Make Your Money Work For You.pdf

HOW TO GROW YOUR IN NVESTMENT DOLLAR RS

KEON CHEE & BEN FOK 3RD EDITION

MAKE YOUR

M NEY

W RK

FOR YOU HOW TO GROW YOUR INVESTMENT DOLLARS

KEON CHEE & BEN FOK 3RD EDITION

© 2006 Marshall Cavendish International (Asia) Private Limited. © 2008 Marshall Cavendish International (Asia) Private Limited. 2nd Edition. Reprinted 2010 © 2011 Marshall Cavendish International (Asia) Private Limited. 3rd Edition. Cover images: kavitha/SXC.hu, hele-m/SXC.hu, 2007 Presidential $1 Coin image from the United States Mint Design: Lock Hong Liang Published by Marshall Cavendish Business An imprint of Marshall Cavendish International 1 New Industrial Road, Singapore 536196 All rights reserved No part of this publication may be reproduced, stored in a retrieval system or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the copyright owner. Request for permission should be addressed to the Publisher, Marshall Cavendish International (Asia) Private Limited, 1 New Industrial Road, Singapore 536196. Tel: (65) 6213 9300, fax: (65) 6285 4871. E-mail: [email protected]. Website: www.marshallcavendish.com/genref The publisher makes no representation or warranties with respect to the contents of this book, and specifically disclaims any implied warranties or merchantability or fitness for any particular purpose, and shall in no events be liable for any loss of profit or any other commercial damage, including but not limited to special, incidental, consequential, or other damages. Other Marshall Cavendish Offices Marshall Cavendish International. PO Box 65829, London EC1P 1NY, UK • Marshall Cavendish Corporation. 99 White Plains Road, Tarrytown NY 10591-9001, USA • Marshall Cavendish International (Thailand) Co Ltd. 253 Asoke, 12th Flr, Sukhumvit 21 Road, Klongtoey Nua, Wattana, Bangkok 10110, Thailand • Marshall Cavendish (Malaysia) Sdn Bhd, Times Subang, Lot 46, Subang Hi-Tech Industrial Park, Batu Tiga, 40000 Shah Alam, Selangor Darul Ehsan, Malaysia Marshall Cavendish is a trademark of Times Publishing Limited National Library Board Singapore Cataloguing in Publication Data Chee, Keon. Make your money work for you : how to grow your investment dollars / Keon Chee & Ben Fok. – 3rd ed. – Singapore : Marshall Cavendish Business, c2011. p. cm. ISBN : 978-981-4328-61-6 1. Finance, Personal. 2. Finance, Personal – Singapore. 3. Investments. 4. Investments – Singapore. I. Fok, Ben, 1961— II. Title. HG179 332.024 — dc22

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To Sarah, For making bubbles float and the sun shine.

Keon To my wife, Sharon, For the encouragement, and to my children, Jeryn and Samuel, for the love and laughter.

Ben

Contents

Introduction

8

Part 1 : Basic Investment Concepts 1 2 3 4

Why Learn About Investing The Major Types of Investments The Risks and Returns from Investing Managing Crises and Diversification

11 20 28 40

Part 2 : Investing In Traditional Assets 5 6 7 8 9 10

Investing in Unit Trusts Selecting and Managing Your Unit Trust Investments Investing in Individual Stocks Selecting and Managing Your Individual Stock Investments Investing in Individual Bonds Selecting and Managing Your Individual Bond Investments

56 67 84 95 110 122

Part 3 : Investing In Alternative Assets 11 12 13 14 15 16 17 18 19 20

Investing in Exchange Traded Funds (ETFs) and Index Funds Investing in Real Estate Socially Responsible Investing Investing in Commodities Investing in Gold Investing in Hedge Funds Investing in Art and Collectibles Understanding Basic Derivatives Understanding Structured Products and Other Derivatives Understanding Currency

132 138 150 161 172 181 191 197 210 220

Part 4 : Special Topics 21 22 23 24 25 26

Investing for Kids Investing During Retirement Protecting Your Wealth with Insurance When Things Go Wrong Getting Financial Advice Protecting Your Portfolio in Downturns and Upturns

231 237 243 249 254 265

Introduction

We belong to the sandwich generation. Our children depend on us, as do our parents. For our children, we are seeing the price of a higher education rising faster than the rate of inflation. For our parents, we are possibly looking at hundreds of thousands of dollars in costs for treating major illnesses they run the risk of contracting. The sandwich generation is being chewed on at both ends. We are struggling to support ageing parents and pay university tuition fees for our children. And this is probably the worst situation you can find yourself in — when you have to depend on others to support you in your retirement years. In the future, you will either have enough money or you will not. If you don’t, chances are that your neighbour living next door to you will. People living in Singapore and in Asia overall are getting wealthier and wealthier. In the year 2009, Singapore saw the highest growth in millionaire households, up 35 per cent, followed by 33 per cent for Malaysia, 32 per cent for Slovakia, and 31 per cent for China (2010 Global Wealth Report by The Boston Consulting Group). Singapore now has the highest concentration of millionaire households in the world. And Asia-Pacific, excluding Japan, is expected to generate millionaires at nearly twice the global rate. It is horrible to retire when you don’t have enough money, and even worse if everyone around you has enough and you can’t even get by. That is why learning how to invest is so important. For many people, it could make the difference between a blissful retirement and a painful one. The investment environment has become very diverse in the last few years. We are seeing a rise in derivatives and currency trading by the public, commodity prices far outpacing stocks and bonds, hundreds of structured products being made available at any one time and challenging market conditions with inflation, lower real returns and a subprime crisis that is taking years to clean up. This is why for this third edition, we have added two

new chapters, revamped one chapter and expanded on previous chapters in the hope of better describing what is out there. To succeed at investing, you need to keep two things in mind. First, you need to keep abreast of what is happening in the investment markets. Once you are armed with the basic knowledge of investing (which we hope you will gain from this book), knowing what is happening in the markets will become not only less strenuous but also an enjoyable pastime. Second, if you have never invested before, you need to take the plunge yourself. There is nothing like direct experience. Only when you handle your own money will you be able to appreciate and understand fully the complexities surrounding the money markets. Finally, and most importantly, investing is your responsibility, not anyone else’s. It is neither the government’s responsibility, nor that of your remisier or financial adviser’s. And when you do succeed, you will probably want to spare a thought for the less fortunate. Social enterprise and socially responsible investing are taking root in Singapore and around the world and not a moment too soon as income gaps around Asia have become particularly worrying. Singapore’s Ambassador, Tommy Koh, described “social inequity” as one of Asia’s three biggest challenges, along with corruption and the environment. Despite headline hogging news about Asia’s booming economies, vast pockets of paralysing poverty remain. Dr. Ifzal Ali, Chief Economist of the Asian Development Bank, estimates that 42 per cent of Chinese live on the equivalent of less than $3 a day. In India, three-quarters of the population (more than 800 million people) survive each day on less than the cost of a Starbucks latte. All told, 60 per cent of all Asians still live in poverty. In the future, you will either have enough money or you will not. There are many exciting things you can do today to make sure that you will have enough — and better still — be able then to spare time and money to help others.

PART

1

BASIC INVESTMENT CONCEPTS We start with the basic concepts you need to know to understand and appreciate the art of investment. While there are many reasons for investing, retirement is by far the most important one. In this section, we will look at the main types of investment assets and discuss whether they are appropriate for you. We will show how investment risks and returns are calculated so you can assess the performance of your investments. Finally, we find out how crises affect investment performance. The findings may surprise you.

01 Why Learn About Investing Congratulations! You have accumulated $1 million in cash and assets, and you are planning to retire next year at age 55. But here is a reality check. Your son, Brian, will be going to the U.S. in two years’ time to do a course in computer science. The cost of this four-year programme will amount to $200,000. Your mum is 78 and healthy. Your dad is 82 and has lung cancer. His expected cost of treatment is $100,000. That is $300,000 to be deducted from your retirement cheque. Then, there is $400,000 tied up in your executive condo. Your million-dollar retirement now looks a lot less attractive. This story may not reflect your situation completely, but the underlying facts are real. We are marrying later, and consequently, by the time we near our retirement, our children may still be financially dependent on us, as may our parents. But let us not allow such grim facts to get us down. There are ways to get around our various commitments, and prudent investing is one of them.

WEALTH ACCUMULATION — THE NUMBER ONE REASON WE INVEST To plan successfully for retirement, we must have a clear picture of when we want to retire (the earlier the better) and how much retirement funds we want to have (the more the better). Being strapped for cash when we are past our peak earning years is not going to be fun. Suppose you are now 40 years old and plan to retire at age 60 and want a monthly income of $5,000 for 25 years. How much money would you need to accumulate in your retirement fund? Assuming these funds are invested at a modest rate of return of 2.5 per cent, you would need to accumulate $1,114,537 between now (at age 40) and retirement (at age 60). That is a huge sum of money!

12 MAKE YOUR MONEY WORK FOR YOU

If you keep your savings under the pillow, you would need to set aside even more — $1.5 million. If you invest and achieve six per cent returns, you halve your burden to $776,034. At higher and higher rates of return, your burden starts to look lighter and lighter. That is the whole idea behind investing — to reach your financial objectives with the least amount of effort and time possible.

TABLE 1.1.TOTAL FUNDS NEEDED TO PROVIDE $5,000 MONTHLY INCOME FOR 25 YEARS Rate of Return

Funds Needed

0.0%

$1,500,000

2.5%

$1,114,537

6.0%

$776,034

12.0%

$474,733

Source: Authors’ own computations

TWO MYTHS ABOUT RETIREMENT Myth 1:

I Will Live Till 80 and That’s It We have one of the highest life expectancies in the world at over 80 years. However, the number 80 is somewhat misleading. It’s not a figure cast in stone. For example, a woman who has reached 65 years of age can reasonably expect to live on till 85 years.1 This means that the longer we live, the more money we will need during retirement. While we should plan for our financial needs based on 80

1 Koh Eng Chuan, “Measuring Old Age Health Expectancy in Singapore”, in Singapore Department of Statistics newsletter, 3rd quarter, 2000.

Myth 2:

I Will Be Spending Less During Retirement After subjecting your mind and body to 40 years of hard labour, you probably want the best vacations, the best doctors and the best foods. No doubt you could spend less by downgrading your lifestyle, but this is surely not something you want. Don’t fall into this self-fulfilling trap. If you plan to spend less during retirement, you will end up with less. Expect to spend more, plan for it and you will end up with more.

CHOOSE YOUR INVESTMENTS WISELY When we invest, there is a multitude of instruments we can put our money into. Historically, some have given higher returns than others. Choosing the right instruments that provide the best returns can make all the difference to your retirement. You can invest in two main investment categories: financial assets and real assets. Real assets — such as real estate, jewellery or art — are tangible; you can touch and take physical possession of them. One drawback of owning real assets is that they are generally harder to buy and sell. For example, selling a house takes time because it is a big-ticket item and potential buyers need time to evaluate. Or if you wanted to buy an antique fountain pen or a rare painting, you may have to go to a specialised auction house such as Sotheby’s. Financial assets — such as stocks, bonds and unit trusts — are financial claims on assets. Rather than taking physical possession of the asset, your ownership is documented by a legal document. So when you invest in a stock, you receive a certificate that acknowledges your claim as a shareholder of the company. Unlike

13 Why Learn About Investing

years as a base mark, it is best we plan for a few extra years — till age 90 or more. So give yourself more leeway when making your investment plans.


real assets, financial assets are easy to buy and sell through organised exchanges such as the Singapore Exchange. As you can probably sense, the scope of investment opportunities is too huge to cover in this book. For this reason, our primary focus is on financial assets.

RETIRING A MILLIONAIRE Consider this: If you contribute $500 per month to your CPF Ordinary Account (CPF OA)2, after 40 years, you will have contributed $240,000. Since the Ordinary Account earns 2.5 per cent annual returns, after 40 years, you will have accumulated $411,709. That’s nearly $172,000 in interest. Not bad. If, instead, you invested the $500 per month over the same period while earning 6 per cent interest, you would have accumulated $995,745. That is almost $1 million. You can retire a millionaire! But if you had annual returns of 12 per cent over the same period, you would have close to $5.9 million ($5,882,386 to be exact). You would retire a multimillionaire!

TABLE 1.2. RETURNS SCENARIOS Instrument Rate of Return Keep under pillow CPF OA STI S&P 500

0.0% 2.5% 6.0% 12.0%

Accumulated $240,000 $411,709 $1 million $5.9 million

Source: Authors’ own computation

Given the wide disparity of possible results, we ought to find out which of these investment returns are realistic and which are not. Based on the history of financial markets, all three return possibilities can actually be achieved. 2 The Central Provident Fund or CPF is Singapore’s mandatory social security savings plan towards which working Singaporeans have to contribute. Such plans are commonly found in other countries. In Malaysia, it is the EPF or Employees Provident Fund. In Hong Kong, it is the MPF or Mandatory Provident Fund.

WHAT ABOUT RISK? If we were given these three investment choices, the obvious choice would be the S&P 500, which provides the best returns. Our decision making would then be a simple process of choosing the investments with the highest returns. But we have yet to talk about risk. Risk is the possibility of losing money on our investments. The CPF OA rate of 2.5 per cent is an almost unchanging rate. It may move up a little, or go down a little, but it will never hit negative, which means that we can’t possibly lose money. Putting our money into the Ordinary Account can be considered risk-free.

FIGURE 1.1. S&P 500, JANUARY 1996 TO DECEMBER 2007

B

A

C

Jan Ju 96 n No -96 v Ap -96 r-9 Se 7 p Fe -97 b9 Ju 8 l De -98 c M -98 ay O -99 ctM 99 ar Au -00 g0 Jan 0 Ju -01 nNo 01 v Ap -01 rSe 02 pFe 02 b0 Ju 3 lDe 03 c M -03 ay O 04 ct M -04 ar Au -05 g0 Jan 5 Ju -06 nNo 06 vAp 06 rSe 07 p07

1800 1600 1400 1200 1000 800 600 400 200 0

(Source: Standard and Poor’s)


The interest rate for CPF OA is 2.5 per cent. Between 1990 and 2005, the Singapore Straits Times Index (STI) of common stocks yielded an annual return of about 6 per cent. In the U.S., over the 75 years between 1930 and 2005, the Standard & Poor’s (S&P) index of large-company common stocks yielded about 12 per cent.


Look at Figure 1.1 (page 15), which plots daily prices of the S&P 500 for the period January 1996–December 2007. Investors who bought around the third quarter of 2000 (indicated by B) and sold in 2003 (indicated by C) would have lost a lot of money compared with those investors who bought at the beginning of 1996 (indicated by A). Investing in the S&P 500 produces winners and losers, and along with that, a sense of unpredictability. We can see that looking at returns without considering risk is clearly a major mistake for any investor. But we are sure you will agree that if you want to seek out the best returns, you will have to tolerate some risk. What history tells us is that there is a positive relationship between risk and return, and we can assign relative risk levels to the three investment choices as follows:

TABLE 1.3. RELATIVE RISK LEVELS Investment Choice

Risk Level

CPF OA

Low

STI

Medium to High

S&P 500 Index

High

Source: Authors’ own illustration

BIG MISTAKES CAN SET YOU BACK — PERMANENTLY An investor needs to do very few things right as long as he or she avoids big mistakes. ~Warren Buffet in Berkshire Hathaway, Annual Report, 1992

Even smart people can make silly mistakes when it comes to investing. Do not take investment lightly — one mistake can set you back for a long time. Just to illustrate, let us tell you about someone we know. Michael was a very successful investor who made $2 million in the markets

Three Mistakes to Avoid When Investing These mistakes are common yet some of them are not so obvious. 1. Keeping Too Much Cash According to statistics from the Monetary Authority of Singapore (April 2010 MAS Monthly Statistical Bulletin), over $320 billion now sit in savings accounts and fixed deposits. This works out to $60,000 per person, young and old. Financial advisers recommend putting away six months’ salary in the bank in case of rainy days. The reason is that if an emergency arises, such as the loss of your job or a major illness, these savings can tide you over while you look for another job or settle medical bills.


over the last four years. In January 2001, he went to the bank to deposit a cheque. The manager serving him suggested he invest some money in a technology unit trust. Michael said no and left. Back home, Michael brought out his charts and found that the fund was trading at 50 cents to its initial offer price of $1. In other words, the fund had already lost 50 per cent of its initial value, which appeared cheap to Michael. IT sector news was robust and a recovery was expected. Being an IT buff and bullish about the sector, he invested $2 million the next day. The technology fund was the first ever unit trust he owned. In six months, the price of the fund dropped to 25 cents. His paper loss was over $1 million. There are a few lessons to learn from Michael’s experience. There are two we would like to highlight. One, avoid the big obvious mistakes by doing your homework. Even a successful investor like Michael should have kept this in mind as he went in impulsively. In the end, he took four years to earn $2 million in investment returns, but lost half of it in only six months. Second lesson: learn to take responsibility. Michael blamed the bank, the IT sector analysis he read, his bad luck, etc. He admitted only much later that it was his own mistake and he was responsible for it.


You may not need so much ready cash, especially if you are still a good way ahead of your retirement age. We recommend you save three months’ salary. First, some of this money can be invested in financial assets such as bonds and unit trusts, since they can be liquidated almost any time, with little or no penalty. Second, if you have a working spouse, there should be sufficient “back-up” income in the event of an emergency. Keeping too much cash means you are earning less, and anticipating emergencies that occur only infrequently in reality. 2. Skimping on Life Insurance If you or your spouse dies or suffers a major illness, you have to make sure your dependents will be provided for. Who cares then if your investments are making 10 or 15 per cent returns if you do not have enough funds for your immediate needs? While you may have some life insurance coverage through your employer, such coverage is not portable. If you get laid off, you lose the coverage. Imagine getting laid off when you have medical problems. Getting a new policy would be extremely expensive, sometimes even impossible if you are in poor health. How much insurance do you need? One rule of thumb is to get at least five times your earnings, plus the total amount of your mortgage, with a little to spare to cover your children’s basic education. Having enough life insurance is so essential that you shouldn’t even think about investing unless you are already sufficiently covered. 3. Taking Care of Others Before Yourself Many people often go the distance for family members and forget to take care of themselves. For example, once you are faced with the monumental task of saving for your child’s university education, it is easy to forget about saving for your own retirement. This is a big mistake.


Saving for retirement should always come first. You and your child can figure out ways of getting through school when the time comes, whether through loans, co-payments or otherwise. What you want to avoid is channelling all your surplus funds into your children’s education, only to discover later that you have little left over for yourself. By all means, provide for your children, but do spare a thought for yourself.

02 20 MAKE YOUR MONEY WORK FOR YOU

The Major Types of Investments Consider this: Two months ago, both you and your aunt decided to make an investment in FoodMall, a food wholesaler. You invested $10,000 in its common stocks, while your aunt bought $10,000 worth of FoodMall warrants. You now sell your shares for $12,000, realising a 20 per cent return. But your aunt managed to sell her warrants for $20,000 — a 100 per cent return. Clearly, there is a difference between common stocks and warrants. The type of security we put our money into matters. In this chapter, we will introduce the different types of investments that are commonly bought and sold by investors — stocks, bonds, derivatives and unit trusts. We will be brief in our introduction because we will be discussing each of these investments in greater detail in later chapters.

THE THREE MAIN TYPES OF BASIC INVESTMENTS One of the most important factors in deciding where to put your money is how soon you think you’ll need it back. Also, what is your overriding motive in investing? Do you need your money safe and secure at all times? Do you need it to grow? Or do you need it to produce a regular income? Your answers to these questions point to the type of basic investment that is most suited to you. There are three main types: 1. Stocks or equities 2. Bonds or fixed income securities 3. Money market investments Each of these is attuned to the three things you need from your investments: growth, income or safety.

Stocks or Equities

Stock Returns The returns from owning stock come from two sources. Cash dividends are earnings that are distributed to shareholders. Unlike

The Major Types of Investments

If you own common stock of company A, you have an ownership interest in the company. If only a few individuals hold a company’s shares, the firm is said to be privately held. Many companies choose to go public by selling common stock to the general public on a stock exchange. Companies go public because they can raise additional capital that way, since there will be a far bigger buying audience. If you buy 100 shares of A’s common stock, you would own 100 per cent of the company, where “n” is the total number of common stock shares. As a stockholder, you have a residual claim on the company’s earnings and assets. When a company generates earnings, you are entitled to the earnings that remain after all expenses have been paid. Such expenses include staff salaries and payments for those who hold fixed income securities (including preferred stockholders). In other words, as a holder of common stock, you will be the last in line when the company pays out its earnings. As a stockholder, you also have a residual claim to assets in case the company goes bankrupt and liquidates its assets. In that case, you will be entitled to the remaining assets only after all other claims (including those made by holders of preferred stock) have been satisfied. This is much like eating the leftovers at a wedding dinner when everyone else has eaten. As owners, the holders of common stock are entitled to elect the directors of the company and to vote on major issues. Stockholders also have limited liability, meaning that they cannot lose more than their investment in the company. Hence, should the company run into financial difficulties, creditors can only claim against the assets of the company, and not the assets of individual stockholders.

21


bonds, stocks do not guarantee the timing or the amount of dividends. At any time, they can be increased, decreased or taken away altogether. The other source of returns is capital gains. This is the main reason people buy stocks. The value of your stock may rise when the earning prospects of the company are favourable. And, of course, your shares may also lose value if the company performs poorly. Stock Risk As a group, stocks generally move up and down in value more than any other type of investments in the short term. People are usually afraid of purchasing stocks because they hear about bear markets, corporate scandals and stock market crashes. But this should be a concern only to investors who need their money back within a few years. In fact, over the longer term, you stand a greater risk of losing money if you don’t invest in stocks.

Bonds or Fixed Income Securities Bonds are loans issued by companies and governments to borrow money, and they have two main characteristics: 1. They have life spans greater than 12 months at the time of issue. 2. They typically promise to make fixed interest payments according to a given schedule. Bonds are hence also called fixed income securities. Bonds have their own unique terms. Let us work with an example. Suppose you buy bonds with a face value of $10,000. These bonds mature in two years and pay 4 per cent interest annually. The 4 per cent interest equates to $400 a year. The face value of the bond, or the principal amount of $10,000, will be returned to you when the bond matures in two years.

Bond Risk Besides interest rate risk, bonds have default risk. Default risk refers to the possibility that the borrower will not make the promised payments. This risk is almost non-existent for Singapore government bonds, but for many other issuers, such as private companies, the risk of default is very real.

