legal-fund-report-reveals-misappropriation) or student accommodation (http://www. international-adviser.com/news/products/update-brandeaux-suspends-entire-fund-range) or in inevitable accidents that have not yet happened. The real warning here is that the knock-on effect will be calamitous for almost all other mark-to-model funds – especially in life settlements, student accommodation, litigation funding and property development but also beware agricultural or recycling models too or anything with illiquid assets.

Because of the power of marketing departments and the yield starvation of the last few years, we are increasingly acquiring new clients whose existing portfolios have had at least one mark-to-model fund that has now imploded. We are tending to immediately sell the other mark-to-model holdings. Assuming that this is a widespread phenomenon and is happening with thousands of different clients at the same time then the failure of one M2M fund simply increases the pressure on all the others. Dealing departments must be getting inundated with sell instructions right now. This creates a stampede and it is better to be at the front of these queues than the rear.

These situations are all obviously very sad news for the investors who entrusted their savings into these funds but the best thing, on the principle that your first loss is your best loss (I prefer least worse), would undoubtedly be a swift liquidation and then, hopefully, investors can get back some Cents in the Dollar. This should have happened back in 2008 and saved five years of pain.

Until we know the facts of any of the situations we should not point the finger too quickly at any individuals especially as Mark-to-Model appears to have become systemic now.

Maybe some good will come of this and the industry will wake up, stand up and take a look at itself – from advisors through to platforms and ultimately to fund managers. Mark-to-model will destroy our industry if it is not nipped in the bud. This debacle ought to be a salutary warning to anyone who still has not realized that and if they have not then why on Earth not? As one well known commentator said recently, “the correlation between those that hold the rubbish that has already collapsed and the rubbish that will collapse is very high.”

All in all, the risks are high, but the returns are completely unknown. The models on which predicted returns are based could well be myths, and there is no real way of knowing what the truth actually is. If any scheme offers a steady rate of return, with underlying assets that have no significant immediate value, then we advise you avoid them completely. In other words, if it looks too good to be true, it probably is.