It is important to screen investment portfolios for risk to identify potential product failures before they happen, says veteran researcher Stephen van Eyk.
"In my experience, the products that really went belly-up over the years were when you had a very high-risk portfolio in a very high-risk market," the van Eyk Research founder told the Morningstar Investment Conference in Sydney last Thursday.
Mr van Eyk described a 'traffic light' stock evaluation system designed by van Eyk Research that was originally offered to fund managers on a subscription basis, but which the research house ultimately used to screen the riskiness of fund manager portfolios.
"We looked up the great investors and what ratios they used to pick their stocks. We hard-coded those ratios in the computer, and we put profit/loss and balances sheet info in one end, and valuation info about the stocks came out the other end," Mr van Eyk said.
One third of stocks were ranked with a green light as being undervalued; amber indicated a neutral valuation; and companies with a red light were "really overvalued", he said.
"We charged [fund managers] about $300 a year ... ASIC said, well, we've changed our mind, not covered under the licence, we're going to close it down.
"But what it was useful for was actually screening manager ports. And when red lights would get above a certain percentage [the fund manager would] invariably go on to crash because they were following the market," Mr van Eyk said.
The most important thing for gauging the likelihood of a product failure is "finding out about the portfolio and trying to judge how much risk the manager is taking", he said.
"Of course, the other side of that is how risky that section of the market is, or how overvalued it is," Mr van Eyk said.
If a fund manager is taking risks in their portfolio and the market is risky, the chances of a product failure increase, he said.
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