Money Market Securities Money market securities are similar to bonds, except that they are short-term investments. They have two main characteristics: 1. They are loans issued by companies and governments to borrow money. 2. They mature in less than a year from the time they are sold, which means the loan must be repaid within a year. Some of the most common money market securities include Treasury Bills (issued by the government and considered the safest investments around), fixed deposits, bank savings accounts and certificates of deposit. Money Market Returns Money market investments maintain a stable value, pay interest and

23 The Major Types of Investments

Bond Returns The returns from owning a fixed income security come in two forms. There are the fixed interest payments and the final payment of principal at maturity. Secondly, there is the potential for capital gains when you sell a bond before its maturity at a price higher than when you purchased it. Imagine a see-saw. The price of a bond rises when interest rates fall, and there is thus the possibility of a capital gain from a favourable movement in rates. Of course, inversely, a rise in interest rates will produce a loss.


can be easily converted into cash. Of the three types of investments, money market instruments pay the lowest rate of return. So why bother with them? For the same reason you leave large chunks of your uninvested money in a fixed deposit — safety. When you buy a money market investment, you are pretty sure you will get your money back with some interest. The chances of losing money — whether from the government or the bank defaulting on its payments or a loss in principal value of the investment — are very low. In other words, when you invest in a money market investment, you are taking very little risk and your expected return should reflect the amount of risk that you have taken. When is a money market investment appropriate? When you need to use the money in a year or so, and you want to know that the money will be there with few surprises. Money Market Risk Beware of inflation. The longer you leave your money in a fixed deposit, the higher the risk of inflation eating away the purchasing power of your money. Money market investments are safest when the money is needed in the short term. The very same safe investments become high-risk the longer they stay invested. Stocks are on the opposite track. They are high-risk investments in the short-term, but are lower-risk investments in the long-term:

TABLE 2.1. RISK COMPARISON OF STOCKS AND FIXED DEPOSIT OVER TIME Investment

1 Year

10 Years

Fixed Deposit

Lower Risk

Higher Risk

Stocks

Higher Risk

Lower Risk


For example, according to a study by U.S. investment management firm, T. Rowe Price, that looked at the S&P 500 index (a basket of stocks that represents the largest 500 companies in the U.S.) from

DERIVATIVES Stocks and bonds are financial assets. When you invest in a financial asset such as a stock in Company X that is currently priced at $10, you receive a contract stating that you have a legal claim on the assets of Company X. If the company does well and its share price rises to $15, you have a direct claim on the company’s assets that is now worth $15, the share price. A derivative is also a financial asset, but it differs from stocks in one fundamental way: the value of the derivative is based on the performance of an underlying financial asset that you do not own.

Options Options are one of the most common types of derivatives. There are two main types of options — calls and puts. A call option gives the buyer the right to purchase a specified number of shares, say 100, of a particular stock at a specified price (called the exercise price) within a specified time frame. A put option does the reverse — it gives the buyer the right to sell 100 shares at a specified price within a specified time frame. A definite advantage for the buyer of an option — whether a call or a put — is that there is no obligation to exercise the option. Let us illustrate with a simple example of a call option. Suppose that you want to own 1,000 Microsoft shares at $30 each. If you are fortunate enough to have this large amount of money ($30,000) on hand, you can pay up right away and own the shares. But suppose you do not have this sum of money to invest directly, and your roommate is willing to sell you the right to buy the 1,000


1926 to 2002, in any one-year period, there is about a 27 per cent chance of losing money. If the holding period is three years, the odds of losing money fall to 14 per cent. And if the holding period is a whole decade, the chances of losing money goes down to just 4 per cent.


shares at $30 each. For this right, he will charge you a fee of $1,500 and this right lasts three months. In effect, your roommate has sold you a call option. If you buy the call option, the value of your investment now depends on the underlying asset — the share price of Microsoft. If the price of Microsoft goes up, so does the value your call option. The reverse is true as well. If the price of Microsoft goes down, your derivative falls in value. When you buy a call option, you pay the seller $1,500 for the right, but not the obligation, to buy the shares at $30 each. If you change your mind because you found a better deal elsewhere, you can just walk away. You will lose only $1,500, which is called the option premium.

UNIT TRUSTS Direct investment in stocks, bonds and derivatives is not for everyone. It requires time to research good buys and a fair amount of skill to sieve the duds from the winners. This is not a simple task, given the infinite number of investment choices available. Indirect investment through unit trusts provides a very attractive alternative. When we invest in a unit trust, we pool our money with that of thousands of other investors. For as little as $1,000 and a relatively small fee, a professional investment manager invests our money in money market securities, bonds and stocks, to reap the greatest possible returns consistent with our objectives. The range of companies and securities invested in will be far more diverse than we could achieve on our own. As with stocks and bonds, unit trusts provide us with a wide range of investment choices. There are more than 500 unit trusts to choose from in Singapore. Add to these the funds available from places such as the U.S., the U.K. and Malaysia, and we have an awesome number of choices. Some unit trusts, such as global equity funds that invest in the top companies in the world, have very broad objectives.


Some others have a very specific focus. For example, some funds focus on high-yield bonds, a particular market segment such as biotechnology, or a specific country such as Thailand. With unit trusts, we can choose funds that match our risk profile. Stock funds are for the more risk-tolerant investors who want their money to grow over a long period of time. Bond funds are for those who want current income and do not want investments that fluctuate as widely in value as stocks do. And if we need the money in the short-term and we do not want our invested principal to drop in value, money market funds can be chosen.

03 The Risks and Returns from Investing The rewards from investing do not come free. They are accompanied by the four-letter word, risk. Thankfully, history offers us two important lessons we should know about. First, there is a reward for accepting risk, and when good investment choices are made, that reward can be substantial. That is the good news. The bad news is that greater rewards usually go hand in hand with greater risks. The fact that risk and return are intricately linked to each other is probably the single most important lesson in investing. Returns are easily understood because it comes down to a number — how much did the investment make? Whether the number is 80 per cent, or -20 per cent, its message is clear. What is not so clear is the concept of risk. We all want high rewards and we all want to bear low risk for it, but we intuitively know that high rewards and low risk seldom go together. In this chapter, we lay the groundwork to understanding the nature of risk and returns, and learn how to measure them. We will mainly consider buying shares in this chapter although the calculations are the same for any investment.

RETURNS When you make an investment, your gain or loss is called the return on your investment. This return has two parts: income and capital gain (or loss). The dividends from shares and interest from bonds you receive constitute the income portion of your returns. The capital gain part of your return comes from the profit you earn when you sell your investment at a price higher than what you paid for your purchase.

29

Measuring Total Returns Over One Period

Total Return (1 year) = (Income + Capital gain) / Purchase Price = (500 + 2,000) / 10,000 = 25% If you sell the stock at $9,000, your loss is 5 per cent: Total Return (1 year) = (500 – 1,000) / 10,000 = -5%

Measuring Total Returns Over Several Periods Suppose you become completely enamoured of Xanadu. You stay invested for 10 years and re-invest the dividends you receive. Table 3.1 is a record of the last 10 years:

TABLE 3.1. XANADU RETURNS OVER 10 YEARS Year

Total Return

1 + Total Return

Year 1

25%

1.25

Year 2

-15%

0.85

Year 3

-20%

0.80

Year 4

-10%

0.90

Year 5

-5%

0.95

Year 6

5%

1.05

Year 7

10%

1.10

Year 8

15%

1.15

Year 9

25%

1.25

Year 10

20%

1.20

Source: Authors’ own computation

The Risks and Returns from Investing

Suppose you buy stock of Xanadu for $10,000 on 1 January. During the year, you receive cash dividends of $500. On 31 December, you sell your stock at $12,000. Your Total Return is 25 per cent:


To calculate Total Return for the entire period, we first add the figure “1” to each yearly Total Return number, then multiply all of these together. (After that, simply subtract “1” from the product) The result is this: Total Return (10 years) = (1.25 x 0.85 x 0.80 x 0.90 x 0.95 x 1.05 x 1.10 x 1.15 x 1.25 x 1.20) – 1 = 1.45 – 1 = 45% Hence, every $1 invested at the beginning would have returned you $1.45 at the end of the 10-year period, or you would have a Total Return of 45 per cent over 10 years.

Measuring Annualised Returns How much did your Xanadu stock earn you on an annual basis? The calculation looks complicated, but it is not that bad. What is important is that you understand what the end result means. The Annualised Return for Xanadu over a 10 year period is: Annualised Return = (1.25 x 0.85 x 0.80 x 0.90 x 0.95 x (10 years) 1.05 x 1.10 x 1.15 x 1.25 x 1.20)1/10 – 1 = 1.451/10 – 1 = 3.8% If the calculation seems complicated initially, do not worry. Unit trust fact sheets and annual reports already calculate this number for you. Here is what the end result means and this is important for you to understand. The Annualised Return is a compounded rate of return over 10 years. It means that after staying invested for 10 years and after having reinvested all your dividends, your return on an annual basis is 3.8 per cent.

RISK

Where Does Risk Come From? Risk consists of two components: 1. Diversifiable (or Non-systematic) Risk 2. Non-Diversifiable (or Systematic) Risk That is, Total Risk = Diversifiable Risk + Non-Diversifiable Risk Diversifiable Risk We wish we could spare you the egg-and-basket routine, but in this instance, it is very useful in explaining diversifiable risk. If eggs were your money and baskets were investment choices, then putting all your eggs (money) in one basket (a single investment choice) is a risky proposition. Anything unpleasant that happens to your one and only invested asset would negatively affect your entire investment portfolio. But if you were to diversify by placing your money into several investment baskets, then chances are good that your entire investment portfolio will be stable enough to withstand

The Risks and Returns from Investing

A risky investment is one where there is a strong likelihood that actual returns will differ from what was expected. The more those returns fluctuate, the greater the risk. There is a positive relationship between risk and return — the higher the risk, the more returns we should expect. The opposite is true as well. At the same time, you cannot reasonably expect high returns if you are only willing to assume a small amount of risk. Supposing then that you want to avoid risk at all cost, you could deposit money into a fixed deposit account to earn a safe and known amount. However, this return is fixed, and you cannot earn more than this fixed rate. In this case, risk has effectively been eliminated, but so have your chances of earning a higher return.

31


an unexpected shock from any one sector. In short, diversifiable risk has these three characteristics: 1. It can be diversified away. 2. It can be controlled or reduced. 3. It is unique to a stock or industry. A diversifiable risk is easy to identify. Let’s look at a few examples. 1. Business Risk This is the risk of doing business in a particular company, industry or environment. For example, a semiconductor manufacturing company faces risks inherent in the electronics industry. An investor can control business risk by investing in other industries. 2. Liquidity Risk A security with poor liquidity means that the security is difficult to buy and sell in the secondary market without incurring price concessions. A Treasury Bill has little or no liquidity risk, whereas a highly priced collectible such as a 1899 Coca-Cola bottle has high liquidity risk because it can be a challenge to find buyers and sellers. An investor can control liquidity risk by investing in assets with high liquidity. 3. Country Risk Country risk refers to all the negative things that can happen to a country’s economy as a whole, including political crises, wars and recessions. If you are like many Singaporean investors who invest most of their money domestically, take note. Despite receiving consistently favourable risk ratings by Political and Economic Risk Consultancy, Ltd. (PERC), Singapore is still

Non-diversifiable (or Systematic) Risk An investor can construct a diversified portfolio and eliminate part of total risk (i.e. the diversifiable or non-systematic portion). What is left is the non-diversifiable portion called market risk or systematic risk. This is any risk that, left in the portfolio, will be directly related to the overall movements of the general market or economy. Like non-systematic risk, systematic risk also has three characteristics: 1. It affects all securities. 2. It cannot be diversified away. 3. It cannot be controlled or reduced. Virtually, all securities have some systematic risk, whether bonds or stocks. There are three systematic risk factors: 1. Interest Rate Risk Security prices tend to move inversely with movements in interest rates. When interest rates go up, security prices come down, and other things being equal, all securities will be affected. Even if you hold a well-diversified portfolio of Singapore stocks, a sudden surge in interest rates will bring down the value of each of the securities in your portfolio. 2. Market Risk This is the risk that comes from fluctuations in the overall market as reflected by an aggregate stock index such as the STI. Poor market sentiment as a result of wars, recessions or plain old pessimism are often mirrored by declines in the overall

33 The Risks and Returns from Investing

subject to country risk. An investor can control country risk by diversifying his portfolio internationally by placing funds in several countries.


market. All securities will be affected no matter how fundamentally sound the companies are. 3. Inflation Risk When inflation rises, all securities are affected. Inflation erodes the purchasing power of your invested dollars, such that what you expect to receive in the future would be worth less today in real terms. Inflation also positively affects interest rates. When inflation rises, interest rates generally rise as well because lenders will demand more for their loss of purchasing power. It is important to understand that an investor cannot escape nondiversifiable risk because the risks of the overall market cannot be avoided. If the stock market falls sharply, most stocks will be adversely affected. Or, if the interest rate or inflation soars, most stocks will fall in value. These market movements do occur.

Measuring Risk Risk is the chance of losing money when you sell your investment. This is the definition that most of us are familiar with although we will refine the definition later in this chapter. But for now, let us keep to this familiar definition. If you put your money in the Post Office Savings Bank (POSB) and you suddenly need to cash out after six months, what are the chances that you would lose money? Zero, unless POSB defaults. Your entire principal sum will be returned to you, plus interest. Risk is calculated by a method called standard deviation (SD). Let us work out a numerical example. Suppose you keep your money in POSB for three years, and each year, the return is constant at one per cent. The average return per year is: Average Return = (1 + 1 + 1) /3 = 1% Notice that each year’s return does not deviate from the threeyear average. Hence, Standard Deviation = 0

(5 – 20)2 (20 – 20)2 (35 – 20)2 Total Standard Deviation

= = = =

225 0 225 450

= √[450 / (3 – 1)] = 15%

Note that by itself, standard deviation is not as meaningful as when it is compared with those of other investments. If the standard deviation of POSB returns is zero and investment ABC’s standard deviation is 15 per cent, we can conclude that investment ABC is a riskier investment because its returns are far more uncertain than POSB savings’. Standard deviation can be calculated very easily on a spreadsheet or financial calculator so this ought to be the first and last time you


A zero standard deviation means that there is no risk, and no volatility. At any time, you will be able to cash out, knowing exactly what you will get. No surprises, ever. (To be sure, standard deviation is an academic definition that refers to the uncertainty of returns — whether negative or positive. In reality, there is no such thing as zero risk. Risk can arise from POSB folding, inflation rising out of control, and many other situations.) Let us take another example. Suppose investment ABC had total returns of 5 per cent, 20 per cent and 35 per cent over the last three years. The Arithmetic Mean is 20 per cent (5 + 20 + 35) / 3. Notice that the first return deviates from the mean by -15 per cent (5% – 20%), the second by zero (20% – 20%), and the third by 15 per cent (35% – 20%). To compute the standard deviation of investment ABC, we square each of the deviations, add them up, divide the result by the number of returns minus 1, and take the square root of the result:


will need to go through a worked-out example. The main point is that the returns from an investment such as Xanadu, for example, are inherently more uncertain than the returns from putting your money in POSB. And the more uncertain the returns are, the higher the standard deviation.

The Risk-Return Trade-Off Now if we were to line up some of the most traditional investment choices such as stocks, bonds and derivatives, we could create a ranking of their standard deviations. The following are listed in the order of increasing standard deviation and risk, with Treasury Bills having the lowest of each: • Treasury Bills • Government Bonds • Corporate Bonds • Common Stocks • Derivatives Figure 3.1 puts together our findings on risk and return. What it shows is that there is a risk-return trade-off. At one extreme, we have Treasury Bills, which are virtually risk-free. At the other end of the continuum, if you are willing to bear a high level of risk, you may then expect to earn what is called a risk premium. Risk premium is the additional return beyond the risk-free rate that one expects to receive for taking on risk. The return we expect from an investment in a risky asset can thus be expressed as: Expected Return = Risk-free Rate + Risk Premium

37

R Returns

FIGURE 3.1. RISK-RETURN TRADE-OFF

Treasury Bills

Government ond Bonds

Corporate Bonds

Common Stocks Stoc o k

Derivatives

Risk Premium Line A

Risk-free Rate Risk


In Figure 3.1., Line A is drawn from the risk-free rate to show the risk premium. If, for example, the expected return of common stocks is 8 per cent and the yield offered by Treasury Bills is 2 per cent, the risk premium will be 6 per cent: Expected Return 8%

= [ Risk-free Rate + Risk Premium ] = 2% + 6%

Risk-Adjusted Returns Look at the returns and risk of these two investments in the utility industry (Table 3.2 on page 38). Which do you prefer? If you decide by returns alone, then company A is the clear choice. Company A generated 10 per cent returns compared with company B’s 6 per cent. If you decide by risk alone, then company B is the clear winner. Company B generated a tiny 2 per cent standard deviation compared with company A’s 5 per cent. How do you break the tie?


A risk-adjusted measurement takes an investment’s return and divides it by its standard deviation: Risk-adjusted Return = Return / Standard Deviation Investments with higher risk-adjusted returns are generally considered superior to investments with lower risk-adjusted returns because they offer more returns for each unit of risk taken. Company B is considered superior because it offers three units of return for every unit of risk taken. You may have come across measurements such as the Sharpe, Treynor, Jensen’s or Information Ratios. These ratios all provide risk-adjusted returns.

TABLE 3.2. RISK-ADJUSTED RETURNS OF UTILITY COMPANIES A AND B Investment

Return

Standard Deviation

Return/Standard Deviation

Utility Company A

10%

5%

10/5 = 2.0

Utility Company B

6%

2%

6/2 = 3.0


MORE ON RISK Earlier, we defined risk as the chance of losing money when you sell your investment. At this point, we need to make two refinements to this working definition. In investments, risk is defined more broadly as the chance of receiving a return that is different from the return we expected to make. Risk, in fact, includes not only bad outcomes, such as lower than expected returns, but also good outcomes such as higher than expected returns. Thus, if the expected return of an investment is 5 per cent, the risk that you will earn a 10 per cent or zero per cent return is exactly the same. In other words, using

MANAGING INVESTMENT RISK The best way to manage risk is to allow yourself ample time. Start investing now rather than later. When you have time on your side, more of your money can be invested in stocks rather than bonds and money market instruments because you will have a larger capacity to ride the ups and downs of the stock market. Finally, the way you divide your investments depends on your specific situation and goals. Spend some time thinking about the best way to divide your money, based on your needs and the type of risk you can take. This exercise will make a big difference to your investment success.


standard deviation, you do not distinguish between downside risk and upside risk. For this reason, some investors may not be completely comfortable with standard deviation as a measure of risk. They may use a measurement called the semi-variance, where only returns that fall below the expected return are considered. Or they may go for simpler yet commonsensical proxies for risk. For example, it makes sense that stocks of technology companies are riskier than those of food companies. Others prefer to create ranking categories. (For example, those ranking money market instruments as lower risk, and technology stocks as higher risk). The risk we have defined so far relates to actual returns being different from expected returns. The second refinement to our understanding is that there are investments whose expected return is known ahead of time. For example, when you buy a bond that pays a fixed interest payment every six months and the return of principal at maturity, you can tell ahead of time what your actual return will be. Hence, in general, it is important for investors to understand that the risk of an investment is indeed broader and more varied than what is typically understood — that risk equals the potential that actual returns will differ from expected returns.


Managing Crises and Diversification We have a crisis today. Oil prices are at historical highs. Terrorists can strike anywhere and at any time. There is uncertainty regarding a sustainable global economic recovery. High inflation is causing problems all over the world. How do you react to these crisis points? Would you sell or stay put? If your answer is “stay put”, you might be doing the right thing. In this chapter, we learn that historical events do indeed have a significant impact on financial markets. Uncertainty often clouds judgement, sending even the best of us into panic and gloom. But history shows that negative events do not necessarily spell doom for investors. While past performance cannot guarantee similar future results, historical evidence suggests that most investors can benefit by staying put. Of course, some investors are skilled at anticipating market movements. They would buy on ups and sell on downs. But how many people can do that consistently? The big question for many of us is whether it makes sense to stay invested regardless of market fluctuations. According to a study by asset allocation expert Ibbotson Associates, the answer is “yes”.

TABLE 4.1. $1 INVESTED IN S&P 500: STAYING PUT OR MINUS BEST 35 MONTHS Value in 1996 Value in 1996 (Minus 35 Best (Stay Put Months) Throughout) $1 invested in 1925 Source: Ibbotson Associates

$1,371.00

$12.50

STAYING PUT IN THE FACE OF CRISES This century has seen many crises and disasters, including two world wars, the 9/11 attacks and the 1997 Asian economic crisis. Crises will continue to take place today and in the future. What would you do when the next crisis hits? If you are still not convinced about staying put in the market, here is more information to consider. Ned Davis Research tracks the reaction of the Dow Jones Industrial Average (an index on major U.S. industrial stocks) to political, economic and military crises since World War I in 1914. They found that staying put makes sense because each time a crisis hits, the index will fall, then rebound to near pre-crisis levels within three months. (The average drop in the market during crises was -6.1 per cent, and from there, the Dow rallied on average 5.2 per cent after one quarter). Instead of being fearful during market downturns, you should be getting “greedy”, because crises provide tremendous opportunities for investing.

TABLE 4.2. DOW JONES INDEX DURING AND AFTER MAJOR CRISES Event

Month/ Year

% Change

1 Month Later

3 Months Later

6 Months Later

12 Months Later

Exchange closed WWI

7/14

-10.2%

10.0%

6.6%

21.2%

80.2%

Bombing at JP Morgan office

9/20

-5.5%

2.4%

-14.9%

-9.5%

-17.3%

41 Managing Crises and Diversification

They found that a dollar invested in the S&P 500 in 1925 grew to $1,371 in 1996. That’s a compounded annual return of 10.6 per cent. But when the best 35 months (less than 4 per cent of total time invested) were removed from the analysis, the same dollar grew to only $12.50, a compounded annual return of only 3.6 per cent. So, unless you are confident of predicting accurately the best and worst months for your investment dollar, stay put.


