August 2007

Welcome to the 8th edition of our Financial Connection e-bulletin.

We hope that you enjoy these e-bulletins. If you have any queries, or would like to discuss any of the issues raised with one of our consultants, please call us on 0845 788 9933 and quote EM-4489.

Update on commercial property exit penalties

Commercial Property has been a fantastic investment over the last few years, having become extremely undervalued relative to equities and bonds in the late 1990s. Commentators have been too quick to predict the end of property's bull-run, although it does now seem to be slowing down to far more sustainable levels.

Bricks and mortar property funds were able to return at least 7% to investors over the year, and something similar should be achievable over the next 12 months. However, some funds have been swinging down their exit price recently, this being the result of institutional investors selling down their exposure and looking elsewhere for returns. Property is an expensive asset class to trade in, and so the change in price simply reflects the extra costs associated with these sales, which otherwise would have to be borne by the remaining investors, such as our clients.

Andrew Wilson, Head of Investment at Towry Law says:

"Towry Law and its Wealth Management clients are long term holders of property funds and, as such, we want to be protected. We therefore believe that the imposed penalties for leaving are good news for us, and other long-term holders, and no worse than neutral for sellers, as they are only paying the costs that they have generated, which is hardly unfair. The round trip cost (the cost of buying and then selling) of investing in commercial property is 5.25%, not taking into account any creation costs the fund may have.

We believe that as long as a fund has net buyers there is no real issue with penalties, and these costs are simply reflected in the NAV. Should there be more sellers than buyers, the fund might have to start selling physical property. The manager is then perfectly entitled to move the fund to a cancellation basis, or swing the price, dependent on what type of fund it is.

It is important to note that this protects existing and remaining unit holders, and correctly penalises sellers, forcing them to wear the costs of their exit. This is why property should be viewed as a long term investment in multi class portfolios, i.e. it is too expensive to trade in and out of."

Yields from commercial property are general low, and there is no longer any positive valuation anomaly versus bonds and equities. Nevertheless, the investment and portfolio building characteristics of commercial property remain intact, and it should remain a crucial part of a multi asset class portfolio.

Patrick Connolly
PR and Marketing Manager

Pensions - Enhanced Protection and partial transfers

The Finance Act 2007 received Royal Assent on 19th July 2007. Amongst other issues, this Act rescinded the ruling that if someone completed a partial transfer of their pension benefits i.e. transferred part of their benefits to a new provider, but left some benefits with the original provider, then this would revoke any enhanced protection the individual had applied for.

The passing of this Bill to an Act now means that anyone who had undertaken a partial pension transfer can now apply for and receive enhanced protection as the amendment backdates the removal of the original ruling to the 6th April 2006 (A Day), thus allowing all partial transfers to qualify as permitted transfers. Please note, where a pension transfer was split to be paid to two or more providers from one source, it is not a partial transfer as all funds left the original scheme and were paid in full to other schemes, which qualifies as a permissible transfer.

Therefore, clients who have been granted enhanced protection may now enter into a partial transfer and retain their protection.

If clients have had their enhanced protection revoked because of a partial transfer being completed then they should contact HMRC to see how their enhanced protection may be reinstated. HMRC currently has no guidance on how this should be dealt with, so individual contact is necessary. If a client undertook a partial transfer without knowing the consequences, then due to the backdating of the effect of the Act this will now be regarded as a permissible transfer and there should be no fine imposed and enhanced protection should be maintained.

Please remember clients only have until 5th April 2009 to apply for enhanced or primary protection and if they have not done so by this date, they lose the right for ever. To qualify for primary protection, an individual must have had total pension benefits with a notional value in excess of £1.5m at 5th April 2006. For enhanced protection, there is no pension fund value threshold, but no contributions must have been paid to a money purchase arrangement since the 5th April 2006. Contracting out rebates into either a COMP or private personal arrangement do not count as contributions for this scenario. Continuing membership and accrual within a final salary scheme need not preclude an individual from being eligible for enhanced protection, even if they have continued to contribute.

Charlotte Clarke
Pensions Specialist

Market Commentary

There is some debate as to whether the current dip in equity markets is the start of a correction, a bear market, or indeed just a period of consolidation before indices move on to bigger and better things. Some sort of consolidation was long overdue, and there is a feeling that the profit taking and rising risk aversion is something that actually should have happened earlier in the year. The trigger has been the sub prime debacle in the US, which is something we have been writing about for a while. However, the effects are becoming far more visible, e.g. collapsing hedge funds, and no doubt there is plenty more to come.

In the US anyone with a pulse has been able to get a mortgage, and self-certified no less. We have mentioned before how one of our fund managers described these mortgages as 'toxic waste', earlier in the year. However, these people who have previously been unable to get mortgages became the marginal players who were driving the US housing market. In a similar vein to the UK, there has also been much investment buying of property in a buy-to-let manner. However, as soon as the housing market stopped being a one-way bet, investors pulled out of their contracts for new properties under construction, en masse, leading to a glut of unsold housing and further weakness in the market. Indeed, many have bought property with money they don't have, on the basis that it can only go up.

US interest rates have been rising, and therefore mortgage repayments have been going up too, while house prices go the other way. It is not just sub-prime mortgages that are consequently defaulting, but Alt-A (one step up the quality curve) is now seeing late payments and defaults at 4 times the average rate. Another $500bn will have an interest rate reset in the remainder of 2007 and 2008.

