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A fatally flawed model - Eureka Report article

The following article written by Scott Francis appeared in conjunction with a piece written by James Thomson - Investors caught in tropical Storm.

PORTFOLIO POINT: Storm Financial grew quickly with its high gearing model, but has been hit hard by the sharemarket fall.

A fatally flawed model

Scott Francis writes: It's being called one of the biggest frauds in Wall Street history: Earlier today Bernard Madoff , operator of a large US based Hedge Fund and Wall Street adviser, was arrested over a failed $50 billion investment scheme which he has now publicly described as ‘basically a giant ponzi scheme'. (A ponzi scheme is where there are no actual investment returns, with early investors paid out of the deposits of future investors, until the scheme eventually collapses).

At the same time, the position of the 16,000 Storm Financial clients is drawn into question as their debt-fuelled investments have collapsed in value in the wake of this sharemarket slump.

Although there is no suggestion of fraud or irregularities at Storm, it is clear the core of the aggressive borrowing that sits behind the Storm model is now looking deeply troubled, if not fatally damaged. Put simply, Storm had people borrowing against their properties - and now there are reports some of these investors will be forced to sell their homes to repay debts.

In a previous article (see Is Share Gearing Worth It?) I looked at the increase in volatility caused by borrowing money to invest. Borrowing money to invest significantly increases the volatility of a portfolio. In situations where basically 100% of the portfolio is borrowed money, then it is very easy for the value of the portfolio to drop significantly below the value of the outstanding loans.

This is not to say that some borrowed money, with a long-term investment horizon, is not a powerful financial planning strategy. However, the aggressive use of large levels of debt - similar to those used by Storm clients may work well in good times - and can be disastrous in poor times.

Many investors will be lucky enough to sidestep Storm given that it was primarily a regional brand centred on Townsville. Neverthless the affair is a reminder to be judicious about the use of debt.

Moreover, the fallout from this overstretched financial adviser reflects poorly on the financial planning profession.

Most financial planners do not use the sort of "double gearing" strategy that most reports have suggested Storm uses - drawing equity out of their property and then using a margin loan as well. Reports suggest that many clients were close to retirement, a time when most advisers would focus on strategies such as increasing superannuation and paying down debt rather than actually borrowing more.

That said, it reflects poorly on the profession that such advice is given anywhere. The very basic financial relationship is that risk and return are linked. Storm Financial, through various documents (for example, its prospectus from 12 months ago showed this example: Client AO - 8 years, 6 months invested. First investment $350,000, current balance $14.9 million) implied that risk and reward were not related. To think that these astronomical returns did not come with huge risks was a fantasy.