Month/ Year

% Change

1 Month Later

3 Months Later

6 Months Later

Pearl Harbour bombing

12/41

-6.5%

3.8%

-2.9%

-9.6%

5.4%

Korean War

6/50

-12.0%

9.1%

15.3%

19.2%

26.3%

Suez Canal crisis

10/56

-1.4%

0.3%

-0.6%

3.4%

-9.5%

Cuban missle crisis

10/62

1.1%

12.1%

17.1%

24.2%

30.4%

Martin Luther King assassination

4/68

-0.4%

5.3%

6.4%

9.3%

10.8%

Kent State shootings

5/70

-6.7%

0.4%

3.8%

13.5%

36.7%

Nixon’s resignation

8/74

-17.6%

-7.9%

-5.7%

12.5%

27.2%

USSR in Afghanistan

12/79

-2.2%

6.7%

-4.0%

6.8%

21.0%

Falkland Islands war

4/82

4.3%

-8.5%

-9.8%

20.8%

41.8%

U.S. invades Grenada

10/83

-2.7%

3.9%

-2.8%

-3.2%

2.4%

U.S. bombs Libya

10/83

2.8%

-4.3%

-4.1%

-1.0%

25.9%

Financial panic ’87

10/87

-34.2%

11.5%

11.4%

15.0%

24.2%

Invasion of Panama

12/89

-1.9%

-2.7%

0.3%

8.0%

-2.2%

Iraq invades Kuwait

8/90

-13.3%

-0.1%

2.3%

16.3%

22.4%

Gulf War

1/91

4.6%

11.8%

14.3%

15.0%

24.5%

Gorbachev coup

8/91

-2.4%

4.4%

1.6%

11.3%

14.9%

U.S. currency crisis

9/92

-4.6%

0.6%

3.2%

9.2%

14.7%

Event

12 Months Later

% Change

1 Month Later

3 Months Later

6 Months Later

12 Months Later

World Trade Center bombing

2/93

-0.3%

2.4%

5.1%

8.5%

14.2%

Oklahoma City bombing

4/95

1.2%

3.9%

9.7%

12.9%

30.8%

Asian stock market crisis

10/97

-12.4%

8.8%

10.5%

25.0%

16.9%

9/98

0.0%

-11.2%

4.7%

6.5%

25.8%

9/01

-14.3%

13.4%

21.2%

24.8%

-6.7%

1/02

-3.0%

10.5%

4.3%

-9.5%

-17.7%

3/03

2.3%

5.5%

9.2%

15.6%

NA

-6.1%

3.9%

5.2%

9.2%

15.1%

Bombing of U.S. embassies in Africa WTC and Pentagon terrorist attacks Enron testifies before Congress Iraq War Mean

Source: Ned Davis Research Inc.

DIVERSIFICATION: THE RANDOM WAY The easiest way to reduce risk is to diversify, by applying the Law of Large Numbers. By randomly adding a large number of securities to a portfolio, the exposure to any particular source of risk becomes smaller and smaller. Random diversification is like investing in stocks selected by darts thrown at an SGX stock report. When you randomly diversify, you care only about selecting as many stocks as possible without caring about criteria such as expected return or risk. Can such a naive strategy work? The answer is “yes”.


Event

Month/ Year


Table 4.3. shows the standard deviations for equally weighted portfolios, each containing different numbers of randomly selected New York Stock Exchange (NYSE) stocks.

TABLE 4.3. STANDARD DEVIATIONS OF RANDOM PORTFOLIOS OF NYSE STOCKS No. of Stocks in Portfolio

SD of Portfolio Returns

Ratio of Portfolio SD to Single Stock SD

1

49.24

1.00

2

37.36

0.76

4

29.69

0.60

6

26.64

0.54

8

24.98

0.51

10

23.93

0.49

20

21.68

0.44

30

20.87

0.42

40

20.46

0.42

50

20.20

0.41

100

19.69

0.40

200

19.42

0.39

300

19.34

0.39

400

19.29

0.39

500

19.27

0.39

1000

19.21

0.39

Infinity

19.16

0.39

Source: Meir Statman, “How Many Stocks Make a Diversified Portfolio?”. Journal of Financial and Quantitative Analysis, September 1987, p.355

There are two important observations to note: 1. Standard deviation declines as the number of stocks increases. By the time we have 20 randomly chosen stocks, the portfolio’s volatility has declined from 50 per cent per year to about 22 per cent per year. 2. Standard deviation declines at a decreasing rate as the number of stocks is increased. With a portfolio of 20 stocks, diversification’s maximum effect has been realised, and there remains very little incremental benefit to be gained by adding more stocks. Adding 20 more stocks (a 40-stock portfolio) will further reduce standard deviation by only an insignificant 1.22 per cent (from 21.68 per cent to 20.46 per cent). Figure 4.1 (page 46) illustrates these two points. Plotted is the standard deviation of the return versus the number of stocks in the


Column 1 lists the number of stocks in each equally weighted portfolio. In a 10-stock portfolio, each stock has a 10 per cent weight; in a 20-stock portfolio, each stock has a 5 per cent weight, and so on. In column 2, we see that the standard deviation for a portfolio of one stock is about 50 per cent. What this means is that if you select a single NYSE stock randomly and put all your money into it, your standard deviation of return would be about 50 per cent per year. If you were to select randomly two NYSE stocks and put half your money in each, your average annual standard deviation would be about 37 per cent. Column 3 measures how risky a portfolio is relative to a onestock portfolio, which is obviously the riskiest portfolio. If you sink your money into a 20-stock portfolio, your annual risk would be about 22 per cent, and it would only be 44 per cent as risky as a one-stock portfolio. Stated another way, a 20-stock portfolio is 56 per cent less risky than a one-stock portfolio.


portfolio. Notice that risk reduction from adding securities slows down as we add more and more securities. Hence, spreading an investment across many assets will eliminate some or most of the risk, but not all. The risk that can be diversified is appropriately called diversifiable risk (non-systematic risk). And the risk that stubbornly remains and cannot be diversified is called non-diversifiable risk (systematic risk).

FIGURE 4.1. PORTFOLIO DIVERSIFICATION

Standard Deviation

60.0

Diversifiable Risk

50.0 40.0 30.0 20.0 10.0 00

Non-diversifiable Risk 1 2 4 6 8 10 20 30 40 50 100 200 300 400 500 1000 Number of Stocks


DIVERSIFICATION: THE BETTER WAY Harry Markowitz was the first person to formally show how portfolio diversification works to reduce portfolio risk. He showed how the inter-relationships between security returns — called correlation — could be used to diversify a portfolio so that risk is minimised while returns are maximised.

What is Correlation? Correlation measures the extent to which the returns on two assets move together. If the returns on two assets tend to move up and

Corr = +1.0 perfect positive correlation Corr = 0.0 zero correlation Corr = -1.0 perfect negative correlation Perfect Positive Correlation Figure 4.2 shows the returns of two assets with perfect positive correlation. If asset X has positive returns, so does asset Y. And if asset X has negative returns, so does asset Y. Do note that perfect correlation does not mean that the two assets move by the same amount; correlation is a measure of direction, not magnitude.

FIGURE 4.2. PERFECT POSITIVE CORRELATION (CORR ( = +1.0))

Asset Y

Returns

Asset X

Time



down together, we say they are positively correlated. If they tend to move in opposite directions, we say they are negatively correlated. If there is no particular relationship between the two assets, we say they are uncorrelated. The correlation coefficient is used to measure correlation, and it ranges between -1.0 and +1.0:

FIGURE 4.3. PERFECT NEGATIVE CORRELATION (CORR = -1.0)

Asset X Returns

MAKE YOUR MONEY WORK FOR YOU

Perfect Negative Correlation In Figure 4.3, the returns of the two assets X and Y move in opposite directions. If asset X has positive returns, asset Y will have negative returns.

A tY Asset Time


Zero Correlation If we know that the returns of X are positive, but have no idea what the returns of Y are likely to be, there is zero correlation.

FIGURE 4.4. ZERO CORRELATION (CORR ( = 0.0))

Asset X Returns

48

Asset Y Time


1. Combining securities with perfect positive correlation with each other provides no reduction in portfolio risk. We should avoid securities that are positively correlated as the total risk is then higher. 2. Combining securities with zero correlation with each other does provide significant risk reduction, although portfolio risk cannot be eliminated completely. 3. Combining securities with perfect negative correlation can eliminate risk altogether. 4. To see how correlation works, suppose you invest 100 per cent of your money in banking stocks. As a group, banking stock returns are highly positively correlated. Good prospects in the industry will see the group rise as a whole. And when prospects are poor, your entire portfolio will suffer as well. In reality, securities typically have some positive correlation with each other. Although risk can be reduced, risk usually cannot be eliminated. As an investor, you should hence find securities with the lowest amount of positive correlation as possible.

DIVERSIFICATION USING STOCKS AND BONDS One of the most effective ways to diversify is to invest in the two main asset classes of stocks and bonds because of their low correlation with one another. How much money should you allocate to each asset group? The ideal asset allocation differs from person to person and is based on the individual investor’s risk tolerance. A young executive typically has a higher risk tolerance than a retiree. The young


Understanding correlation helps us improve the diversification process of reducing portfolio risk:


executive, therefore, may have an asset allocation of 80 per cent stocks and 20 per cent bonds (since stocks are riskier than bonds), while the retiree may have a less risky allocation of 20 per cent stocks and 80 per cent bonds. The idea is to mix and match stocks and bonds in the proportion that generates the highest return possible based on the amount of risk we are able to tolerate. In general, the higher our risk appetite, the higher will be the proportion of stock in our portfolio, vis-à-vis bonds. Two questions you could be asking thus far: 1. What returns can I expect from a diversified portfolio of stocks and bonds? 2. How can I create a diversified portfolio of stocks and bonds if I do not have much money? We will answer these two important questions in the next section where we talk about investing in the major investment types. We end this chapter and this section by finding out how much risk you can take as an investor — that is, your risk tolerance.

FINDING OUT YOUR RISK TOLERANCE Are you a conservative investor or an aggressive investor? The answer to this question determines the amount of risk you can tolerate and hence the type of asset allocation appropriate for you. To keep things simple for now, let us work with just stocks and bonds.

The Risk Profile Questionnaire Approach Risk profile questionnaires ask pointed questions to find out your risk tolerance. There is no one single version but many. The CPF Board has one. Your bank officer has one. Your insurance adviser has one. Chances are that you are likely to see a different version from every company you deal with.

1. Your Ability to Take Risk How old are you? When do you need the money? How long will your assets be invested? The younger you are or the longer your investment time horizon, the higher the amount of risk you can afford to take. 2. Your Appetite for Risk This is the amount of risk you are comfortable with taking. Do you sleep soundly at night when your investments fall in value? Are you patient enough to see your investments grow over the long-term? 3. Your Overall Financial Situation How much money do you already have? The richer you are, the more willing you are to take on risk. Sample Risk Profile Below is a sample risk profile. Answer the six questions by circling the choice that best represents your investment situation. Questions 1 and 2 ask your age and investment time horizon, two objective factors that test your ability to take risk. They have each been given twice the number of points as the other questions because age and time horizon tend to weigh more heavily in considering one’s tolerance for risk. The other four questions are more subjective; they test your appetite for risk. Add up the points from the six questions to determine your risk tolerance score. The possible range of scores is 8 to 24. In general, the higher your score, the more comfortable you are with taking risk, and the higher the proportion of stocks your portfolio should contain.


Despite the many versions, risk profiles all have the same objective — they ask you questions to find out the appropriate balance of stocks and bonds for your investment allocation. Questions in general ask:

52

RISK TOLERANCE QUESTIONAIRE


How old are you? 1

a. (6 points) Below 40 years old b. (4 points) 40 to 54 years old c. (2 points) 55 years or older When do you plan to use the money you have invested?

2

3

a. (2 points) Within 3 years b. (4 points) 4 to 9 years c. (6 points) 10 or more years Given two hypothetical unit trusts, how would you invest? Unit Trust A — Gives an average annual return of 5% with minimal downside in any one year. Unit Trust B — Gives an average return of over 10% but portfolio can fall 20% in any one year. a. (1 point) 100% in Unit Trust A b. (2 points) 50% in Unit Trust A and 50% in Unit Trust B c. (3 points) 100% in Unit Trust B How do you feel about losing money?

4

a. (1 point) I hate losing money and I am willing to accept lower returns. b. (2 points) I do not mind moderate risk. It is OK to see some fluctuation in my returns, but not too much. c. (3 points) I am willing to take high risk because I believe returns will be higher over the longer term. You accept that your portfolio will fluctuate in value over time. What is the maximum loss you could accept in any one-year period?

5 a. (1 point) 5% b. (2 points) 15% c. (3 points) 30%

53

6

a. (1 point) I would be so upset that I would not be able to sleep. b. (2 points) I will find out what happened from the news or from my contacts. I might be tempted to sell. c. (3 points) I would not be overly bothered as it is probably a short-term fluctuation.

Calculate your total score and record it here: TOTAL SCORE: _______ Then check Table 4.4 below for your risk profile and the matching allocation for stocks and bonds. This sample risk profile has five allocations.

TABLE 4.4. RISK PROFILE AND INVESTMENT ALLOCATION Total Score

Risk Profile

% Stocks

% Bonds

8–10

Conservative

20%

80%

11–13

Moderately conservative

40%

60%

14–16

Balanced

60%

40%

17–19

Moderately aggressive

80%

20%

20–24

Aggressive

100%

0%


Managing Crises and Diversification

Suppose the market lost over 25% in value in just one day today. How will that affect you?


Your Target Investment Allocation Before moving on, use the following checklist to record your target investment allocation. Check one: _________ _________ _________ _________ _________ _________ _________

Aggressive Moderately Aggressive Balanced Moderately Conservative Conservative % Stocks % Bonds

You realise that risk profile questionnaires and the recommended allocations for equity and bonds are not an exact science. As we mentioned, you will not find two risk profile questionnaires that are exactly alike. Risk profiles, nevertheless, give you a first level guide to what your risk tolerance is, from which the appropriate asset allocation of stocks and bonds can be determined. Remember that a particular asset allocation is appropriate only at a certain point in time. When you get older and your circumstances change, your risk tolerance will change and your asset allocation must evolve along the way.

2

PART

INVESTING IN TRADITIONAL ASSETS The best way to benefit from this section is to invest in something — if you have not already done so. Suppose you had $2,000 or $20,000 to invest. How exactly do you begin? We recommend unit trusts as a start because they offer instant diversification and professional expertise at a low initial price. Then, when your skills and confidence are better developed and you are ready to do more, investing in individual stocks and bonds will be an appropriate next step.

05 Investing in Unit Trusts Many investors start out with unit trusts. Even experienced investors with large portfolios make generous use of unit trusts. Investors today have a lot of choices. There are over 3,200 funds available to investors in the Singapore marketplace (www.fundsingapore.com) — six times more than the number of stocks listed on the SGX. Unit trusts fall into two main categories: 1. Equity Funds (or stock funds)1 — unit trusts consisting of stocks, 2. Fixed Income Funds (or bond funds) — unit trusts consisting of bonds. Equity funds invest in the equity of companies and are for the more risk-tolerant investors who want their money to grow over a long period of time. Fixed income funds are for those with a smaller risk appetite. They invest in the debt of governments and corporations. Fixed income funds offer current income and do not fluctuate as widely in value as equity funds do. If you need a brief refresher on some of the more popular types of unit trusts found in the Singapore market, refer to the unit trust glossary at the end of this chapter. You should have, by now, figured out what sort of investor you are. If you have not, answer the risk profile questionnaire found in Chapter 4. The next step is to find out the type of equity and fixed income funds to invest in.

1 An equity fund (as compared with a stock fund) is actually the more common name for a fund containing mainly stocks. A fixed income fund (as compared with a bond fund) is the more common name for a fund containing mainly bonds. We will use both these terms interchangeably.

FIGURING OUT THE TYPES OF EQUITY FUNDS IN WHICH TO INVEST

TABLE 5.1. RECOMMENDED ALLOCATION OF EQUITY FUND INVESTMENTS Type of Equity Fund

Recommended Allocation

U.S. Equity Fund European Equity Fund

30% 30%

Asia ex-Japan Equity Fund

30%

Japan Equity Fund TOTAL

10% 100%

Source: Authors’ own recommendations

According to the IMF World Economic Outlook, these four regions represent 75 per cent of world gross domestic product (GDP), which is a measure of economic output. The economic output of each is weighted roughly in the percentages given above.

2

The act of diversifying your money into equity funds and fixed income funds is called asset class diversification. Global diversification then takes each asset class and diversifies it across the globe — into global equities and global fixed income.

Investing in Unit Trusts

If you invest all your money in Singapore and the Singapore economy tumbles, your entire portfolio will fall. That is because the stock market is sensitive to what happens to the economy as a whole. Now, if you split your money 50-50 and say, invest in both Singapore and the U.S., then it is likely that when Singapore falls, the U.S. might rise or when Singapore rises, the U.S. might fall. Economies do not rise and fall at the same time. (It is the reason we place our money in different asset classes, namely stocks and bonds.) That is why it makes sense to diversify our investments across countries. This process is called global diversification.2 We can easily achieve this by investing in four types of funds, each representing one of the four major economic regions of the world, in the following proportions:

57


These GDP figures are not static of course. They go up and down, but in general, unless there is some long-term structural change in the economic outputs of the four regions, we can simplify the recommended allocation to 30-30-30-10. Japan is set apart from the rest of Asia, the reason being that Japan is itself a very large and developed economy — the third largest in the world. Even though it is not geographically a region, its economic status qualifies it as such. Funds invested in Asia fall mainly into two fund categories: Asia ex-Japan and Japan.

FIGURING OUT THE TYPES OF FIXED INCOME FUNDS IN WHICH TO INVEST Now that you have figured out the types of equity funds in which to invest, figuring out the types of fixed income funds to invest in is a walk in the park. The same principle of diversification holds true, with a few exceptions: • Asian Fixed Income Fund In the equity fund allocation, we had Asia broken down into Asia ex-Japan, and Japan. In this fixed income fund allocation, both regions are clumped together because Japan’s fixed income funds are not sold in Singapore, whereas all-Asia fixed income funds are. • Singapore Fixed Income Fund Singapore bonds are typically of the highest quality and have very low risk compared with other types of fixed income funds. They also have little exchange rate risk and provide good stability for your fixed income fund portfolio. Always bear in mind that the allocation to each type of equity and fixed income fund is not an exact science. Treat what has been discussed as a general guideline. Generally, in order to create a globally diversified equity or fixed income portfolio, you should be investing in all the major economic regions in the world.

TABLE 5.2. RECOMMENDED ALLOCATION OF FIXED INCOME FUND INVESTMENTS Recommended Allocation

US Fixed Income Fund

30%

European Fixed Income Fund

30%

Asia Fixed Income Fund

30%

Singapore Fixed Income Fund

10%

TOTAL

100%


HOW DO GLOBALLY DIVERSIFIED UNIT TRUST PORTFOLIOS PERFORM? Here is a study that summarises the important points we are making. Look at Figure 5.1 on page 60, which is based on 32 years of data. The uppermost 100 per cent equity line is based on the highest amount of risk taken by the Aggressive Investor. You can see that returns fluctuate up and down quite a bit, and are very volatile. Starting with a 100 per cent Equity portfolio, we can lower risk by adding fixed income funds to our portfolio as seen by an increasingly flatter return line on the graph. Notice that adding fixed income funds to the equity portfolio also reduces the returns we can expect. As we add fixed income in 20 per cent increments, returns fall gradually to 5.4 per cent (for a 100 per cent Fixed Income portfolio). You must treat the return numbers shown in Table 5.3. (page 60) as mere guideposts to what can be expected of asset allocation in general. It is impossible to use any historical figures to project the future with 100 per cent accuracy. Taking a different period for study would yield different results, but the pattern of higher returns from portfolios with higher concentrations of equities can almost always be expected to occur.


Type of Fixed Income Fund

59

60

FIGURE 5.1. PORTFOLIO VALUE STARTING WITH $10,000


$ 300,000 250,000 200,000 150,000 100,000 50,000 0 1970

1974

1978

1982

100% equity 40% bonds, 60% equity 80% bonds, 20% equity

1986

1990

1994

1998

2002 Yr

20% bonds, 80% equity 60% bonds, 40% equity 100% bonds

Source: iFAST Financial Pte Ltd, “Rebalancing With Bond Funds”, (24 February 2003)

TABLE 5.3. ANNUALISED RETURNS OF VARIOUS EQUITY-FIXED INCOME COMBINATIONS Equity-Fixed Income Fund Allocation

Annualised Return

100–0 80–20 60–40 40–60 20–80 0–100

9.0% 8.4% 7.7% 6.7% 5.6% 5.4%

Source: iFAST Financial Pte Ltd, “Rebalancing With Bond Funds”, (24 Febuary 2003)

61

In order to create your portfolio so that it includes all the above recommended fund types, you will probably need between $10,000 and $50,000. This is because most funds require a minimum investment of $1,000. For example, if you are a conservative investor (20-80 equityfixed income fund allocation), you could organise your portfolio the following way:

TABLE 5.4. RECOMMENDED ALLOCATION FOR A CONSERVATIVE INVESTOR WITH $50,000 TO INVEST Equity Funds


Investment Amount

US Equity Fund European Equity Fund Asia ex-Japan Equity Fund Japan Equity Fund

30% 30% 30% 10%

$3,000 $3,000 $3,000 $1,000

TOTAL Equity Funds (20%)

$10,000

TOTAL Fixed Income Funds (80%) TOTAL Invested

$40,000 $50,0003

Source: Authors’ own recommendation

If you have less than $5,000 to invest — buy a global balanced fund (also called an Asset Allocation fund). These funds invest in both equities and bonds in almost equal proportions. Global Balanced Fund

3

100%

The minimum amount needed can be calculated as the minimum investment amount per fund ($1,000) divided by 20% (equity fund allocation) x 10% (smallest equity fund allocation) = $1,000 / (0.2 x 0.1) = $50,000.


HOW TO BEGIN INVESTING WHEN YOU DO NOT HAVE MUCH MONEY


If you have less than $10,000 to invest – buy two funds, a global equity fund and a global fixed income fund. For example, if you are a moderately aggressive investor (80-20 equity-bond allocation), your portfolio can look like this: Global Equity Fund Global Fixed Income Fund

80% 20%

If you have more than $10,000 to invest — you can begin by buying individual fund types in sequence. As you have more and more money available for investment, you may buy another fund in another category. The following is a suggested buying sequence. While you may not be following your recommended investment allocation to a tee, you should still end up with a reasonably well-balanced portfolio. Do this until you have enough money to take full advantage of the allocation that applies to you. So, if you have more than $10,000 to invest, buy them in the following order:

TABLE 5.5. RECOMMENDED SEQUENCE OF BUYING FOR ONE-AT-A-TIME PURCHASES Equity Fund

Fixed Income Fund

1

Global Equity Fund

Global Fixed Income Fund

2


Asian Fixed Income Fund

3

U.S. Equity Fund

Singapore Fixed Income Fund

4

European Equity Fund

U.S. Fixed Income Fund

5

Japan Equity Fund

Europe Fixed Income Fund


We suggest you start off with a global fund in order to obtain instant global diversification. You may be thinking that this is tricky to pull off, but it is not. You see, you do not have to be precise as

UNIT TRUST GLOSSARY There are more than 3,200 funds available to investors in the Singapore marketplace, of which two out of three are equity funds.