The point to this is that these mortgages get packaged up into loans and sold on as CDOs (Collateralised Debt Obligations), which, by the same token can also include credit card receipts, bank loans and the like. The CDO can have several different parts to its capital structure: equity, high yield, mezzanine, or senior investment grade, for example. Where all these different tranches have ended up was anyone's guess; but we are starting to find out. At the moment it may well be that many are not 'marked to market' and so it will only be when the owner is obliged to value it properly that the damage becomes clear. Good recent examples include Australia's 7th largest hedge fund, which blew up with the equity portion of CDOs. Two Bear Stearns hedge funds, with a 3rd on the way, have also collapsed.

The difficulty in valuing these things is that they do not trade every day on an exchange and hence are only worth what someone is willing to pay for them at a certain time. Furthermore, the price you might attain in a fire sale of these assets, at a time of increasing investor risk aversion, might be significantly lower than what they might be worth if held over time. It is not totally clear why anyone would want to hold one of these things in the first place, other than as a (hopefully) known risk, that one tries not to get caught holding, a reverse pass-the-parcel crossed with musical chairs if you will.

With apologies for the long-winded explanation, the point is that no one really knows who owns what tranches of which CDOs, or when and if they will be obliged to mark them to market, or sell them (for a price they almost certainly won't like). Everyone from Investment Banks to Pension Funds could be on the plate for this.

It is hard to be overly sympathetic as investors have either not understood something they have bought, have been greedy, or unbelievably foolish. In any event, from our own perspective the issue is whether the current contagion in financial markets will spread to the real economy. One would expect the US economy to slow as the average consumer is surely going to have less cash in his back pocket, and feel less happy about life in general.

So, the global economy may slow a little, and certain financial companies may endure a fall in their share price. However, the hope and expectation has to be that much of the rest of the investment world will be reasonably unaffected. Investor risk aversion ebbs and flows as a matter of course, and though it may be tougher to borrow money, this initially only has a bigger effect on private equity firms, as generally corporate balance sheets are actually in good shape, and they can always issue equity rather than bonds. Furthermore, the current volatility in financial markets will inevitably throw up opportunities too. In these instances the proverbial baby almost always ends up getting thrown out with the bath water, and sentiment driven moves in the market go to unwarranted extremes.

Ultimately, multi asset class portfolios are designed to ride out the turbulence of such periods. Patience and discipline are the keys to our philosophy and, as Michael Mauboussin says, 'like a good diet, it only works if it is sensible over the long haul and you stick with it'.

Andrew Wilson
Head of Investment

Current Market Conditions

You cannot have failed to notice the recent volatility in financial markets.

Corrections are not unusual events and can have a positive cleansing and base building effect, and this one was probably long overdue. At times like these we expect to see the true benefits of stable and diversified multi asset class portfolios; managed to reduce downside risk.

A poor July for equity markets has been followed by extreme weakness in recent days. Markets tend to be quite illiquid at this time of year in any case (fund mangers on holiday etc), which leads to large swings in prices. In 2007 this has been exacerbated by the great uncertainty emanating from the US sub prime mortgage debacle (see 'Market Commentary' article also), and uncertainty is something that markets hate more than almost anything else.

Sub prime mortgages have been wrapped up into Collateralised Debt Obligations, which are not necessarily designed to price daily, and in fact, in times gone by one would mark them down at book price/cost and hope to patiently accumulate value over time. This method, however, runs into difficulties when you have borrowed money to buy these things, and the lending bank wants more collateral (sensing the value is going down) or indeed all its money back.

The problem is that any asset is only worth what someone else will pay for it. The more illiquid the market you are dealing in, and the more the buyer suspects that they can get a 'fire sale' price, then the worse the outcome.

Bear in mind, as an analogy, that if your house is worth £250,000, and you had to sell it today, and you only had one offer of £100,000; then your house is actually only worth £100,000 and that is the price it will be sold for. Notional investors in your house might not be that pleased about their return! You may then sell higher quality assets elsewhere to make up the short fall, which just exacerbates the selling in financial markets and helps keep assets away from their true fair value price. Indeed we have noticed that over the last few months there has been little rationality in equity markets, with anything driving relative stock performance other than fundamentals.

Towry Law Position

Towry Law client portfolios are established to effectively manage risk through the use of strategic asset allocation. The portfolios combine a blend of different assets that have low correlation characteristics with each other, which means all of the assets do not fall at the same time.

This approach means that, while client portfolios will have suffered due to stock market falls, they will not be over-dependent on equities and will hold significant weightings in other assets, which have not fallen in value, in order to cushion the blow.

So, although it is likely that volatility will continue, we are confident that our portfolios will continue to produce particularly attractive risk adjusted returns relative to equity markets and competitor portfolios, and will do what they are designed for - in terms of reducing volatility, preserving wealth and producing competitive long-term returns.

Andrew Wilson
Head of Investment

This Global Markets Commentary is solely for information purposes and is not intended to be, and should not be construed as investment advice.

Whilst considerable care has been taken to ensure the information contained within this commentary is accurate and up-to-date, no warranty is given as to the accuracy or completeness of any information and no liability is accepted for any errors or omissions in such information or any action taken on the basis of this information.

The opinions expressed are those of Towry Law Investment Management Limited on behalf of Towry Law Financial Services Limited and are made in good faith, but are subject to change without notice.

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