Lesson from Lehman crisis: Stay invested in equities even in bleak times

Investors also need to avoid getting over-allocated to a particular asset class during good times

It has been 10 years since Lehman Brothers collapsed. This watershed event had an impact on financial markets and economies around the globe. In India, the benchmark Sensex shed a staggering 52.48 per cent during the calendar year 2008. Liquidity dried up within the debt market, while the real estate industry was hamstrung by lack of funding. Job losses and salary cuts led to demand contraction. A decade later, investors need to imbibe the lessons from that black swan event so that if another one of a similar magnitude strikes, they are better prepared to handle it.

Over-exuberance leads to losses

The Lehman crisis occurred after a long bull run in equities from 2003 to 2007. Investors forgot the mantra of asset allocation and over-invested in equities, instead of running diversified portfolios. Within the mutual fund universe, they bought into new fund offers (NFOs) of infrastructure-oriented funds, instead of sticking to diversified funds. Many of these funds fell steeply after the crisis and investors could not recover their money for several years.  

One key takeaway from the crisis is not to be over-allocated to any one asset class. "Though equities may give better returns than other assets, investors should not have 100 per cent of their portfolios in it. And even within equities, they need to be diversified across market caps and sectors. Sector funds should be a limited part of the portfolio," says K N Sivasubramanian, former chief investment officer at Franklin Templeton Asset Management (India).  

The crisis also offered a lesson on valuation. "When valuations within the equity markets become too high, cut down exposure to it and bide your time, instead of getting carried away by momentum," says Sivasubramanian.

The crisis held lessons for investors on handling fear in the markets. "Investors became fearful due to drop in prices. Many of them redeemed due to the losses without looking at their asset allocation or investment objective. Many others stopped their SIPs due to negative returns," says Nilesh Shah, managing director, Kotak Mahindra Asset Management. For two-three years after the crisis, retail investors stayed away from the equity markets. At the start of 2009, valuations were very attractive. A few bravehearts who entered the markets then did very well, as did those who continued their SIPs. Shah says that it is important to be an optimist in the equity markets since the storm does pass eventually. "Discipline of regular, long-term investment and asset allocation goes a long way towards creating sustainable wealth in the markets," he says.  

For direct equity investors, the key lesson from the crisis is to avoid over-leveraging. "It looked too good to be true - borrow paying peanuts as interest and make tons of money. When things turned, as they eventually do, their leveraged investments came crashing down like a pack of cards," says Arun Kejriwal, director at KRIS Capital, an investment advisory firm.

Make safety your priority in fixed-income

The Lehman crisis had an impact on the debt market in India too. Liquidity dried up and the premium on liquid papers shot up. Risk perception changed dramatically within a short period of time. Investors and money managers made a beeline for quality and safety. Credit spreads expanded sharply.

The markets also witnessed panic reactions from investors. In those days, some FMPs were open-end with high exit loads. Investors redeemed from these schemes despite the loads. The high redemption pressure put many funds in a spot.  

In the aftermath of the crisis, the regulator turned FMPs into closed-end products that had to be listed on the exchanges. Today the maturity of securities in their portfolios can't exceed the maturity of the FMP even by a day. Liquid funds, too, have turned into more conservative products, where the maturity of papers can't exceed 90 days.

Ten years after the crisis, some lessons appear to have been forgotten. "Today we have almost a ~1500 billion credit fund industry. We have done work which shows that a large part of this industry is quite illiquid, which is worrisome," says Suyash Choudhary, head-fixed income at IDFC Mutual Fund. He adds that fund managers, instead of maintaining liquid portfolios,  are relying on tranching of liabilities. In other words, they expect that investors will not want to redeem at the same point of time, because their funds have exit loads. "But what the Lehman crisis showed was that if the size of the shock is big enough, you can have periods in an open-end mutual fund when investors will want their money despite the exit load. Hence, fund managers need to ensure that a significant portion of their portfolios are in liquid instruments," says Choudhary.

Fixed-income investments in India need to keep their investments simple. "The larger portion of your investments should be in funds that control both duration and credit risk. Invest largely in AAA-oriented short-term, ultrashort-term and medium-term funds," says Choudhary.

Another lesson from the 2008 crisis, when markets froze, is that investors should have at least 5-10 per cent of their savings in safe, highly liquid instruments where they can be easily accessed, like saving deposits and flexi deposits of banks.

Avoid over-leveraging in real estate

The Lehman crisis hit India's real estate market hard. Both banking and non-banking finance available for development dried up. Investing by scheduled commercial banks reduced. NBFC and private-equity lending, a major source of real estate finance, dried up completely. The government stepped in and asked banks to start lending to the real estate sector. Interest rates were also reduced. But the lack of PE and NBFC funding had a deep impact on the pace of development.

Over the next 12-18 months, job losses occurred across sectors. New jobs were not being created. This had a drastic impact on the demand for housing, which revived only in 2010.

Commercial real estate, too, was affected in a big way. In 2007, India had absorbed around 42 million square feet of office space. In 2009, the number halved to around 21 million square feet. Developers, who were building based on the demand they had witnessed in 2006-07, were caught on the wrong foot.

The key lesson from the crisis for retail buyers is that they should avoid over-leveraging. "Today the banking market in India is a lot deeper than it was 10 years ago. Individual buyers must assess their repayment capacity carefully and stay within it. Make sure that you will be able to pay your EMIs in case of job loss," says Anshul Jain, country head and managing director, Cushman and Wakefield India. He adds that when the economy is in good health, investors should maintain a contingency fund of six months, which they should boost to 9-12 months in difficult times. Those who invest in commercial real estate, he says, should be cognizant that during an economic recession demand in this segment tends to decline steeply.

Gold is a safe haven

The yellow metal acted as a safe haven amid the turmoil. During the crisis, it acted as a ballast in the portfolios of investors who had made some allocation to it (See returns table). "A 10-15 per cent allocation to gold in the portfolio reduces risk significantly," says Chirag Mehta, senior fund manager-alternative investments, Quantum Asset Management.

 

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