Equity Funds (Also Called Stock Funds) An equity fund is a unit trust that invests in stocks (or equities). A stock represents a share of ownership or equity in a company. While the stock market is known for its ups and downs, equities have historically provided higher returns than bonds over a long-term period. International Equity Funds An international portfolio of securities promises less risk and greater diversification than one that is purely domestic. A 100 per cent domestic portfolio consisting only of investments in Singapore makes your entire portfolio vulnerable to any Singapore market downturn. International equity funds are of several types: • Global Equity Funds invest in promising companies anywhere in the world. • Regional Equity Funds invest in the stocks of a single geographic region, such as Asia, Europe or Latin America. The share prices

63 Investing in Unit Trusts

to how to allocate your money as long as you conform to these guidelines at the start. Succeeding in your investment allocation has less to do with being precise in the way you allocate your money than in making sure you are invested in different fund types, so that you will always have some money in categories that are doing well. Following this approach also frees you from the stress of worrying if you are too heavily invested in weak areas. Your challenge is deciding how to invest money so that it becomes available in the future. From our experience, the above guidelines will help you reach your desired investment allocation in a sensible and stress-free way.


of these funds typically fluctuate more than the share prices of broadly diversified global equity funds. • Single-Country Equity Funds invest in the stocks of a single foreign country such as China, Singapore or the U.S. These funds are considered riskier than regional funds because of their narrower focus. • Emerging Market Equity Funds invest in countries that are moving towards an industrialised economy or to a free-market economy. These markets offer the potential for faster economic growth than established markets, but they also present substantial risks. Examples of such countries are Brazil, Mexico, Indonesia and South Africa. Keep in mind that emerging markets and single-country funds can fluctuate widely because of their narrower focus, and they are not for everyone. If you wish to diversify internationally and seek safety, it is best to consider global and regional funds before singlecountry and emerging market funds. Sector Funds Sector funds invest in a specific industry such as technology or healthcare. Investing in a narrow segment is higher risk, because if fortunes in that sector fall, the whole portfolio becomes vulnerable. Sector funds are attractive if you already hold a diversified portfolio and you want to take on more risk because these funds can sometimes achieve spectacular returns. Index Funds Index funds are unit trusts that closely track and replicate market indices such as the Straits Times Index. The fund manager does not actively seek the best investments to outperform the market. As a result, they are cheaper to own as they have lower operating

Fixed Income Funds Fixed income funds invest in bonds issued by companies and governments. Like equity funds, there are fixed income funds that invest globally, regionally, in emerging markets and in individual countries. We do not need to explain these fund types. Many other types of fixed income funds exist. Here are two: 1. High-Yield Fixed Income Funds Such funds seek higher returns by investing in high-yielding, lower-quality corporate bonds. 2. Mortgage-Backed Funds These funds seek to maximise income by investing in mortgagebacked securities. Such securities are bonds backed with a claim on specific property, and are thus of lower risk than unsecured bonds that are not backed by any asset.

Other Types of Funds Money Market Funds Closely related to bonds are very short-term loans (between three and 12 months) known as money market instruments. Singapore government Treasury Bills, commercial paper and corporate bonds maturing within a year are some examples.

65 Investing in Unit Trusts

expenses. One drawback of index funds is that they do not offer any chance of above-market returns. Indexing is a passive form of fund management that has been successful in outperforming most of the actively managed mutual funds in the U.S. A close relative of the index fund is the exchange-traded fund (ETF), which trades like a stock on an exchange, thus experiencing price changes throughout the day as it is bought and sold. We have devoted a chapter to index funds and ETFs.


Money market funds are good for your portfolio because they tend to be used like savings accounts, where the goal is not to generate maximum income, but to preserve capital. Balanced Funds (Also Called Asset Allocation Funds) Such funds combine about equal proportions of stocks and bonds in a single fund. In this sense, balanced funds provide the best of both worlds, offering the growth potential of equities and income from bonds. Offshore Funds These are funds that are registered outside Singapore in places such as Luxembourg and Dublin. The benefits provided by these jurisdictions are well-developed regulations to register and operate funds and a low-to-no-tax requirement on both capital gains and income. Feeder Funds A feeder fund is a fund that is registered locally and invests in an offshore fund. Rules have now been relaxed and fund houses today can bring offshore funds directly into Singapore for sale, thereby eliminating the expenses incurred by registering a feeder fund.

06 Selecting and Managing Your Unit Trust Investments You have by now an equity-fixed income fund allocation that matches your risk profile. You know the type of equity funds and bond funds that will diversify your investment portfolio across the world. It is time to select good unit trusts in each fund category and to manage your portfolio over the longer term. As there are several hundreds of funds available, the process of finding good funds must be undertaken with care. That is because fund distributors can typically find some performance measure that they can beat, such that all funds appear to be “good” funds. For example, a fund may be shown as having beaten all its peers during the last one year. Impressive in itself — until one finds out that the fund lost out in every other measurement over the last 10 years. Not all funds are good, but there are many that are, and the challenge is finding the ones that are right for you. If you have a financial adviser helping you, make sure you ask why he is positive about any particular fund. Better still, do your homework first. We will show you how you can get a list of good funds later.

SOURCES OF INFORMATION ON FUNDS If you want to select your own funds, there are four main sources of information available: 1. Third party fund analysis from Lipper, 2. Banks, 3. Online distributors of unit trusts such as Fundsupermart, DollarDex and Finatiq, and 4. Financial advisers.


Each of these sources uses similar criteria to evaluate funds. If the fund you are interested in buying is rated highly by at least two of these sources, chances are that you have found a good fund.

THIRD PARTY FUND RATINGS As a start, we prefer to consult the ratings provided by Lipper. This organisation does not sell unit trusts. That is why we can expect them to offer objective, independent ratings. Use the following criteria as a first cut. Keep in mind that the steps outlined below are based on actual screenshots at a certain date. So be sure to expect different results when you do your own search.

Review Top-Performing Funds Here is how you can generate a list of top-performing equity funds with at least a 5-year record. Go to www.fundsingapore.com • Click on the Basic Search tab • Make the appropriate selections: Universe – select Unit Trust Asset Type – select Equity This produced 1,963 Fund Type Matches that are “Unit Trusts” of type “Equity” (Figure 6.1., as at mid-2010). To narrow our search to the top-performing equity unit trusts over a 5-year period, make the following selections: • Time Frame – select 5 Year • Total Return – select 5 • Consistent Return – select 5 • Preservation – select 5 • Expense – select 5 This produced 15 Lipper Leader Matches (Figure 6.2.). Click the “15 Matches” icon and the first 10 Lipper Leaders (Figure 6.3.) appears:

FIGURE 6.1. SETTING CRITERIA TO FIND ALL EQUITY UNIT TRUSTS

Universe

CPF Included

Unit Trusts

All

CPF Account type

Select An Asset Type

All

Equity

CPF Account type

CPF Account type

HIGHER RISK MEDIUM TO HIGH RISK LOW TO MEDIUM RISK LOWER RISK

Aberdeen Asset Management Asia Limited AIMS AMP Capital Industrial REIT Management Ltd Alliancebernstein (Luxembourg) SA. Allianz Global Investors KAG mbH

Ctrl=click selects multiple options

Fund Type Matches: 1963

FIGURE 6.2. SETTING CRITERIA TO FIND TOP PERFORMERS OVER 5 YEARS

Select a Time Frame

Overall

3Years

5Years

10Years

Choose the Lipper Leader Rating from the categories below that match your investment goals. You can make multiple selections. Total Return

SELECT S ALL

5

4

3

2

1

Consistent Return

SELECT S ALL

5

4

3

2

1

Preservation

SELECT S ALL

5

4

3

2

1

Expenses

SELECT S ALL

5

4

3

2

1

Highest

5 4 3 2

1

Lowest

Historical Performance SGP Lipper Leader Matches 15

Source: www.fundsingapore.com

69

70

FIGURE 6.3. DISPLAYING THE LIST OF TOP PERFORMERS


Lipper Leader Ratings — What They Mean Funds are ranked against their Lipper peer group classifications each month for 3-, 5-, 10-year, and overall periods. For each measure: Rating ‘5’ ‘4’ ‘3’ ‘2’ ‘1’

Position in Peer Group Top 20% of funds Next 20% of funds Middle 20% of funds Next 20% of funds Lowest 20% of funds

This is what each of the measures1 mean: • A high rating for Total Return denotes a fund that has provided superior total returns (income from dividends and interest as well as capital appreciation) when compared to a group of similar funds. This measure is for investors who want the best historical return, without looking at risk and may not be suitable for investors who want to avoid downside risk.

1

adapted from www.lipperleaders.com

• A high rating for Preservation is a fund that has demonstrated a superior ability to preserve capital in a variety of markets and minimize downside risk relative to other fund choices in the same asset class. • A high rating for Expense identifies a fund that has successfully managed to keep its expenses low relative to its peers.

About Your List of Good Funds As you can see, finding good funds is really easy. You should go through this exercise every six months to see how your fund is performing or what other good funds have come within range of your radar. We will teach you how to read some of the performance statistics later in this chapter. On the other hand, if you prefer to let your financial adviser do the selection for you, do not forget to ask how he generates his list and why he thinks the funds are good. Be careful not to follow recommended funds blindly. Treat your list of funds as a source of names for further investigation.

ADDITIONAL TIPS ON IDENTIFYING GOOD FUNDS Here are other suggestions to help you avoid mistakes when making buying decisions.

Should Big Funds be Avoided? It is common to hear investors say that big funds — those with over $500 million or $1 billion in size — should be avoided altogether. They argue that when a fund gets that big, it is very difficult to be nimble.

71 Selecting and Managing Your Unit Trust Investments

• A high rating for Consistent Return identifies a fund that has provided relatively superior consistency and risk-adjusted returns when compared to a group of similar funds.


Let us take Singapore funds for example. Prudential’s PruLink Singapore Managed Fund, which invests 70 per cent in Singapore equities and 30 per cent in Singapore bonds, had a fund size of $3.1 billion in July 2010. It is the largest fund invested in Singapore securities. That must seem too big for a Singapore fund. But did you know that there are nearly 100 companies on the Singapore Stock Exchange valued at $1 billion or more? That Singtel alone has a value of over $55 billion? Now the Prudential fund does not seem so big after all. In fact, fund managers look long-term and close their funds to further subscription if they feel their fund is too large. After all, they will not want a fund so large that they cannot manage it well enough to bring in good results.

Should Small Funds be Avoided? Suppose for the last three years, a fund averaged $10 million in size and its expense ratio is 2 per cent. That means $200,000 is available to pay for the fund manager’s salary, the salary of research staff, electricity, PCs and other operating expenses. Do you think that is enough? Experience points to funds getting closed when their size is too small. Funds have to be a certain size to be feasible for the fund manager. For the investor, it makes sense too for the fund to be big enough because small funds are expensive to run. Mercer conducted a study on CPFIS funds in 2001. What the study found is that smaller funds are a lot more expensive to run than bigger funds:

TABLE 6.1. BIG FUNDS HAVE SMALLER EXPENSE RATIOS Fund Size

<$5m

$5–10m

$10–50m

>$50

Expense Ratio

3.1%

2.4

2.2

1.8

Source: Expense Ratios: Analysis of Trends, Oct 2001, Mercer Article No. 5 – Oct 2001

Should Funds with Large Expense Ratios be Avoided?

TABLE 6.2. CPF’S EXPENSE RATIO THRESHOLD Equity Risk

Type of Unit Trust

Higher risk Medium to high risk Low to medium risk Lower risk

Equity funds Balanced funds Bond funds Money market funds

Max. Expense Ratio 1.95% 1.75% 1.15% 0.65%

Source: www.cpf.gov.sg

If you have already invested in funds that exceed these benchmarks, the CPF Board will not require you to sell or switch your investments although it will likely offer you opportunities to switch from these funds for free within a certain time frame. In the end, remember that expenses is just one of the factors (although a big factor!) that affect your returns. It is usually worthwhile to pay more for a fund that gives you superior performance even if they are expensive to own. So if you come

Selecting and Managing Your Unit Trust Investments

It depends. Just as a Lamborghini takes more fuel to run than a 150cc Vespa scooter, some funds are inherently cheaper to run, such as index funds whose expense ratios are as low as 0.3 per cent annually. Then there are specialised funds that focus on particular sectors such as technology and healthcare; these funds tend to be more expensive to run because they require heavy resources for research and analysis. It follows then that given two funds of the same type, it makes sense to avoid, or to think thrice, about funds with larger expense ratios. The CPF Board is so concerned about expense ratios eroding investment returns that at the end of 2006, it announced that unit trusts and Investment-Linked Policies (ILPs) cannot accept CPF monies if their expense ratios exceed certain benchmarks. From 1 January 2008, expense ratios cannot be higher than those shown in Table 6.2.:

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across a fund that has a high expense ratio, don’t write it off just yet. Ask yourself or the salesperson why it has higher charges, and accept nothing less than a good and convincing reason. It may be a specialised fund or it has a superior performance record. Other than a really good reason, drop funds that have high expense ratios.

Should You Invest in New Funds? The easy answer to this perennial question is, “I won’t invest in a fund that has not been around for at least three years.” Some investors would like to see how funds have performed relative to their peers as well as in good and bad markets. Still, there are those adventurous souls amongst us who would consider taking the plunge each time a new fund or stock is available. If you are one of these risk-loving investors, ask yourself the following questions and be comfortable with your answers: • Is your portfolio already diversified? Do you now want to add risk? If yes, go ahead and take some risk. If not, then you are taking a big risk with your money. Remember, your first duty is to have a portfolio protected by diversification. Then you can set aside some money or a portion of your portfolio to include riskier, even speculative, investments. • Does the fund manager already have a track record elsewhere? If he is a newly minted MBA or just old enough to shave, do not touch the fund. • Are you going to set aside the time and effort to monitor these new fund investments? Our advice to you is that while it might be worthwhile buying a new fund that is run by an established fund manager, you are advised to monitor its performance more regularly than you might an aged fund.

MONITORING FUND PERFORMANCE

How Often Should You Check? Every six months is usually a good bet. If you really want to get into your investments, you might do it monthly, but those who review their investments too often might overreact to short-term market movements. The fact is that every fund, even the best ones, will underperform its peers periodically. For example, if you are checking a fund every month and you see that it is underperforming for the last four months, you might pull the trigger and sell the fund. But as so often happens with good funds, the underperformer comes back alive and produces quarter after quarter of dazzling results. So, review your funds every six months, and do not leave your funds alone for more than one year. Reviewing fund performance only takes a few minutes when you use a website like www. fundsingapore.com. The second thing to do when you monitor your portfolio is to rebalance it, if necessary. Suppose you started off with a 90-10 equity-bond portfolio. During the next six months, the portfolio shifts to 70-30 equity-bonds because equity prices have fallen and bond prices have risen. To rebalance it back to 90-10, you would simply sell off part of the bond portion and use the proceeds for the equity portion to return the portfolio back to a 90-10 allocation.

WHY REBALANCING MAKES SENSE Rebalancing forces us to put into practice the “Buy Low, Sell High” principle. For example:

Selecting and Managing Your Unit Trust Investments

One of the great things about owning a unit trust is that you are paying someone (about $200 per year for a $10,000 investment) who is very qualified and smart to worry about how your money is invested. But you still need to check periodically on how the funds you own are doing. You do not want to find out 10 years from now when you need the money that the fund you bought has turned into a pumpkin.

75


• The equity portion had fallen sharply and we rebalanced by buying low. • The bond portion had risen sharply and we rebalanced by selling high. Rebalancing also forces us to add bonds when interest rates rise (bond prices fall) and sell equities when the stock market goes up. These are very wise things to do.

Does Rebalancing Work Over the Long-Term? In the iFAST study we examined in Chapter 5, the 100 per cent equity portfolio produced a 9 per cent annualised return over 32 years. Well, this portfolio was actually rebalanced every year. Whenever equities fell relative to fixed income, equities were bought and fixed income was sold. If the strategy had been buy and hold, the return produced would only have come to 7.3 per cent.

How Often Should You Rebalance? You may want to set some rules. For example: • Rebalance right away when any of the major regional stock indices such as the S&P 500 or Nikkei 225 has moved up or down by more than 20 per cent. • Rebalance right away when interest rates have moved up or down quickly by more than 2 per cent.

Rebalancing: Points to Consider While the mechanics of rebalancing are straightforward, sometimes the cost or inconvenience of rebalancing may outweigh the benefits.

Time and Effort If you have a large number of funds and the amount to rebalance is a mere few hundred dollars, it may not be worth the trouble. Perhaps you should wait another six months. In any case, you cannot reach that conclusion without going through exactly where your portfolio stands today. Even if you do not want to rebalance, you should review your portfolio every six months. Change in Risk Profile As your time horizon nears, your risk profile will change. When you are 10 years away from your objective, your risk profile is likely to be more aggressive. This may call for an 80-20 equityfixed portfolio. As you get closer and closer to your objective, your profile will become more conservative and your portfolio will take on more and more fixed income and fewer and fewer equities. Bear in mind that the risk profile you started off with is not going to be the same profile you end up with eventually. Ask yourself each time when you rebalance — has my risk profile changed? After every few years, the answer should be “yes”. One criticism of rebalancing is that when a fund does well, you will be removing those positions that can go up even higher.


Transaction Costs This is the most obvious drawback. How much does it cost to switch funds? The transaction costs can be high enough to stop you. Fortunately, switches between funds of the same family are usually cost-free. Better yet, you may want to try something called a wrap account. When you have a wrap account offered by some financial advisers, you can rebalance for free among funds from several fund managers.

78

FIGURE 6.4. DON’T FORGET TO REDO YOUR RISK PROFILE


> Aggressive 80% Equity 20% Fixed Income

Balanced 60% Equity 40% Fixed Income

>Conservative 20% Equity 80% Fixed Income

10 years

5 years

3 years


Can You Count on Past Performance? If you had picked any one of the top-performing Lipper Leaders five years back, you will have come out a winner. But we are investing for future results, not past. The question we need to answer is, “Is past performance indicative of future results?” If your answer is “yes”, then you believe that any of these three dream performers should be winners again in the future. You believe that relying on fund rankings (when you want to buy a fund or to check if you should sell a fund because it is not ranked favourably anymore) is a good strategy. If your answer is “no”, then you are saying that these top performers will probably not be able to hold their position in the future. Many experts believe this to be true. They say that past performance is pretty much worthless when it comes to figuring out the future. Unlike reports that measure the reliability of cars, investment performance is very difficult to predict. Economies go up and

TABLE 6.3. TOP PERFORMERS MAY NOT STAY ON TOP FOR VERY LONG Performance Over 5 Years

Top 50% Finishers Over Next 5 Years

Top 20% Performers

44.8%

Second 20%

47.7%

Third 20%

51.5%

Fourth 20%

52.3%

Fifth 20%

0.99%

Source: www.efmoody.com/investments/pastperformance.html

We believe that while the past is not indicative of the future, it still does a decent job, but we have to be careful. To make our choices more bullet-proof, we rely on the following rules of thumb: • Buy funds with good track records with as long a history as possible. If fund A is the top performer over the last three years and fund B is a steady performer over the last 10 years, we would choose B. • Buy funds with lower expense ratios, all else being equal. If fund A’s expense ratio is 2.5 per cent and fund B’s is 1 per cent, fund A will cost 1.5 per cent more to run per year. If you hold the fund for 10 years, you lose out on 15 per cent of returns.


down, funds change, managers and sectors such as technology can blow hot, then cold. In fact, underperforming after being a hot fund is common. Nobel Prize Laureate in Economics, William Sharpe, in an article on past performance, for example, discussed Barkdale and Green’s findings: funds that finished in the top 20 per cent over the past five years were the least likely to finish in the top 50 per cent over the next five years:


• When it comes to investing, it is important to examine current trends, rather than past ones. For example, technology is part of a long-term trend even though it fluctuates during shorterterm cycles. China is a long-term growth opportunity even if it might overheat and have high inflation. • Most of all, diversify your assets across the different asset classes, across the globe, and across different fund managers, and stick to a strategy that keeps your retirement goal in perspective.

IS THERE A RIGHT TIME TO SELL? Newspapers and fund distributors have little trouble telling you what funds to buy and when, but finding advice on when to sell a fund can be much harder to come by. More often than not, investors tend to sell their funds for the wrong reasons. So, is there really a right time to sell? It is generally accepted that the best time to sell is when you have reached your profit goal. But as we will see, there are also situations where the fund ought to be sold, even when it is not profitable.

You Need the Money Sometimes there will be emergencies in your life when you need money and you have little choice but to sell your investments. Despite the urgency, you should still weigh your choices. Can you get a loan that charges you a rate of interest lower than the rate of return you are getting on your investments? If you can, it might be best to hold off selling your investments.

Your Objective is Met If you set out a clear target of accumulating $100,000 in 10 years for your daughter’s education, then when your $100,000 target is attained, sell your investments. Sure, your investments could skyrocket after you sell, but can you

Your Fund is Underperforming If your fund is not doing well, find out why. One of the worst reasons for selling a fund is when its category is going through a tough time. If equity funds have gained 8 per cent this year and fixed income funds have lost 6 per cent, you might think fixed income funds do not belong in your portfolio. This is the best way to shoot yourself in the foot. But as you know from Chapters 1 and 2, allocating your money appropriately in equity funds and fixed income funds is far more important to investment success than chasing after the hottest funds. Here is a good rule to follow when a fund is underperforming its peers: “Never sell a fund unless it has underperformed its peer group for two years in a row.” A good fund underperforming its peer group in any one year is a common thing. But when a good fund underperforms for two years in a row, something is probably wrong.

Drastic Change in Fund Size Fund size can change dramatically during bull and bear markets. Sometimes funds that get big very quickly can be a problem. Here is an example. Suppose fund manager Tommy is great at picking a portfolio of 20 company stocks. His success brings a lot of attention, resulting in a large influx of investor money. The problem is that with so much more money, he may end up owning a majority of several stocks, which leads to liquidity problems, because as a major shareholder of the stock, his moves are going to be closely watched by the market. To get around this problem, he has to hold more stocks. His job is much tougher now because he is forced to find 40 or 50 good stocks.


stomach the alternative? Suppose you hung on and the market falls sharply and you end up with insufficient money for your objective. The best thing to do when you reach your objective is to sell.


On the other hand, it is also difficult for a small fund to survive. This is because the fund managers will have a tough time meeting expenses and investors will be paying high expense ratios.

The Fund Manager Leaves A good unit trust is often backed by a solid fund manager. If the fund you hold is run by a star manager and the manager leaves, think about selling the fund if the replacement is not known to be a performer. Selling a fund right away because of the fund manager’s departure is generally a mistake. The fund management company surely wouldn’t replace its star performer with a slouch or loser. This does not mean you should blindly ignore a change in manager. Watch your fund more closely after the change. If its performance lags far behind for a few quarters, you may want to sell all or part of the fund more quickly than you would in normal conditions. (We should mention that in Asia, fund management companies tend to adopt a team approach to investing rather than rely on individuals. This makes monitoring manager turnover less meaningful.) Conversely, a manager’s departure can be a good thing as well. If the fund has been underperforming its peers, a change in fund manager may encourage an investor to hold onto the fund more tightly.

YOU NEED TO REBALANCE YOUR PORTFOLIO If you have an asset allocation you want to stick to, you may need to rebalance your holdings by selling and buying securities in order to return your portfolio back to its desired allocation. There is another time when you may want to rebalance, and that is when your risk profile changes. If your retirement is five years away and your risk profile has turned conservative, your current portfolio may no longer be appropriate. If you are thinking about selling a fund and the primary reason for selling it is not on the list above, you may want to reconsider. Selling a unit trust is not something you do without a great deal


of consideration. Remember that you originally invested in the fund because you were confident of it — make sure you are clear on your reasons for letting it go. But if you have carefully considered the pros and cons and you still decide to sell it, do it and do not look back.

07 Investing in Individual Stocks When you buy a unit trust, you are entrusting someone else to make decisions for you and you lose control over what to buy and sell, and when. Investing in individual stocks requires time and money to manage them effectively. The good news is that by combining both methods of investing — unit trusts and individual stocks —you can take advantage of the opportunities that both ownership methods offer. And fortunately, buying and selling stock is a relatively simple task, as seen by the millions of stocks that are traded among investors every day. You begin the process by opening a trading account with one of the 20 or so brokerage companies in Singapore, and you can begin submitting orders to buy or sell. But before you do, let us first beef up on more details.

INVESTING IN INDIVIDUAL STOCKS AND BONDS Assuming you already have a diversified unit trust portfolio that you plan to hold for retirement or some other objective, then you could allocate up to 20 per cent of your total invested money in individual stocks. For example, if you have $50,000 in total to invest, you can allocate up to $10,000 or 20 per cent in individual stocks.1 We feel 20 per cent is a safe guideline. If these investments suffer a major setback, such as a 30 per cent drop, the effect on the overall portfolio is just minus six per cent (-30% x 20%). This guideline is, of course, not etched in stone. For example, you could build a globally diversified portfolio consisting of individual stocks, bonds and other supplementary investments for your retirement. 1

We recommend that up to 20 per cent of your total invested money be invested in individual stocks, bonds, more speculative and other supplementary investments that need not form part of your long-term retirement portfolio.

COMMON VERSUS PREFERENCE STOCK

TABLE 7.1. MAJOR DIFFERENCES BETWEEN COMMON AND PREFERRED STOCK Common Stock

Preferred Stock

Voting Rights

Always

Seldom

Dividends

Not fixed or promised

Fixed. Can be suspended if company has net loss.

Maturity

Perpetual

Normally perpetual. Sometimes the company can terminate the issue or investors can convert to common stock.

Price Movement

More volatile

Less volatile

Source: Authors’ own compilation

Types of Common Stock Common stock returns come in the form of dividends and capital appreciation — an increase in the share price. But not all stocks are the same. Some pay dividends, some do not. Some have stable prices while others have volatile prices.

Investing in Individual Stocks

Most stocks sold in Singapore are common stock. If you buy a common stock, there is no guarantee that you will make money. You bear the risk that the stock price might go down or that it would not pay any dividends. It is possible that you could lose a big chunk of your initial investment. For the risk that you take, you stand to make money if the company does well. In fact, over time, stocks have always outperformed bonds, often by a comfortable margin. Owners of preference stock are also shareholders. Unlike common shareholders, preference shareholders benefit from a fixed dividend that does not increase even if the company has a boom year. Of the 500 companies on SGX Mainboard and Catalist, there are just about five preferred stock issues traded. For this reason, our focus will be on common stock.

85


One way to differentiate stocks is to observe how closely a company’s prospects is tied to the economy:

FIGURE 7.1. A TYPICAL BUSINESS CYCLE Peak

Expansion

Recession

Bottom Source: Authors’ own illustration

As the business cycle (see Figure 7.1.) moves from bottom to peak during an expansion, different industries benefit differently from the economic changes that accompany the cycle. Cyclical Stocks Cyclical stocks are the most sensitive to business cycles. They do best during expansions, but do badly during recessions. Airline stocks are typically cyclical. People postpone travel when the economy is slow, but when the economy grows, travellers can suddenly appear in droves at the travel agent’s office. Defensive Stocks Defensive stocks are the least sensitive to business cycles. Food and utility stocks are defensive because people will still eat and turn on the electricity during market downturns. On the flip side, defensive stocks underperform during expansions — people would not suddenly eat a lot more or keep the lights on all night.

Value Stocks Value stocks are stocks that are underpriced by the market for reasons that have nothing to do with the business itself. Value stocks are good investment opportunities that may have been oversold or may be temporarily out of favour. Blue-Chip Stocks Blue-chip stocks are solid performers that generate some dividend income, decent growth and, most of all, safety and reliability. Consider blue-chips if you want to invest in a stock for the long-term and you do not have much tolerance for risk. Speculative Stocks Speculative stocks are typically unproven young companies. Prepare for a rollercoaster ride if you invest in a speculative stock. They may be erratic, but can be winners in the making when there are, for example, promises of technological breakthroughs. Interest Rate Sensitive Stocks Interest rate sensitive stocks are greatly affected when interest rates change. Utility companies have huge fixed costs in plant and equipment, and they typically pay a lot of bond interest. When interest rates rise, the cost of servicing its loans rises and this has a downward effect on its stock price.

87 Investing in Individual Stocks

Growth Stocks Growth stocks perform better than the industry average, and growth may occur regardless of the business cycle. A growth stock usually pays little or no dividends, but puts profits back into the company to finance new growth. Investors buy growth stocks for their potential price appreciation and not for dividends. While the prices of growth stocks usually rise in value more than those of other types of stocks, they also decline in price more significantly.


Income Stocks Income stocks pay a higher-than-average dividend. Companies whose stocks fall into this category are typically in stable and mature industries such as utilities and tobacco. While income stocks may not have the growth potential of growth stocks when prices are rising, their prices tend to hold up more when growth stock prices are tumbling. International Stocks International stocks are stocks of foreign companies. Many of the world’s largest companies have their headquarters overseas. While buying shares of foreign companies can pose a challenge for some investors (we will discuss some of these challenges in the next chapter), many large companies are listed on the Singapore Stock Exchange. In any case, the easiest way to own international stocks is to buy international unit trusts.

SELLING NEW STOCK THROUGH AN IPO It is the dream of every entrepreneur to take the company he started from private to public ownership. The road to an Initial Public Offering (IPO) often begins with an entrepreneur who comes up with an idea for a product or a service and raises money from his own family and friends to start up a business. If the business grows, the entrepreneur often seeks a second level of funding called venture capital that is provided by wealthy investors and investment companies. Venture capitalists expand the private ownership of the business by sharing the risks of the new business in exchange for the privilege of helping to run the business and sharing in its profits.

The Primary Market — Buying an IPO Going public means that the business sells new stock that previously did not exist. This is done in the primary market, which is the first part of a financial market and is part of the process of getting listed on a stock exchange.

The Secondary Market — SGX At the end of the IPO subscription period, the shares trade in the secondary market such as the Singapore Exchange (SGX), the only formal exchange for stocks in Singapore. Once shares start to trade in the secondary market, the share price can rise and fall, depending on investor expectations. At this time, the original issuers receive no additional cash from these secondary market transactions.

READING THE STOCK PAGE This is an adaptation of a quotation from a mainboard-listed company, which we shall call Stock X. 52-wk high

52-wk low

Company

Last sale

Vol ‘000

Day High

Day Low

Net P/E

M Cap $Mil

222

188

* Stock X

210

789

213

210

18.6

6071


The highest and lowest prices for the past 52 rolling weeks are reported daily. The range between the high and low is an indication of the stock’s volatility or price movement. The more volatile the stock, the more you can profit or lose in a relatively short time. For example, the price ranged between $1.88 and $2.22, or about 18.1 per cent.

89 Investing in Individual Stocks

The management of the IPO goes to an investment banker who agrees to underwrite the stock issue, that is, to buy all the public shares at a set price and to resell them to the public at a higher price for a profit. These underwriters advise the company on the valuation of the company, the number of shares that should be issued and the price per share. IPO shares are sold during a subscription period, which typically lasts up to a few weeks. Some IPOs are so hot that they can be completely sold out in just a few days, and become oversubscribed.


The stock was issued with a par value of 10 cents. The * on the left of the company name indicates that it is one of the index stocks that make up the STI. The last sale or closing price was $2.10. Volume of 789,000 refers to the number of shares traded the previous day. “High” and “low” reports the highest and lowest prices for the previous day. The daily difference is usually small compared with the 52-week spread. The price-earnings ratio (PER) shows the relationship between the stock’s price and the company’s earnings for the previous year. It is obtained by dividing the current price per share by the earnings per share. Stock X’s P/E of 18.6 means that its current price of $2.10 (last sale) is 18.6 times the previous year’s earnings per share. This implies that earnings per share is 11.29 cents (barring any rounding error): P/E = 18.6 2.10 / E = 18.6 E = 2.10 / 18.6 = 11.29 cents If you were to buy up all the outstanding shares of the company, you would have to fork out $6.071 billion — its market capitalisation. It is calculated as the number of outstanding shares multiplied by the current share price.

BUYING AND SELLING SHARES IN THE SECONDARY MARKET Opening an Account There are a few ways to trade shares in the secondary market. If you know exactly what you want and are more a “do-it-yourself ” investor, you can trade shares through an online brokerage such as Phillip Securities (www.poems.com.sg). Commissions for online

91

Imagine that you paid $20,000 through your broker for 1,000 shares of BigCo. One week later, the price of BigCo has doubled and your shares are now worth $40,000. Elated by your windfall, you call your broker and ask him to sell your shares. But your broker tells you that the individual who sold you the BigCo shares failed to deliver the shares to your broker. Now if your BigCo shares were traded through a regulated exchange like SGX, the integrity of your share purchase is guaranteed by CDP. CDP provides the clearing and depository function for the Singapore share market — it guarantees and clears all securities traded on SGX. Brokerage firms act as intermediaries between you, the investor, and the CDP.

trades are usually lower than for offline trades done through dealers and remisiers who are representative of the brokerage. Trades commonly cost a minimum of $25 for online and $40 for offline, and the cost increases based on various contract value sizes. In order to trade shares, you first have to open an account at the Central Depository Pte. Ltd. (CDP), which handles the clearing of trades. Once you have your CDP account, you can approach a member stockbroking company to open a sub-account and begin trading.

Opening a Cash or Margin Account Your broker will need to know if you want a cash account, margin account or both. Cash accounts require you to pay in full after a purchase is made. A margin account allows you to borrow money from the brokerage company to buy more securities. This is called leverage and is not for everyone because you can double or triple your profits as well as losses.


HOW THE CDP WORKS


Brokerages in Singapore typically offer a margin equal to 3.5 times your cash amount deposited. Hence, a deposit of $10,000 cash translates into a margin account of $35,000 to buy up to $35,000 worth of securities.

Establishing a Long or Short Position When you buy a share, you are said to have a long position. Your decision to buy means that you hope to profit from an increase in price in the future. If you had no existing long position and you expect the market to decline, you may wish to take a short position to profit from the expected decline. When you “short” a security, you are in fact hoping and praying that the price of the security will go down so that you can buy it back and replace the security at a lower price. To you, bad news is good news. How can you sell something you do not own? You can today with the SGX Securities Borrowing and Lending (SBL) Programme launched in January 2002. To see how this works, suppose you short 1,000 ABC shares at $10 a share. If the short sale was for $10 a share and you buy the stock a month later at $7 a share, you make a profit of $3,000 ([$10-$7] x 1,000 shares). If, instead, ABC is bought back at a higher price of $12 ($2 higher than the short-sale price), you will have a loss of $2,000 ([$10-$12] x 1,000 shares). Short selling is a very aggressive strategy since your upside potential is fixed (the price of the stock cannot go below zero), and your downside potential is unlimited (the stock can go up and up).

Issuing Buy and Sell Orders When you decide to buy a share, how exactly do you tell your broker to establish a position? If you are not careful, you may end up paying more than you expected. It is really important to understand how orders are given and executed.

There are three common types of orders:

2. Limit orders 3. Stop orders Market Orders When you phone your broker and say, “Buy 1,000 shares of XYZ,” you are placing a market order. A market order does not specify a price. Some investors feel that market orders are risky because if the market runs up suddenly, they may end up paying much more. But market orders make sense for other investors. If they think a stock is really hot and they do not want to miss getting the stock, a market order at whatever the current price does the job. Limit Orders A limit order, on the other hand, specifies the exact price at which you want an order executed. For example, “Buy 1,000 shares of XYZ at $10.00.” There may be other buy orders in front of yours at more than $10.00. These investors will be serviced ahead of yours because they are all willing to pay more than you are. You can see that a limit order may never be executed so long as there are orders ahead of yours in terms of price. Stop Orders If you want your order to go through no matter what, you can place a stop order. A stop order guarantees that your order is filled by stating the price at which a market order takes effect. A buy stop order is placed above the current market price, while a sell stop order is placed below the current market price. For example, say you absolutely must own XYZ and it is currently trading at $1.00. You can place a stop order to buy XYZ at $1.20. The


1. Market orders

93


order becomes a market order to buy as soon as the market price reaches $1.20. The order may not be filled exactly at $1.20 because the closest price at which the stock trades may be $1.25. The exact price specified in the stop order is therefore not guaranteed. A sell stop can be used to protect a profit. Now suppose XYZ has risen to $2.00. You want protection against a price decline, and at the same time, you want to hang on to the share for extra gains. To lock in most of the profit, a sell stop order could be placed at $1.80. When market price falls to $1.80 or below, a market order to sell is triggered.

08 Selecting and Managing Your Individual Stock Investments There really is no secret to picking good stocks. The winning techniques have been tested over and over. They may not work all the time, but they work often enough. Because good stocks tend to stay good, take your time to find the right information. Do your homework, learn about the industries your favourite stocks are in and do not rush into any purchase even when the stock price is running away from you.

FUNDAMENTAL ANALYSIS So how do the pros sort out the good stocks from the bad? By looking at a business at its most fundamental and financial level. This type of analysis examines key financial ratios of a company, giving us an idea of the company’s financial health and the value of its stock. Even if you do not plan to do thorough fundamental analyses yourself, it will help you follow stocks more closely if you understand these key terms and ratios.

IT IS ALL ABOUT EARNINGS The bottom line is what investors want to know. How much money is the company making and how much is it going to make in the future? Earnings are profits and that is what buying a company is about. Increasing earnings generally lead to a higher stock price and, in some cases, a regular dividend. And when earnings drop, the market may knock the stock price down. Suppose company A and company B are in the same industry. Both companies made sales of $1,000 but company B earned more as it incurred lower expenses. Which company would you buy?

96

TABLE 8.1. EARNINGS OF COMPANIES A AND B


Company A

Company B

Sales

1,000

1,000

- Expenses

-700

-600

Earnings

300

400


Company B for sure. Yet while earnings are important, by themselves they do not tell you anything about the value of the company’s stock.

Earnings Per Share (EPS) One of the challenges of evaluating stocks is making sure we make apple-to-apple comparisons. Comparing the earnings of one company with another really does not make any sense, if you think about it. Suppose Adam’s family earned $300 and Adam is the only child, while Betty’s family earned $400 and she’s got nine other siblings. Which family has more earnings to go around? Using raw numbers ignores the fact that two companies have a different number of outstanding shares. Let us look at earnings per share (EPS). We calculate EPS by dividing earnings by the number of outstanding shares: EPS = Earnings / Outstanding shares

TABLE 8.2. EPS OF COMPANIES A AND B Company A

Company B

Earnings

300

400

Number of Shares

10

100

EPS

$30

$4


1. Trailing EPS — last year’s actual numbers. 2. Forecast EPS — based on future numbers, which are projections.

Price-Earning Ratio (PER) If there is one number that people look at than more any other, it is the Price-Earning Ratio (PER). It looks at the relationship between the stock price and the company’s earnings. The PER is the most popular tool for analysing a stock, although it should not be the only one to consider. You calculate PER by taking share price and dividing it by the company’s EPS. PER = Stock price / EPS For example, if company A has a stock price of $300 and company B’s price is $80, their PER are 10 times and 20 times respectively:

TABLE 8.3. PER OF COMPANIES A AND B Company A

Company B

EPS

$30

$4

Stock Price

$300

$80

PER

10 times

20 times


97 Selecting and Managing Your Individual Stock Investments

Now suppose company A has 10 shares outstanding, while company B has 100 shares outstanding. Which company’s stock do you want to own? Should you buy Company A because its EPS of $30 is higher? We are not quite there yet to answer that question, but we are close. We still do not know how much we would pay for the stock of company A and B. Before we move on, you should note that there are two main types of EPS numbers:


What does PER tell us? The PER gives us an idea of what the market is willing to pay for the company’s earnings. The higher the PER, the more the market is willing to pay for the company’s earnings. A high PER can be read as an overpriced stock. While this may be true, a high PER stock can also indicate that the market has high hopes for the future prospects of this stock and has bid up the price. Such a stock is called a growth stock. Their PERs can be quite high and they can still be considered “cheap” by the market. On the other hand, a low PER stock may indicate the market’s lack of confidence in the stock. Its future prospects are dim and the market is depressing its stock price relative to its earnings. Or it could be a value stock — an underpriced stock that the market has overlooked. Investors can make fortunes by spotting these sleepers before the rest of the market discovers their true worth. Still, a company’s PER does not provide much of any buy and sell clues until it is compared with: • PER values of the same company over the past few years If the PER of company A is currently 10 and its PER average over the last 10 years is 15, we can say that the stock is cheap compared with its past. • PER values of other companies in the same business If company A has a PER of 10 and is in the chemicals industry that as a whole has a PER of 5, we can say that the stock is expensive compared with its peers. • PER values of stock indices representing the market as a whole If company A has a PER of 10 and the STI stock index has a PER of 20, we can say that the stock is cheap compared with the entire market.

Forecasting Stock Price with PERs PER is very commonly used by investors to forecast the future price level of stocks and the market. Forecast price = Trailing PER X Forecast EPS EXAMPLE: Stock A is trading at $15 and its trailing EPS is $1 based on its latest annual report. Given a trailing PER of 15 ($15/$1), what is the forecast price of stock A if its forecast EPS is $1.20? Note that stock A has an historical PER of between 15 and 20 times in the last 10 years. Forecast price

1

www.zacks.com

= 15/1 X $1.20 = $18


Using the PER to Value Stocks The PERs we see on the stock pages in newspapers are trailing PERs. It uses the current stock price divided by a historical earnings figure from the company’s latest annual report. A forecast PER on the other hand uses the current stock price divided by the stock’s forecast EPS. Forecast earnings are found in company research reports generated by analysts. You should use these individual forecast PERs with care because they are based on the earnings estimates made by a few individuals from one brokerage house. What is generally more reliable are earning forecasts taken by averaging the estimates of several dozen analysts who follow the stock. One example is Zacks consensus estimates (called Zacks Rank) for the U.S. market. Are these consensus estimates reliable? The best stocks picked by Zacks Rank have outperformed the S&P 500 for 15 out of the last 16 years.1


Since the current price of stock A is $15, and assuming the forecast proves accurate, one can expect stock A to increase in price by $3. It is thus a good buy because this stock at $15 today is an undervalued stock. In order to make such a conclusion, one has to have certain beliefs: • That the stock’s eventual PER will reach a level of 15, which is at the low end of the range for the last 10 years. • That the forecast EPS of $1.20 is generally reliable. • That forecast prices are estimated from assumptions about company growth, the economy and other factors, and that these assumptions can be proven wrong in the end. In other words, we are taking calculated risks when we rely on forecast numbers. In the end, investors buy a stock not for what it can do for them today, but for what they hope it will do for them tomorrow. If it does not live up to expectations, they will probably bail out of the stock. There are countless other financial terms and ratios you can learn and use. We have highlighted the most popular — the PER.

TRACKING THE MARKET THROUGH INDICES We track the market because it has an overall effect on the performance of individual stocks. This is an established fact. The Straits Times Index (STI) is the most widely quoted index for the Singapore market. It consists of a basket of 30 stocks and measures the average price level of the market. The STI is plotted for the period between June 1995 and July 2010. If you had invested your money in the Singapore stock market sometime during this period, you would either be very happy or very upset, depending on which period of time you were in the market.

101

FIGURE 8.1. STI PERFORMANCE BETWEEN JULY 1995 AND JULY 2010 4000 3500 3000 2500 2000 1500 1000 500 8

7

6

9 Ju l-1 0

Ju l-0

Ju l-0

Ju l-0

4

5

Ju l-0

Ju l-0

2

1

0

3

Ju l-0

Ju l-0

Ju l-0

Ju l-0

8

9

Ju l-0

Ju l-9

6

7

Ju l-9

Ju l-9

Ju l-9

Ju l-9

5

0

(Source: www.sgx.com)

Look at the self-explanatory volatility shown in Table 8.4 (STI levels are rounded to the nearest 50):

TABLE 8.4. THE STI’S BIG JUMPS AND FALLS Period

of STI Start STI End No. months

% change

Feb 96–Aug 98

2450

800

30 months

-67%

Aug 98–Dec 99

800

2500

16 months

213%

Dec 99–Sep 01

2500

1250

21 months

-50%

Sep 01–Mar 02

1250

1800

6 months

44%

Mar 02–Apr 03

1800

1200

13 months

-33%

Apr 03–Oct 07

1200

3850

54 months

221%

Oct 07–Feb 09

3850

1600

16 months

-58%


That is why the experts harp so much on diversification. By putting your money into several baskets, you reduce both risk and anxiety.

102

Components of the STI


What makes the STI go up and down? The answer is this: When its component stocks go up and down. Singtel, Wilmar, DBS, UOB, Jardine Matheson Holdings and OCBC typically occupy the top six positions in terms of weight. The top six weighted companies constitute about 50 per cent of the index. If these top six stocks collectively rise 10 per cent, the impact on the STI is 5 per cent (50% X 10%). A higher weight therefore means a greater influence on the index.

Using the STI as a Yardstick Stock indices provide a good yardstick against which investors can compare their portfolios. If you own a unit trust that is broadly invested in Singapore stocks, you could compare its performance with that of the STI.

FIGURE 8.2. BENCHMARKING A SINGAPORE EQUITY FUND AGAINST THE STI Aberdeen Singapore Equity SGD (MF)

Singapore Straits Time TR (IN)

175 0 150 125 5 141.3 1

0 100 75 5

80.7

50 0 5 25 0 5 -25 -50 1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Percentage Growth Total Return, Changes Applied (31/08/99 – 30/06/10) Source: www.aberdeen-asia.com

International Investing Investors looking for ways to diversify their portfolio have a world of opportunity through international investing. Buying stocks from an overseas market can earn you returns in three ways. For example, if you buy Microsoft (a U.S. stock), you gain when: • The stock rises in price. • The stock pays dividends. • The U.S. dollar rises against the Singapore dollar (when you sell the stock, each U.S. dollar converts to more Singapore dollars). But there are other risks as well. Besides the stock price falling, dividends getting cut and the foreign currency falling in value, you will have to contend with: • Confusing accounting rules that may cause earnings to be under- or overstated. • Inadequate disclosure requirements. • Language barriers or complicated trading rules, and others. 2 We rebase in order to compare apples with apples. To rebase any data series, we take each data point and divide it by first data point minus 1. If the first data point of STI is 1200 and the second is 1500, the chart would plot 0 (1200/1200 -1) and 25 per cent (1500/1200 -1).


Figure 8.2. is an excerpt from a factsheet of the Aberdeen Singapore Equity Fund, a unit trust invested broadly in Singapore stocks. The bottom line chart is the STI rebased to 100 for the period September 1999 to July 2010. The top chart is the Singapore equity fund also rebased to 100 for comparison. It shows the Aberdeen fund outperforming the STI benchmark over this period.2


CURRENCY RISK AND REWARDS Currency movements can accentuate your gains as well as losses. If your U.S. investment was purchased at US$1,000 when the conversion rate was S$1.8 : US$1.0, a major currency move when you sell the stock can bring very happy — or unpleasant — results. Suppose you sell the stock after one year for US$1,000, a breakeven position in terms of price. If the US$ rises to S$1.9, you will receive S$1,900 — a S$100 profit. But if the US$ falls to S$1.6, you will only receive S$1,600 — a S$200 loss. Exchange rate risk is a major added risk you need to consider when you invest overseas.

How to Invest Internationally There are several ways for you to buy international stocks: • Local brokerages with access to overseas markets — for example, DBS Vickers provides access to Hong Kong and Thailand stocks. • Some foreign companies list their stocks directly on Singapore exchanges such as Noble Group (Hong Kong) and Total Access (Thailand). • Open an account directly through a foreign brokerage such as Ameritrade and E*Trade. • Unit trusts that invest in international markets.

Keeping Track of International Markets There are hundreds of indices that measure the broad market or specific parts of it. Table 8.5 on the following page lists some of the most important indices used around the world.

TABLE 8.5. IMPORTANT INDICES AROUND THE WORLD Index

Singapore

The Straits Times Index (STI) is the most widely quoted stock index in Singapore with 30 large-cap, highly liquid stocks.

U.S.

The Dow Jones Industrial Average (DJIA) consists of 30 blue-chip stocks such as General Motors, IBM and McDonald’s. Despite being the most widely quoted stock index in the U.S., unit trust fund managers seldom refer to it as their benchmark.

U.S.

The Standard & Poor’s 500 (S&P 500) consists of 500 large-cap companies quoted on the New York Stock Exchange (NYSE). These companies make up 80 per cent of the NYSE’s total value. Most U.S. funds use the S&P 500 as their benchmark because it is a broader measure of the market.

Europe

The MSCI Europe consists of over 500 European stocks from 16 developed markets.

Asia

The MSCI Asia ex-Japan index consists of more than 500 stocks in 13 countries.

Japan

The Nikkei 225 is based on the 225 common stocks traded on the Tokyo Stock Exchange.

World

The MSCI World Index consists of more than 1,500 stocks in 23 countries globally.


Selecting and Managing Your Individual Stock Investments

Country or Region

105

106

PICKING A MARKET


Fund managers tend to analyse markets from a top-down perspective, focusing on a region’s or a country’s economic environment first and then on individual companies. Among factors that make a country’s stock attractive are the stability of the economy, exchange rate movements and its interest rate environment. The best conditions for an investor to find in an overseas economy are that it is growing, its currency is strengthening and its interest rates are low.

FIGURING OUT WHEN TO SELL A STOCK Selling a stock or bond often seems more difficult than buying one. That is because every investor has sold a good investment too soon or failed to get out of a bad one soon enough. Sounds familiar? Well, it happens to the best of us, but you do not want to make a habit of it. In the end, there really are not many clear-cut hard and fast rules. That is why we begin watchfully with “Warning Signs”.

Warning Signs If any of these warning signs appear, your stock is probably a good sell candidate: The Company is Embroiled in a Scandal This is the most ominous of all warning signs. Do not wait around expecting to see any silver lining or buying opportunity — sell right away. Scandals are long-drawn affairs. It may take many months between the time the scandal is first revealed, and when investigations are complete and made known. Do not hang around when the ship is sinking. The Company is Not Doing Well If your darling tech stock is showing negative or big drops in earnings two years in a row and other tech stocks in the same industry are registering record sales, something is probably very wrong with your stock. You can be patient with a stock that does badly for one

You Made a Mistake You bought a lemon from the start and you know it. You have a strong sense of regret, but yet you are hanging on for a miracle. If this happens to you, sell the stock right away. You are Over-Exposed to One Stock in Your Portfolio We know people who buy nothing but their company stock. They say it is plain loyalty and they are confident their company will prosper. We say this is suicide. Remember to diversify. If any one stock grows to occupy more than 20 per cent of your portfolio, you should start thinking very carefully about how much risk you are taking on.

General Market Conditions When economic indicators suggest that the economy is headed towards a recession, then no matter how good your stock is, it is probably going to decline as well. Here are some general guidelines for predicting market declines, although, of course, the direction of the stock market can never be reliably or consistently predicted. These guidelines are based on economic information that’s available in the newspaper. Interest Rates are Rising to Historical Highs When interest rates are high, companies face the prospect of high borrowing costs and cut back on borrowing and business expansion. Consumers cut back on spending as it gets too expensive to borrow. Company stock prices fall as a result. Furthermore, bond returns increase and become more attractive compared with stocks. High interest rates are one of the worst enemies of any stock investor. Stock Prices are Soaring and Economic Activity Does Not Seem to be Picking Up Strong economic activity justifies strong stock market performance.


year, but you should be impatient if it lags behind two years in a row when the whole industry is doing fine.


If economic activity is not robust, then it is difficult for any market rally to sustain itself. For example, suppose the economy is coming out of a recession and the stock market has raced ahead in anticipation of increased economic activity. But you notice consistent poor news — unemployment is high and is expected to increase, inflation from high commodity prices such as oil is pushing up the cost of doing business, and consumers aren’t going out to spend money. This is not good news for stocks.

SOME COMMON MISTAKES FOR NOT SELLING If you are still not convinced that the stock you own should be sold, you probably own a good stock. Still, some of us may stubbornly hang on even when there are obvious reasons for selling. Here are some mistakes for not selling that you should avoid:

You are Emotionally Attached to the Company Maybe your grandparents worked there all their lives and left you stock of the company. This and other sentimental reasons may be valid reasons to hold and therefore not sell a stock. But you have to accept that what you are doing makes little economic sense when the stock is performing really badly.

You Hate to Take a Realised Loss This is classic. Your stock is trading at $7 and you bought it for $10. You are making a 30 per cent paper loss. You have started to reject fundamentals. Your good sense shifts to, “Let us wait until the price rises back to the purchase price.”

MANAGING INDIVIDUAL STOCKS IN YOUR PORTFOLIO Individual stocks are flexible. If you plan to keep stocks for your retirement portfolio, a selection of 5–10 blue-chip, high-quality stocks across several industries should provide a good amount of diversification. Do not hold 20 or more stocks because it becomes exceedingly difficult to follow your investments. Just so no stock has


a very heavy impact on the portfolio, each stock should constitute no more than 20 per cent of the total stock portfolio. You can also trade stocks speculatively. Just remember that you should not have more than 20 per cent of your invested money in individual stocks. Some investors are going to speculate and take high risk anyway. Putting a cap on such investments is a sensible way of taking high risk within a safe overall framework that should not sabotage your retirement plans.


Investing in Individual Bonds Just about everyone knows that in the long run, stock returns do better than bonds. Then why would anyone invest in bonds? Bonds have two main characteristics that stocks simply cannot match. First, bonds return a known amount at the end of a stated period. Unless the borrower goes bankrupt, a bond investor can almost be certain that the capital originally invested will be returned. With stocks, the loss of money is not only possible, but it can happen quite frequently. Secondly, bonds pay interest according to a fixed schedule (typically twice a year). This interest can provide valuable income for retired individuals, or for those who want predictable cash flow. Do you need bonds? You will need bonds if: • You are a conservative investor and you cannot stomach the ups and downs of the stock market. • You have to set aside a fixed sum of money, such as for your child’s education, and you want the certainty of receiving known and specific amounts in the future. • You are retired and you want the certainty of income and your capital protected from fluctuation. For example, suppose you invested in $100,000 worth of bonds that pay eight per cent interest semi-annually and which mature in 10 years’ time. These bonds would pay you $4,000 every six months or $8,000 yearly, giving you money to live on or to invest elsewhere. Finally at the end of 10 years, the principal sum of $100,000 is returned to you. As an investor, you are spoilt for choice because there are as many types of bonds as there are ice-cream flavours. There are bonds that

BONDS ISSUERS Bonds are issued by corporations and by the government.

Corporate Bonds When corporate bonds are issued, they are normally sold at par, usually in units of $1,000, and subsequently traded in the stock

THREE MAIN FEATURES OF A BOND 1. Face value This is the original value of the bond that will be returned to the investor upon maturity. The face value (also called par value) of most bonds is $1,000. 2. Coupon The coupon indicates the interest income that the bondholder will receive over the life of the bond, usually payable in semi-annual instalments. For example, an 8 per cent coupon bond with a par value of $1,000 pays $80 annually or $40 semi-annually twice a year. 3. Maturity The maturity indicates when the bond matures. At the time of issue, the time to maturity is at least one year and can be as long as 30 or more years. At maturity, the issuer or borrower makes a final payment to the bondholder equal to the bond’s par value. In general, the longer the maturity, the higher the interest rate to compensate the investor for tying up his money for a longer time.

111 Investing in Individual Bonds

pay regular interest, bonds that pay no interest, bonds that can be called back by the issuer before maturity and even bonds that convert to stock. Knowing what bonds to invest in and when to do so can make a big difference to your bottom line.


exchange. Retail interest in corporate bonds is very low in Singapore as investors prefer the stock market. There are thus no more than a handful of outstanding corporate bonds on SGX. Here are two examples traded on SGX:

TABLE 9.1. SAMPLE LIST OF BONDS TRADED ON SGX Live Quotes from SGX

Buy

Sell

LTAn4.08%120521 10K

1.00

1.06

JTCn4.826%121024 10K

1.064

1.075

Source: : Extracted from www.sgx.com (29 July 2010)

The LTA bond pays 4.08 percent coupon interest per year, matures on 21 May 2012 and has a par value of $10,000. The Buy price is the price being offered for the bond, or what a buyer is willing to pay. The highest price submitted was 1.00 or 100 percent of par value, that is, $10,000. The Sell price is the price at which a seller wants to sell the bond. The best (lowest) selling price was 1.06 or 106 percent of par value, that is, $10,600.

Government Bonds Government bonds (called SGS or Singapore Government Securities), on the other hand, are issued by MAS. SGS are not listed on SGX, but are available through banks, financial advisor companies and Fundsupermart (an online distributor). Governments are not profit-making enterprises and do not issue stock. Bonds are the primary way they raise money to fund daily operations in running the country as well as capital improvements such as building mass rapid transit systems and highways. The Singapore government is the safest of all issuers because it has taxing power, the ability to print more money if necessary, and more importantly, has the highest credit quality assigned by the major rating services (see Table 9.2.).

Rating

Aaa

AAA

AAA

Source: www.sgs.gov.sg

MAKING MONEY WITH BONDS Conservative investors use bonds to provide steady and predictable income. They buy a bond when it is issued and hold it till maturity. They expect to receive regular coupon payments during the term. And at the end of the term, the principal is returned. More aggressive investors may sometimes trade their bonds before they mature, particularly when interest rates fall. When bonds are issued at a high rate of interest, they become increasingly valuable when interest rates fall. For example, suppose you buy a bond for $1,000 when interest rates are at 5 per cent. If interest rates fall to 3 per cent, new bonds will offer 3 per cent interest. The older bond which pays 5 per cent will become more valuable and hence more expensive. This means that an increase in the price of a bond, or capital appreciation, can produce more profits for the investor than holding the bond to maturity. But you can lose money as well.

INVESTING IN BONDS IS NOT RISK-FREE Interest Rate Risk If you sell the bond before maturity when interest rates have gone up, the price of your bond will go down and you will incur a capital loss. This is because buyers can buy new bonds that offer a higher interest rate and the price of your bond offering a lower interest will have to go down to attract buying interest. Interest rate risk is one of the three major risks bond investors face.


TABLE 9.2. CREDIT RATING OF SINGAPORE GOVERNMENT BONDS Moody’s S&P Fitch

114

Inflation Risk


Since the dollar amount you receive on a bond investment is fixed, the value of those dollars will be eroded by inflation. At a rate of inflation of 2 per cent, $100 received in 10 years’ time is worth just $82 today. That’s a loss of $18. In general, the longer the term of a bond, the higher would be the interest rate offered to make up for the risk of tying money up for a longer period.

Default Risk This is the risk that the borrower fails to pay you interest and principal. We will have more on this topic later.

WHAT IS A BOND WORTH? When you put $1,000 into a bond, the bond could be worth more or less the very next day. While you know how much coupon interest you will get in the future, your capital value or the current price of the bond can fluctuate. Like everything else in life, bond prices too are driven by supply and demand. When investors want to buy or sell, they consider two main factors: 1. Interest rates in the economy. 2. Credit rating of the bond issuer. Before we go on, we have to admit that investing in bonds can be a daunting task for the new investor because of the mathematics. There are all sorts of calculations and terms to master, and many of them seem different from those of stocks. We urge you to devote time and energy to learning the mathematics that drive bond prices and returns. It will set you apart from most other investors.

Interest Rates in the Economy When a bond is first issued, the coupon rate is typically set to the

Seller sells at par Par value Term Coupon Interest

$1,000 10 years 6 per cent

If Lizzie were to hold the bond to maturity, a period of 10 years, she would receive 20 payments of $30 each every six months and the return of $1,000 par value on maturity. Buyer buys at par Price $1,000 Holding period 10 years Interest income 20 semi-annual payments of $30 At maturity $1,000 Her dollar return is $600 and her yield is 6%. Return to buyer Interest (20 x $30) Par value

$600 $1,000 $1,600


market rate of interest so that the issuer can receive an amount equal to par value. For example, if the market interest rate is 6 per cent, the issuer sets the coupon rate at 6 per cent, making the price of the bond on the day of issue exactly $1,000. Market interest rates change as time passes by. As a result, bond prices after the day of issue are seldom equal to par value. Interest rates and bond prices move in opposite directions like two sides of a see-saw. When interest rates fall, bond prices go up. And vice versa. Let us go through an example: Suppose KayOn Pte. Ltd. issues a new 10-year bond offering six per cent interest semi-annually. Lizzie buys a bond at the full price or par value of $1,000.


Less cost Return

– $1,000 $600

Yield to buyer Current yield

$60 / $1,000 = 6%

Two years later, interest rates have gone up to 8 per cent. If new bonds costing $1,000 are paying 8 per cent interest, no buyer will pay you $1,000 for a bond paying 6 per cent. To sell her bond, Lizzie would have to offer it at a discounted price that could wipe out the interest she has earned so far. Suppose Lizzie sells the bond for $840. She would incur a loss of $40. Seller sells at discount of $840 Market price $840 Interest received $120 (4 payments x $30) $960 Less cost – $1,000 Loss -$40 The buyer pays $840 and if the bond is held to maturity, $1,000 will be repaid, or a capital gain of $160. The buyer can also expect 16 interest payments of $30 for the remaining eight years of the bond’s life. Buyer buys at $840 Price $840 Holding period 8 years Interest income 16 semi-annual payments of $30 At maturity $1,000 Return to buyer Interest (16 x $30) $480

Par value


$60 / $840 = 7.14 per cent

Of course, the reverse can also happen. If, in two years’ time, new bonds selling for $1,000 offer 4 per cent interest, Lizzie would be able to sell her 6 per cent bond for more than what she paid. Buyers would be willing to pay more for a bond that pays a higher rate of interest than that prevailing in the economy. If she sells the bond for $1,200, the premium (or capital gain) plus interest received of $120 will make her a nice profit of $320. Seller sells at premium of $1,200 Market price $1,200 Interest received $120 (4 payments x $30) $1,320 Less cost – $1,000 Profit $320 Buyer buys at $1,200 Price $1,200 Holding period 8 years Interest income 16 semi-annual payments of $30 At maturity $1,000 Return to buyer Interest (16 x $30) Par value Less cost

$480 $1,000 $1,480 – $1,200


Less cost Return

$1,000 $1,480 – $840 $640


Return

$280


$60 / $1,200 = 5%

MORE ON YIELD Yield is what you actually earn. When interest rates fluctuate and cause bond prices to move, the investor’s yield changes as well. When Lizzie buys the 10-year $1,000 bond paying 6 per cent coupon and holds it to maturity, she earns $60 a year — an annual current yield of 6 six per cent or the same as the interest rate. Current yield remains the same throughout her ownership of the bond. Current yield = Coupon interest / Market price = $60 / $1,000 = 6% An investor who buys the same bond two years later in the secondary market will be looking at a different yield. That is because the market price of the bond has changed. For example, if interest rates had risen to 8 per cent: Current yield = $60 / $840 = 7.14% There is an even more precise measure of a bond’s value called Yield to Maturity (YTM). Compared with current yield, YTM takes into consideration both coupon interest and capital gains/ losses. The investor of the $840 discount bond will earn $160 in capital gains at maturity, and this amount is not captured in current yield. YTM is the single most important calculation for a bond, but it does have a complicated formula. But there is a simpler, albeit less accurate, formula that helps to explain how YTM uses both capital gains and interest income in its calculation.

YTM (approximate) = (160/8) + 60 (840 + 1000) /2 = 8.7% You should know the actual YTM value when you invest, although you need not kill brain cells to calculate it. It is best left to a spreadsheet or your financial adviser who is handy with a financial calculator.

BOND CREDIT RATINGS As a bond investor, you want reasonable assurance that you will get your interest payments and principal back at maturity. It is impossible for individuals to track the credit worthiness of individual bond issues. Fortunately, rating services such as Moody’s Investors Service (Moody’s) and Standard & Poor’s Corporation (S&P) provide this valuable service. These rating services pore through voluminous financial statements and study the business prospects of bond issuers to answer the question, “How likely is the issuer to default on its payments on a particular bond issue?” Bonds that rank low in terms of risk receive a higher quality rating.


Here it is. First, find out the annual discount or premium over the life of the bond. The KayOn bond has an annual premium of $20 ($160 / 8 years). Second, add the annual premium of $20 to the annual coupon of $60 to get $80, which is the annual return from both the capital gain and the income portions. Third, divide the annual return of $80 by the average price of the bond. The average price is obtained by adding the buying price of $840 and the maturity price of $1,000 and dividing the result by 2. From doing all this, the result is 8.7 per cent, which is slightly off the actual result of 8.83 per cent:


Bond ratings are assigned to a particular bond issue, not just to the issuer of those bonds. For example, a secured bond issue gives the investor a claim to specific assets in the event of default. This gives a secured bond a higher credit rating than an unsecured bond even when issued by the same corporation. The top four grades (Aaa, Aa, A and Baa in the case of Moody’s) are considered investment grades. All other grades are considered high-yield or junk.

TABLE 9.3. RATINGS TABLE Moody’s

S&P

Investment-Grade Bonds

Aaa

AAA

Highest credit rating, maximum safety

Aa

AA

High credit rating, investment-grade bonds

A

A

Upper-medium quality, investmentgrade bonds

Baa

BBB

Lower-medium quality, investmentgrade bonds

Moody’s

S&P

Speculative Bonds

Ba

BB

Low credit quality, speculative-grade bonds

B

B

Very low credit quality, speculativegrade bonds

Moody’s

S&P

Junk Bonds

Caa

CCC

Extremely low credit quality, highrisk bonds

Ca

CC

Extremely speculative

C

C

Extremely poor investment

D

D

Bonds in default

Source: Authors’ own compilation from Moody’s and S&P

121

Ratings Influence Yield

YIELD

FIGURE 9.1. LOW QUALITY SPELLS HIGHER YIELD

AAA

AA

A

BBB

BB

RATING


B

CCC

CC

C

D

Investing in Individual Bonds

As Figure 9.1. shows, credit ratings influence the interest rate an issuer must pay to attract investors. Given the same maturity, the higher a bond’s rating, the lower the interest it pays. On the other hand, the lower a bond’s rating, the more an issuer must pay. That is why the lowest-rated bonds are often described as high-yield bonds. In the next chapter, we will look at strategies for buying and selling, and how you can manage your bond investments.

10 Selecting and Managing Your Individual Bond Investments Some investors think that bonds are conservative, even boring investments. Think again. A $1,000, 4 per cent coupon bond, with 10 years to maturity, could rise $149 or fall $180 in response to a 2 per cent change in market interest rates. Knowing about bonds — when to buy them and how to select among a multitude of choices — can reap huge rewards.

THE MANY FLAVOURS OF BONDS Bonds have many different features, which make each bond unique. As you learn about each feature, bear in mind whom the feature benefits — the issuer or the investor. If a feature benefits the investor, then the bond has lower risk, its yield should be lower, and its price should be higher. So once you know who benefits from a feature, you will have a good idea about whether to pay more or less for such a bond. Here are some of the most common bonds you will find.

Government Bonds Government bonds (called SGS or Singapore Government Securities) are issued by the Monetary Authority of Singapore (MAS). At the time of issue, government bonds have maturities of between one and 15 years.

Corporate Bonds Corporate bonds are issued by corporations. They are bought and sold mainly by institutions. There is limited interest from retail investors.

Secured Bonds Secured bonds are backed by specified assets such as mortgages

Unsecured Bonds Unsecured bonds (or debentures) are the most frequently issued type of bond. They are backed by the credit quality of the issuer. In general, the higher the credit quality, the higher the chance the borrower will pay you as promised. Although unsecured bonds sound risky, they generally are not. Debentures are issued by high-quality corporations, and they are often more highly rated than secured, asset-backed bonds.

Floating-Rate Bonds Floating-rate bonds (or floaters) periodically adjust the coupon interest according to a formula based on current market interest rates. When market interest rates are going up, floaters adjust their coupon interest upwards.

Zero-Coupon Bonds Zero-coupon bonds do not pay coupon interest during the term of the bond. Instead, the interest is built up and paid in a lump sum at maturity. Zero-coupon bonds are sold at a discount. For example, if you buy a zero-coupon bond for $900 and you collect $1,000 on maturity, you would have earned $100 in interest.

Callable Bonds Callable bonds give the issuer the right to call back the bond and repay its debt before maturity. For this reason, callable bonds do not always run their full term. Issuers tend to call a bond if interest rates fall, in the hope of paying off the original loan and reissuing another bond at a lower rate of interest.

123 Selecting and Managing Your Individual Bond Investments

and accounts receivables. In general, bonds have to be backed by something for investors to be convinced to part with their money. For example, a mortgage-backed bond bundles mortgages, and then sells investors the right to receive the payments that consumers make on those mortgage loans.


If you think that is unfair, it is the same idea as you refinancing a mortgage to get a lower interest rate to make lower monthly payments. Callable bonds are less attractive for investors because an investor whose bond has been called now faces a lower, reinvestment environment. Callable bonds are riskier for investors and hence offer a higher rate of return than non-callable bonds.

Convertible Bonds Convertible bonds are hybrid investments because they possess some qualities of a bond and some of a stock. Hybrids are normally safer than either a bond or a stock. If interest rates rise and the bond falls in value, the investor can still benefit if the stock price has risen. If the option to convert is not exercised, the convertible remains in existence until the bond’s maturity and you continue to receive interest income. This flexibility is especially appealing to conservative investors who seek regular income and downside protection against falling share prices. Because convertible bonds have a little something extra — the right to convert to common stock, they cost more than straight bonds without conversion features. Convertible bonds are less risky for investors and hence offer a lower rate of return than nonconvertible bonds.

High Yield Bonds High yield bonds are lower-grade bonds that pay higher interest rates. High yield bonds are not inferior bonds at all except that they are riskier than investment-grade bonds. They are often just a grade below investment grade and are issued by emerging market economies and by good companies that have fallen on bad times.

CHOOSING THE RIGHT TYPE OF BOND

• Maximum current income — Choose high-yield bonds. • Protection from rising interest rates — Choose high-yield bonds or short-term bonds. The prices of short-term bonds are less volatile because they are closer to maturity. • Protection from default risk — Choose investment grade bonds. • Take advantage of falling interest rates — Choose long-term bonds and zero-coupon bonds. • A worry-free investment in a bond — Buy bonds and hold them to maturity. The closer the bonds are to maturity, the less worrisome.

MAKING A BOND INVESTMENT There are two main ways you can have a bond investment: 1. Purchase individual bonds. 2. Purchase bonds through a unit trust. Instead of buying individual bonds, many investors find it easier to invest in bonds through unit trusts, which offer a diversified portfolio of bonds for as little as $1,000. The typical bond fund has 50 to 100 individual bonds of different maturities, yields and credit ratings. This allows investors to diversify risk easily and inexpensively across a broad range of bonds. What is more, bond funds come with a fund manager and an investment team — they provide expertise that most individual investors do not have access to.

Selecting and Managing Your Individual Bond Investments

There are so many types of bonds that it can be confusing trying to pick one over another. Here are some rules of thumb, depending on what you want:

125


Here are some things to consider when making a decision about whether to invest in individual bonds or in a bond fund.

TABLE 10.1. CHOOSING BETWEEN INDIVIDUAL BONDS AND BOND FUNDS Invest in Individual Bond

Invest in Bond Fund

Definite maturity date.

Bond funds never mature. As some bonds mature or are traded away, new bonds take their place.

Capital Preservation

Capital returned is predictable. It is at par at maturity, regardless of prevailing interest rates (unless issuer defaults).

Capital returned is unpredictable — based on the price of underlying bonds (Net Asset Value), which are affected by prevailing interest rates, among other things.

Income

Individual bonds send you interest income on fixed dates.

Interest income is usually not paid out but reinvested.

Interest Rate Risk

Less affected by interest rate risk. In fact, the risk diminishes as bond reaches maturity.

Constant exposure to interest rate risk.

Default Risk

The impact of a default is greater, especially when few distinct bonds are owned. Conservative investors should seek mainly lower-risk, investment-grade bonds.

Default risk is minimised because a fund typically holds 50–100 distinct bonds.

Management

You are on your own when it comes to managing your bonds. When the bonds are repaid on maturity, you will have to think about what you are going to do with the cash.

Unit trusts offer management expertise on an ongoing basis.

Maturity


BOND PICKING STRATEGIES

Buy Bonds When You Think Interest Rates are High When you buy a bond, you are locking yourself into receiving a fixed amount of interest every year until the bond matures. If interest rates are low, you should be fussier about what you buy. Look for shortterm bonds that mature in a few years and certainly give long-term bonds a skip. Buying when interest rates are high gives you two benefits. The interest you receive on your bond will be higher. Second, if interest rates are high, there is probably a good chance that interest rates will fall and the price of your bond will go up.

Laddering Maturities Laddering means staggering the maturities in a bond portfolio. Here is how it works. Suppose you have $20,000 to invest in a bond portfolio. Buy 10 bonds each with $2,000 face value, maturing annually for 10 consecutive years. As time passes and the first bond matures, invest in another 10-year bond. Continue this cycle, as long as you want to remain in bonds. This approach means that you are never concentrated in any one maturity. If there is a significant change in interest rates, you will have avoided putting a heavy portion of your money on a single maturity. Laddering maturities reduces the effect of interest rate risk on bonds.

Beware of Callable Bonds Callable bonds can be called and retired by the issuer before maturity. They pay more interest because they are riskier than noncallable bonds.

Selecting and Managing Your Individual Bond Investments

Along with your newfound knowledge of bonds, here are some strategies on picking bonds that will help you become a successful bond investor.

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Be careful of callable bonds because bonds are often called when interest rates have fallen. Calling a bond allows the issuer to reissue the bonds at a lower interest rate. This does you no good because you will reinvest your money in a lower interest rate environment. What is more, callable bonds fix the price that is paid to you. Just when you think that lower interest rates point to higher bond prices, you remember that callable bonds have a clause stating the maximum price the issuer will compensate you in the event of a call. This price is always lower than the price of a bond with no callable feature.

Buy Quality Bonds Be careful about chasing after the highest yielding bonds. Such bonds may be low quality and have a high chance of default. While it is alright to allocate a small portion of your money to speculative bonds, do not focus only on high yield bonds. If you are buying individual bonds worth from about $10,000 to $20,000, it is difficult to achieve a lot of diversification. You should therefore focus on high quality bonds.

Buy Bonds That You Expect to Hold till Maturity When you buy a bond and hold it till maturity, you will know the rate of return because it can be calculated on the day you buy your bond. You may still hope to buy a bond and sell it for a nice profit when interest rates fall. But you have to ask yourself what you will do with the proceeds of your sale. For example, you bought a bond when interest rates were at 5 per cent, and which have now fallen to 3 per cent. Sure, you can sell the bond and make a profit (if you cash out totally), but it would not make sense to use the proceeds then to reinvest in another bond that pays only 3 per cent.

FIGURING OUT WHEN TO SELL A BOND Selling a bond before it matures is a big decision. We indicated in the previous two chapters that one of the best reasons to buy a bond

1. Slipping of credit rating While a drop in rating from AAA to AA is not such a big problem, a bond falling into the junk or CCC and below category is very risky and has a high chance of default. 2. You need the money We hope you will never find yourself in this sort of situation: you have an emergency and your emergency funds are not enough. The worst thing about forced selling is that it may be the wrong time, especially when interest rates have risen and bond prices have fallen. 3. Falling interest rates Bond prices are rising as a result and you are now tempted to cash in your profits. This is not a bad idea if you are thinking of cashing out. But if it is to buy another bond, then realise that other bonds are also paying lower returns. This defeats the whole purpose of selling. Still, there are two situations in which selling makes sense. First, when interest rates fall, this is usually favourable to stocks. You may move out of bonds when prices are high and move into stocks as they benefit from falling interest rates. But be careful that you have really understood the fundamentals. It is easy to get the signals wrong. Second, falling interest rates is a good sign overall for the whole economy as even shaky companies have a higher chance of survival due to cheaper debt. Sophisticated investors do take such opportunities to switch from safer bonds to higher-yielding bonds of a lower quality in order to generate higher returns.

129 Selecting and Managing Your Individual Bond Investments

is when you plan to hold it to maturity. Nevertheless, there may be situations where selling makes sense:

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MANAGING INDIVIDUAL BONDS IN YOUR PORTFOLIO


Like stocks, bonds are very flexible investments. If you want protection of capital and high liquidity, you can consider short-term bonds, preferably of investment grade quality, that mature in one to three years. If you want to match a bond with your retirement, you can consider a bond whose maturity closely matches your time of retirement. For example, if you plan to retire in 10 years, then you should go for investment-grade bonds that mature in 10 years. Because the yield to maturity is known, this is a low risk strategy of ensuring a certain return along with good protection of your money as your retirement gets closer.

3

PART

INVESTING IN ALTERNATIVE ASSETS Investing in traditional assets in Part 2 showed you how to build a portfolio of unit trusts for a long-term objective such as retirement. It also showed you how, after setting aside your funds for this most important objective, you could add individual stocks and bonds to your portfolio. In this section, we go beyond traditional investments to include products such as gold and hedge funds. This is not to say that the traditional products are inadequate, but some of us would like to go a little further. Remember to stick to the 20 per cent rule — no more than 20 per cent of all your invested funds can be allocated to individual stocks and bonds and alternative products. The chapters in this section are shorter than the other sections because they build on what you already know. For example, a capital guaranteed fund is made up of bonds and derivatives. We suggest that you plan your retirement portfolio before putting a single dollar to alternative investments.

11 Investing in Exchange Traded Funds (ETFs) and Index Funds An ETF is like a typical unit trust1 but it differs from it in two fundamental ways: • An ETF trades on a stock exchange such as SGX; and • An ETF passively mimics an underlying index rather than attempting to beat it actively. Take the streetTRACKS STI Fund for example, which is listed on SGX and passively mimics the Straits Times Index (STI). On the other hand, a unit trust that focuses on Singapore stocks, such as the Schroder Singapore Trust, looks actively for Singapore stocks that together attempt not only to match, but beat, the performance of the STI. You probably have these questions: • How is a portfolio of ETFs different from a portfolio of actively managed unit trust funds in terms of risk, performance and cost? • Can you build a globally diversified portfolio of ETFs where each passively follows an index? We’ll answer these questions about ETFs in this chapter and also talk about how they are similar to index funds.

ETFs An ETF trades like a stock on an exchange and so its price fluctuates during trading hours. By owning an ETF, you get the diversification 1 What we mean by a typical unit trust here are those unit trusts whose objective is to beat a specific underlying benchmark.

TABLE 11.1. COMPARING ETFS AND UNIT TRUSTS ETF

Unit Trust

Objective

Passively tracks an index. Will not outperform or underperform the underlying index.

Actively attempts to outperform the underlying index.

Buying Charges

Based on what stock brokerages charge, typically measured by bid-offer spread.

1.5% to 5% of amount invested.

Recurring Fees

Typically between 0.75% and 1.5% per annum of amount invested.

Typically between 1% and 3% per annum of amount invested.

Trading Price

What you see on the trading screen is your paying or buying price.

Based on forward pricing. Investor will not know price paid or sold at usually till 1–2 days later.


133 Investing in Exchange Traded Funds (ETFs) and Index Funds

of an index as well as the flexibility of trading it like a stock. This means that you can sell short, buy on margin and purchase as few as one share at a time. Your upfront cost of buying an ETF is the brokerage fee, which is the same as that paid for stock trading. And there is no 3 to 5 per cent front-end load, which is typical for a unit trust. Most ETFs fully replicate the underlying index by investing in every stock in the index, weighted proportionately. It is because of this passive approach to mimicking the index that ETFs are never expected to beat or lose out to the underlying index in terms of performance. If the STI goes south by 10 per cent, you can expect an STI ETF to fall in the same direction by the same magnitude. Its passive nature means the fund manager has to do far less research and analysis to construct the ETF. As a result, ETFs have lower expense ratios. In most cases, an ETF stays fully invested at all


times while actively managed funds may keep a portion of investor funds in cash depending on market conditions. Table 11.1 (page 133) summarises the key differences between ETFs and unit trusts.

INDEX FUNDS Index funds are unit trusts based on an index and mirror its performance. Index funds came about before ETFs did. In the U.S. where index funds were first launched, there are 2.5 index funds for every ETF. The thinking behind index funds has strong academic backing. For a long time, many academics have been saying that it is impossible to beat the market consistently without raising your risk level — a theory known as the Efficient Market Hypothesis (EMH). In 1975, John Bogle of investment management company Vanguard took the position that if you can’t beat the index, create a fund to mimic it. That’s when the first low-cost mutual fund was created mirroring the S&P 500 index. Index funds have been a hit in the U.S. because many investors are disillusioned by the returns of actively managed funds. In study after study, data show that the majority of active mutual funds fail to outperform the S&P 500 and other indices. So why pay a fund manager to look actively for the best investment opportunities for you, when more likely than not, the fund manager will not be able to do better than the index? One of the reasons this is true in the U.S. is that the fund industry is very large and well followed. The stocks of the world’s largest companies are tracked by hundreds of analysts. The amount of information sharing and efficiency is very high. There is little that one manager can know that is of material significance to his portfolio that other managers would not know about. In Singapore and many parts of Asia, this phenomenon is less pronounced. Our markets are smaller, are followed by far fewer analysts, and have a lower degree of information efficiency in the sense that fund managers are able to extract information and

BUILDING A PORTFOLIO OF ETFs AND INDEX FUNDS There are differences, of course, between ETFs and index funds. But overall, they are more similar than different in that both are passive investing styles that track indices in terms of composition and performance. In chapter 5, we showed you how to build your own globally diversified portfolio using actively managed unit trusts by allotting your money in the following regions:

TABLE 11.2. RECOMMENDED ALLOCATION OF EQUITY FUNDS Type of Equity Fund


US Equity Fund

30%

European Equity Fund

30%


30%

Japan Equity Fund

10%

TOTAL

100%


You can do the same with a combination of ETFs and index funds that are available today. Table 11.3 shows a sample of such funds:

TABLE 11.3. SAMPLE OF ETFS AND INDEX FUNDS AVAILABLE IN SINGAPORE Focus Index Tracked Example Fund Global Funds Global Equity

MSCI World Index

DBXT MS World

Regional Funds U.S. Equity

MSCI USA Index

DBXT MS USA

European Equity

MSCI Europe Index

DBXT MS Europe


analysis that is not commonly known. In fact, studies show that actively managed funds in Asia do at least as well as, if not better than, passively managed ones.


Focus Asia ex-Japan Equity Japan Equity

Singapore equity Singapore bonds Hong Kong equity

Index Tracked MSCI AC (All Country) Asia-Pacific Ex-Japan Index Tokyo Stock Price Index (TOPIX) Single-Country Funds Straits Times Index iBoxx ABF Singapore Bond Index Hang Seng Index

Example Fund Lyxor Asia Lyxor Japan

STI ETF ABF SG Bond Lyxor Hang Seng

Korea equity

MSCI Korea Index

Lyxor Korea

China equity

Hang Seng China Enterprises Index

Lyxor China

India equity

MSCI India Index

IS MSCI India

Commodities

RJ/CRB Index

Lyxor Commodity

Gold

Gold Spot Price

SPDR Gold Shares

Technology

DJ US Tech Sector Index

IS DJ US Tech

Sector Funds


As indicated by Table 11.3, there’s enough out there for you to create a globally diversified portfolio as well as have some focused investments in specific countries and sectors. For example, if you had $10,000 to invest, you could build any one of the following portfolios: • Portfolio 1 — Put $10,000 all into one global stock ETF/index fund for instant global diversification. • Portfolio 2 — Put $3,000 each into U.S., Europe and Asia exJapan funds, and $1,000 into a Japan fund. This gives you instant global diversification, plus more control over the amount you want in each region.

You may be wondering how come you don’t own such funds when the cost of owning them is a lot lower. One reason is that you have may not have been approached too persuasively to buy such funds. ETFs do not earn financial advisers any money and index funds are less lucrative to sell compared with actively managed funds. On the last point, lest you are fuming slightly, you must understand that there is a cost to distribution. The bank and financial adviser who service and advise you need to earn their keep too. These investments work in the U.S. because the degree of self investment there is higher — thanks to the much longer history that U.S. investors have had with discount brokerages such as Schwab and E*Trade. We in this region generally prefer to be helped and advised. Of course the other reason is, as we have mentioned, actively managed funds in Singapore and the region do generally beat their regional benchmarks. In the end, you need to appreciate these different dynamics between a smaller market such as Singapore, and the U.S. market, which is the largest in the world. ETFs and index funds will become more important as the market expands, and you’ll have increasingly more choices ahead. Our advice is that if you are looking for a fund such as a Japan fund, you need to challenge your financial adviser by asking whether an active or passive fund is better for you. And if your interest is in the U.S. market, the question becomes even more important because passive funds in the U.S. are the ones that generally do better than active funds. There are no straight answers, of course, but it is important that you cover these angles when you are buying.


• Portfolio 3 — Put up to $2,000 into sector and single-country funds, and the rest into a diversified portfolio. This way you get to have a long-term diversified portfolio and are still be able to have some fun and take more risk with more focused investments.


Investing in Real Estate Once you own one home, as do most Singaporeans, the idea of owning another home as an investment might pop into your head. Whether you are looking at an investment property in Singapore, Australia or Malaysia, pulling the trigger is something more and more affluent individuals are doing. In fact, according to the 2010 Merrill Lynch World Wealth Report, affluent individuals have 18 per cent of their investment portfolios in property. Why is there such an age-old fascination with property? The most obvious reason is that few things in life provide a greater sense of security than having a roof over your head.

FIGURE 12.1 PRIVATE RESIDENTIAL PROPERTY PRICES VERSUS GDP ((1990 = 100) INDEX 300 0 250 0 200 REAL GDP

0 150 REAL PPI PI

0 100 0 50 0 1975

1978

1981

1984

1987

1990

1993

1996

1999

Source: “Residential Property Prices and National Income,” Economic Survey of Singapore, First Quarter 2001, pp 49

The second most attractive reason is that property prices rise over the long term — as long as the underlying economy is growing. Will Rogers once said, “Buy land. They ain’t making any more of the stuff.” How true especially if you live in Singapore. Look at Figure

INVESTING IN A RENTAL PROPERTY You buy a property and rent it out to a tenant. As the landlord, you are responsible for paying the mortgage, taxes and cost of maintaining the property. Ideally, the rent paid to you will cover your monthly expenses of that property. You can then sit tight till the mortgage is paid off and you own the property exclusively, and then you can enjoy the rent as profit. Alternatively, you may sell the property when its price has appreciated significantly. This all seems to make a rental property an ideal investment, but landlords will tell you that there are always challenges. Unlike a stock or a bond, a rental property requires you to devote time to maintaining your investment. When the bath tub leaks or the electricity gets cut in the middle of the night, it’s you who will get the phone call. You could also have trouble finding a tenant or end up with a bad tenant who damages your property. You might receive poor rent and have problems servicing your mortgage. It can get even worse if the property’s valuation falls below your loan amount and you fall into a negative equity position. That’s when the bank will demand that you top up the difference.

1

http://app-stg.mti.gov.sg/data/article/21/doc/NWS_Property.pdf. Also here: www.asiaone.com/print/Business/My%2BMoney/Property/Story/ A1Story20100426-212422.html

139 Investing in Real Estate

12.1,1 which shows a clear long-term correlation between property prices and GDP from 1975 to 1999 (although there have been periods of exuberance such as in 1981–84 and 1994–97). Property costs hundreds of thousands of dollars and may be out of the reach of some investors. Fortunately, buying directly into a physical property isn’t the only way to invest. You can participate in other ways including real estate investment trusts (REITs), property funds and land banking. We start by looking at rental properties.

140

Some Strategies on a Recession-Proof Property Investment


Knowing that property prices go hand in hand with economic growth, how do you ensure that the price of your investment property does not go south when the economic climate is rough? There are certain strategies you can employ to recessionproof your investment. Since most homeowners will buy and sell several times in their lives, you are likely to have a chance to use these bulletproof principles the next time you buy. We will discuss just two principles that we have found most critical in our own experience.

Location, Location, Location You’ve probably heard it before, and it’s true: Location really matters. Remember that homes are replaceable, but land is not. A mansion in a poor location is a usually a worse off investment than a modest apartment in a good location. If you’ve got a spot everyone wants, your place will sell faster and for a better price than a similar house elsewhere.

TABLE 12.1 GOOD PROPERTY LOCATIONS City Bangkok, Thailand Hong Kong, China Jakarta, Indonesia Kuala Lumpur, Malaysia Singapore Sydney, Australia Tokyo, Japan

Good Property Locations Sukhumvit, Lumpini, Silom Happy Valley, Deep Water Bay, Mid-Levels Cilandak, Kebon Kacang, Pondok Indah Kenny Hills, Ampang, Bangsar Bukit Timah, Orchard Road, Shenton Way Chatswood, Rose Bay, Bondi Roppongi, Minato, Shibuya


A location is considered good when it is close to good schools, the central business district, the beach, popular shopping malls, the airport and railway stations. A home in a remote, far away location

Holding Power Can you hold on to your property even when prices are spiralling downwards? Property investment needs your long-term commitment and holding power. If you have little savings in the bank, and servicing your loan takes up most of your monthly income, you probably have taken on a larger loan than you can manage. This means your holding power is weak, and a sudden drop in home prices could force you to liquidate your investment suddenly at a loss. For instance, our friend Dawn bought a semi-detached home in 1997 for $3.2 million. It was her sixth property. Every property she had bought till then had produced huge profits. The bank was happy to loan her more and more. However, when property prices crashed, she found herself in a negative equity position for most of her properties, and she had to sell five of her properties at fire-sale prices. The semi-detached home was sold for less than $2 million. She was left with one property, her matrimonial home, and a debt of close to $5 million. Home prices later recovered and it pained her to think, “if only I could have hung on.” Thus consider your holding power before you invest in property.

INVESTING IN REAL ESTATE INVESTMENT TRUSTS (REITS) If you have always wanted to own your favourite shopping centre such as Tampines Mall or Junction 8, but you do not have $500 million in spare cash, do not fret. For as little as $1,000, you can invest in a piece of commercial real estate to call your own. When you invest in a Real Estate Investment Trust (REIT — pronounced “reet”), a group of real estate professionals buys and manages real estate on your behalf. REITs allow people to invest in real estate without buying property directly. The properties


has far less potential for attractive price appreciation even when the rest of the economy is doing well.


are then leased and rented out, and the income is passed on to investors. REITs mostly specialise and do not mix and match the types of real estate they own. For example, some REITs may focus their investments geographically (such as by country or city), or in specific property types (such as shopping malls, industrial buildings or residential apartments). The first Singapore REIT is Capital Mall Trust, which debuted in July 2002. Over 20 REITs trade on SGX today. Table 12.2 shows a sample of those REITs.

TABLE 12.2. REITS AND WHERE THEY ARE INVESTED Name of REIT Invests Mainly In AscendasIndT

Commercial buildings in India

AscendasREIT

Industrial parks

AscottREIT

Service apartments in Asia

Cambridge

Industrial buildings

CapitaComm

Commercial buildings

CapitaMall

Shopping malls

CapitaRChina

Shopping malls in China

CDL HTrust

Hotels

First REIT

Healthcare real estate in Asia

Fortune REIT

Shopping malls in Hong Kong

FrasersCT

Shopping malls

K-REIT


LippoMapletreeIndonesia

Shopping malls in Indonesia

MapletreeLog


Parkway Life

Healthcare real estate in Asia-Pacific

Saizen REIT

Residential real estate in Japan

SuntecREIT

Shopping malls


Why Invest in REITs?

1. Liquidity REITs are traded on stock exchanges and are liquid compared with buying real estate directly. Try selling a house in a hurry and you will find that it’s not easy to liquidate. 2. High dividend yield REITs typically offer two per cent above 10-year government bond yields. So if 10-year government bond yields are three per cent, REITs can be expected to yield five per cent. But REITs have risks too. In fact, you should take extra precaution, especially in times when there are many dollars chasing after REITs: 1. Management risk Unit trusts invest in companies in which each company has a different management team. With REITs, it is just one management team that makes decisions not only on buying and selling, but also on managing and operating the REIT properties. 2. Interest rate risk When interest rates rise, the income from REITs will become less attractive relative to other investments. For example, government bond yields will rise when interest rates rise. The situation becomes worse if the economy is coming out of a low interest rate environment, and the upside for interest rates is strong. Capital values are likely to be vulnerable as well. Higher interest rates mean that the cost of borrowing goes up and REITs will suffer from larger interest payments on mortgages and bonds.

Investing in Real Estate

Many investors turn to REITs as an alternative to savings and fixed deposit accounts. And why not? REITs offer two attractive benefits:

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3. Industry risk While a REIT may be less risky than an investment in an individual property, the fund has all the risks associated with sector funds because of its exposure to real estate. Their values will fall in an economic downturn while savings and fixed deposits are virtually immune to economic downturns. 4. Depreciation Because of depreciation, the capital value of REIT properties decreases over time. This is especially true for REITs that invest in industrial property that sits on leasehold and not freehold land. For example, if a landlord leases industrial land for 30 years at a time, the property is returned to the landlord when the lease runs out.

S-REITs in Strong Position in Asia The U.S. REIT market is the largest in the world with over 50 per cent of total global market value. In Asia, the Singapore REIT (S-REIT) market is the second largest after Japan. The future looks bright as investors are attracted by the number of choices available today. S-REITs are well diversified with interests in retail, commercial, industrial, hospitality and healthcare. S-REITs are also well stocked with offshore assets as they have interests in more than 10 countries, thus providing geographical diversification.

Managing REITs in Your Portfolio REITs behave like fixed income securities and one can rely on REITs for income. However, the capital value of REITs can rise and fall along with cycles in the property market. If you plan to keep a REIT for retirement, do a serious evaluation of the property sector as a whole every three to five years. Even if dividend yields remain strong, the capital value of your investment can go down. Remember that an investment in REITs is first and

INVESTING IN PROPERTY FUNDS Compared with REITs, property funds are more diversified in their investments in terms of geography. As seen in Table 12.2. (page 142), such funds are typically invested broadly across Asia, Europe or globally. These funds may invest in one or a combination of the following: 1. Funds that invest in REITs. 2. Funds that invest in investment companies (holding companies that buy properties and receive rental income). 3. Funds that invest in property developers (companies engaged in building and land development activity).

TABLE 12.3. EXAMPLES OF PROPERTY UNIT TRUSTS SOLD IN SINGAPORE Name of Unit Trust

Launch Date

Amundi Asian Real Estate Dividend Fund

April 2005

DBS Global Property Securities Fund

March 2005

First State Global Property Investment

February 2005

Henderson Asia-Pacific Property Equities Fund

March 2006

Henderson European Property Securities

June 1999

Henderson Global Property Equity Fund

March 2005

IOF-Asian Property Securities

March 2008

United Global Real Estate Securities Fund

March 2005


If you would like to gain exposure to global and regional property markets without having to buy physical property, such funds can make a good addition to your portfolio.


foremost an investment in real estate. And we all know how volatile that is.

146

INVESTING IN LAND BANKING


Land banking is the practice of purchasing raw land with the intent to hold on to it until it is profitable to sell it. The intended increase in value generally comes from the conversion of raw land to residential or commercial use, or from the potential for extraction of natural resources.

FIGURE 12.2. THE LAND BANKING PROCESS

Land Acquisition Conduct due diligence on the area before acquisition.

Important Trends to Consider • Population Growth • Economic Growth • Government Policy

Land Syndication Dividing the land in smaller units and selling it to investors collectively as co-owners.

Important Considerations • Safety of investment • Holding period • Expected Returns

Land Value Enhancement Creating value by having the concept plan approved by the authorities.

Important Considerations • Zoning process • Time horizon • Growth requirements

Land Exit Land sold to developers with concept plan already approved by the authorities.

Important Considerations • Exit strategy • Transparency • Taxes


Look Before You Leap Investors like the concept of land banking as it is a tangible asset as opposed to stocks and bonds. Based on the advertising that you have probably seen, you might expect that this investment would produce attractive returns with little risk. Of course, this is not always the case. In fact, land banking has been in the Singapore news recently because of the failure of a land banking company to honour its financial obligations on a certain project. Does this mean we should avoid land banking altogether or was the company’s failure a onceoff event? Land banking is not regulated by the Monetary Authority of Singapore (MAS). MoneySENSE, a national financial literacy program launched by the MAS, issued a consumer article on land banking in June 2010.2 The article explains what land banking is, highlights the key risks and important questions you should consider before deciding whether to invest in land banking. The key risks highlighted are: 2 See: www.moneysense.gov.sg/publications/quick_tips/Consumer_Portal_Land_ Banking.html


The most desirable parcels of land for land banking are those that lie directly in the growth path of developing cities. The goal is to identify such “virgin” parcels well in advance of developers and wait for the value to be realised. Some of the best known land bankers are people like Donald Trump and the Rockefellers in the US, Li-Ka Shing in Hong Kong and the late Ng Teng Fong in Singapore. Figure 12.2 shows an overview of the land banking process. One important difference between Donald Trump and far less famous investors like ourselves is that we are investing in undivided units of land rather than whole big plots of land. Through land syndication, big plots of land are chopped up into investible pieces for sale to investors like yourselves.

148

• It could turn out to be a scam.


• What if plans to develop the land are derailed? • What if you need cash urgently? • Foreign exchange risks. Some key questions to ask yourself are: • What do you know about the land you are purchasing? • What do you know about the company you are dealing with? • What do you know about the law of the country where you are investing in? As an added note of caution, if you were to perform an Internet search on “land banking,” you would likely see a fair amount of negative views on the investment.

Land Banking — Not All Bad News Land banking has been available in Singapore for over 15 years and enjoys a good following amongst many investors. There are many land banking investors who have earned good double-digit returns over the years. Still, we’d like to leave you with more advice on its risks from our experience with the product. We believe that if you heed more advice than less, you too can become a successful land banking investor. A few more words of caution: • Remember that there is no guarantee that a land banking company will repeat its success even if it has had a proper track

• If you do invest in land banking, make sure that it is no more than 5–10 per cent of your total investment portfolio. • Some land banking firms may stress that all their projects resulted in profits for their investors. In such cases, you might like to check on the duration it took for the investors to exit. Investors might have waited for a long time before the development approval took place or the company may have simply have bought back the project. • Do your homework because most land banking projects are in foreign countries and you need to be aware of the rules and laws in those countries. This is not to be taken lightly as any legal dispute is likely to adhere to the laws and regulations of that country. • Profits are realised when the investors collectively exit from the project upon approval of the development proposal which was offered. Investors should check with the land banking firm on their plans should the proposal fail to get the expected approvals.

CONCLUSION Investing in property is exciting and rewarding, although it can be fraught with dangers from bubbles to recessions to scams. Fortunately, there is one fact that always works in our favour: as long as the underlying economy is growing (and it usually is), chances are that your property investment will bring you bountiful rewards. Once you decide that property would be a good addition to your portfolio, you have many choices. You can invest in a rental property, property unit trusts, REITs, a land banking project or other choices you may come across.


record of past performances and its projected returns on land bank investment look promising.

13 Socially Responsible Investing Humanity is sitting on a ticking time bomb. If the vast majority of the world’s scientists are right, we have just ten years to avert a major catastrophe that could send our entire planet into a tail-spin of epic destruction involving extreme weather, floods, droughts, epidemics and killer heat waves beyond anything we have ever experienced. ~An introduction to the Oscar-winning documentary An Inconvenient Truth by Al Gore (www.climatecrisis.net)

I don’t think any of you would want to retire a multimillionaire on a planet where the air stinks with pollution, wars are going on across continents, and the poor are not getting by with their most basic food and medical needs. Is there another way? Integrating your personal, social and environmental concerns with your financial considerations is called socially responsible investing (SRI). SRI helps you meet your financial goals while ensuring that your investments have a positive impact on people and the planet. SRI describes an investment strategy that strives to maximise both financial returns and social good. This is also known as having a “double bottom line”, because you are looking not only for a profitable investment, but also for one that meets certain moral criteria and lets you sleep well at night. There is a wide range of attitudes and values out there as SRI investors screen companies and funds to check if they conflict, or are aligned with their beliefs. For instance, some will not invest in those that pollute and damage the environment, use innocent mice for research, or rely on cigarettes and alcohol to make a profit. There are also investors who screen according to their religious beliefs, such as Muslims who will not invest in the pork industry and interest-bearing securities. Various terms have been used to describe SRI. Some call it Ethical

HOW SRI CAME ABOUT SRI has been around for some time, and its beginnings can be attributed to many people and places. Many believe social investing began with the Quakers (a Christian religious denomination founded in the seventeenth century) in the U.S. that in 1758 took an official stand against slavery. Religious institutions have been at the forefront of social investing ever since. Another early adopter of SRI was John Wesley (1703–1791), one of the founders of the Methodist Church. A sermon of his, entitled The Use of Money, outlined his principles on social investing that included not harming your neighbour through your business practices and avoiding industries such as chemical production that could harm the health of workers. The modern SRI movement probably began during the Vietnam War. A photo in 1972 of a naked nine-year-old girl with her back burning from napalm dropped on her village directed outrage against Dow Chemical, the manufacturer of the napalm. This prompted widespread protests across the U.S. against Dow Chemical and other companies profiting from the Vietnam War. In the late 1970s, SRI activism turned its attention to nuclear power and automobile emissions control. Towards the end of the 1970s, an international outcry was raised for South Africa to end apartheid, and some investors took their money out of multinational companies that did business there. Although economic sanctions against South Africa ended in 1993, investors continued the practice by applying similar principles to other companies. The U.S. is the hotbed of SRI activity today. According to The Social Investment Forum, a major national membership association

151 Socially Responsible Investing

Investing and Green Investing while others refer to the concept as Environmental, Social and Governance (ESG) investing. These varying labels make it difficult to frame the market, but nevertheless there are certain shared strategies that form the foundation of SRI.


of social investment practitioners and institutions, SRI is growing at a faster pace than the broader universe of all investment assets under professional management. Roughly 11 per cent of assets under professional management in the U.S. are now involved in SRI. Between 2005 and 2007 alone, SRI assets increased more than 18 per cent while the broader universe of professionally managed assets increased less than 3 per cent.

WHAT IS YOUR SRI PRIORITY? Before you put any money into SRI, decide what your sociallyoriented priorities are. Not all SRI investors agree on or have the same priorities, and some issues are more popular than others. For example, the top five priorities of SRI investors are that they: 1. Reject companies that support the tobacco industry. 2. Reject companies that support the gambling industry. 3. Reject companies that support the alcohol industry. 4. Reject companies that support the defence industry. 5. Support companies that have a good environmental record. On the lower-priority scale, SRI investors: 1. Support companies that demand human rights practices. 2. Support companies that support labour issues. 3. Support companies with a stance on abortion or birth control. 4. Support companies with a stance on animal rights.

FINDING SRI OPPORTUNITIES How do you go about finding appropriate SRI investments after you’ve narrowed down your social priorities? There really are just two main strategies to consider — exclusionary or inclusionary.

Exclusionary Strategy In an exclusionary strategy, you create a list of companies that you won’t invest in and exclude them from your portfolio. The only thing you need to do with this style of investing is compile a list of companies you want to avoid. This can be very time consuming and expensive as you have to analyse whole groups of choices to find the social duds to avoid. Exclusionary SRI can also become a slippery slope, where you end up excluding an ever-growing number of companies from your portfolio. For example, hotel chains are innocent enough, but they sell alcohol in their cafés and many allow smoking in their rooms. If you expand SRI investing too far, you could end up excluding large segments of the economy.


There are several approaches you can take to apply your second bottom line, most of which relate to how strict you are about a company’s “purity”. For example, how far along the supply chain would you hold companies accountable? If the company you invest in sells instant noodles to a casino, would you still invest in it, or does the company have to be actively participating in the offending activity for you to screen it out? Or you could take another more moderate approach and include companies under certain conditions. One condition could be that the company is the best in its industry for taking the most steps to cut down on pollution, even though it still pollutes. As with establishing your social issues, the standards to which you hold companies are also completely up to you.


When it comes down to the bottom line, few investors may be willing to throw out traditional investment logic by sacrificing investment opportunities in exchange for the satisfaction of doing the right thing and sleeping well at night.

Inclusionary Strategy Inclusionary investing, also called activist investing, is a more proactive style. It involves either selectively investing in companies that share your core beliefs, or purposely investing in companies that violate them so you can become a shareholder and vote to change company policy. By investing in companies that meet your desired ethical values, you are supporting their efforts by increasing their stock price. A good example is green tech companies that are working to provide alternative energy sources, or firms that treat their workers well. By investing in companies engaging in undesirable practices, you establish yourself as a shareholder to which the company management must answer. Therefore, through activist investing, you can use your shareholder rights to vote proxies in line with your goals and attend shareholder meetings to propose appropriate changes. It is impossible to have a completely “clean” company in the sense that finding a company of any size that is 100 per cent in compliance with every social and moral guideline all the time is unrealistic. Nevertheless, the screening process is an honest attempt to find the truth and pick the best of the lot.

SACRIFICING PERFORMANCE FOR SOCIAL GOOD? As an investor, you cannot be completely philanthropic and expect nothing in return for your investment other than that pure feeling of having invested in a company that reflects your own values. How do you know if trusting your hard-earned dollars to a treehugger or rainforest conservationist, no matter how earnest and well intentioned, will actually do something positive for your net

INVESTING IN VICE If investing in virtue offers the possibility of superior returns, should you focus on SRI and avoid “irresponsible” investments altogether? In 2002, the Vice Fund was launched in the U.S. to 1 “Socially Responsible Mutual Funds”, May/June 2000 issue of the Financial Analysts Journal.


worth? The reality is that there are no guarantees that your money will even come back to you, let alone add to your net worth. SRI advocates argue that screening helps eliminate companies that have risks not generally recognised by traditional financial analysis. Critics take the stance that any approach that reduces the universe of potential investments, will result in a sacrifice in performance. No doubt the debate will continue, but there are several reasons to be confident that investing in a socially responsible manner does not equate to giving money away. Here are some statistics to make you feel more at ease. The record of the Domini 400 Social Index (DSI) is an indication that socially responsible investors do not have to assume a sacrifice in performance for sticking to their values. Created in 1990, the DSI was the first benchmark for equity portfolios subject to multiple social screens. The DSI is modelled on the S&P 500 and has outperformed that unscreened index on an annualised basis since its inception. The next question is, how does the performance of socially responsible funds measure up to that of a regular portfolio? Professor of Finance Meir Statman1 of Santa Clara University reviewed 31 socially screened mutual funds and found that they outperformed their unscreened peers, but not by a statistically significant margin. The bottom line appears to be that SRI funds do not behave all that differently from regular funds and that investing in a SRI fund does not negatively affect your returns compared with choosing a conventional index fund.


invest in companies that have significant involvement in industries such as tobacco, gaming, weapons and liquor. According to Daniel Gross, a columnist for Newsweek who has been following the vice versus virtue divide, both are effective investing strategies and have handily beaten the S&P 500.2 Is it that investing in vice or virtue is a better investing discipline than looking at P/E ratios, discounted cash flow and charts? Perhaps. The folks managing such funds have clearly been good stock pickers. As investors ourselves, we can safely say that SRI is a viable investment strategy, and it’s not just fluff and apple pie.

INVESTING IN SRI Once you have established your second bottom line or social priority, you have two main options: (a) invest in unit trusts or (b) pick individual companies yourself. Investing in unit trusts is a good way to begin as it is not easy to screen companies on your own. Although there aren’t many SRI funds in Singapore and those available don’t quite span the breadth of SRI, there are more than a handful of attractive choices. We can also look internationally for choices and to the future as well when more choices become available in Singapore as it becomes a bigger magnet for SRI. Here are three funds you may consider: 1. The DWS Global Climate Change Fund by Deutsche Bank invests mainly in companies that are active in energy-efficient technologies, renewable and alternative energies, and climate protection. Between 35 and 40 per cent of its portfolio is invested in the U.S. alone. 2. The DBS Mendaki Global Fund launched in September 1997 is one of the oldest SRI funds in Singapore. The fund invests in 2

www.slate.com/id/2123644/

3. Fortis L Green Future invests primarily in the shares of companies whose technologies, products and services bring solutions to environmental problems. If you are a more active investor, do look at the individual company investments that SRI unit trusts make. The DBS Mendaki Global Fund, for example, has Apple Computer, BHP Billiton, Hyflux and Keppel Corp among its top holdings (June 2010). If these companies are already top performers in your books, then you would be satisfying both your social and financial bottom lines.

POPULAR SRI THEMES Let’s now turn our attention to some of the most popular themes around today that you have probably been hearing about, such as corporate social responsibility, green investing, biofuels, solar energy, water and Islamic finance.

Corporate Social Responsibility CSR generally applies to company efforts that go beyond what may be required by regulators and involve incurring short-term costs that do not provide immediate financial benefit to the company, but instead promote positive social and environmental change. Companies have a lot of power in the community and in the economy. They control a lot of assets, and may have billions of dollars at their disposal for socially conscious investments and programmes. Even smaller companies with a dozen staff can make significant contributions to the community in addition to expanding their corporate bottom lines. Many of America’s largest companies that had previously been labelled polluters have adopted eco-friendly ways. Hewlett Packard


listed equities anywhere in the world that harmonise with Islamic philosophy and law.


reports on its website that after 20 years, it has reached its longterm goal of recycling one billion pounds of computer hardware and supplies in 2007. Singapore has its own CSR society called The Singapore Compact. It is a non-profit organisation whose membership includes some of Singapore’s largest companies as well as SMEs (small-medium enterprises). The Singapore Compact promotes the idea that “Companies with positive CSR experiences that have the support and respect of their stakeholders are more likely to work better and be sustainable in the long run.” In October 2007, it congratulated 26 winners of the “Inaugural CSR Recognition Award for Good Corporate Citizens”.

Green Investing There isn't a huge difference between SRI and green investing. Green investing is actually a form of SRI and both terms refer to investment philosophies that are backed by ethical guidelines. The biggest difference is that green investing focuses on what’s good for the environment. Cleantech, or clean technology investing seeks to invest in environmentally friendly technologies and includes six types of industries: energy, water and waste water, advanced materials, energy efficiency and manufacturing, transportation, and agriculture.

Islamic Finance Like green investing, Islamic finance is a subset of SRI. Islamic finance is based on Islamic principles and jurisprudence (or Shariah). The heart of Islamic finance lies in two defining principles: The prohibition of riba (interest) and the sharing of profit and loss. These principles help to ensure that funds are being channelled into real business activities as opposed to speculative activities. Islamic law also prohibits any participation in weapons, pork, gambling, pornography and alcohol businesses.

KEEP A LEVEL HEAD BEFORE YOU INVEST It is easy to let the green movement dictate your pocket book because wanting good returns and promoting social good at the same time is an ideal situation for any investor. Yet it is wise to maintain a level head: 1. Get informed — Learn about socially responsible investing, which funds qualify and where you can buy them.


It used to be that overcoming these prohibitions was very difficult in the conventional finance system. Yet as the Islamic finance industry progresses, many Islamic financial institutions have developed a vast range of products designed to serve the growing market. These products cater for housing and consumer finance, business loans and project funding. Furthermore, these products are increasingly providing both Shariah compliance and good returns. Singaporeans have good access to Islamic finance products and information. There are over a dozen conferences on Islamic finance in Singapore every year today. Singapore is a full member of the Islamic Financial Services Board (IFSB), which was set up in 2002 to formulate international regulatory and prudential standards for Islamic finance. Singapore already has a well-developed capital markets framework to allow our institutions to leverage its conventional expertise to structure Shariah-compliant versions of their products and services. Looking at our neighbours, we have even more positive hope that Islamic finance will reach mainstream channels. Malaysia is one the world’s leaders in Islamic finance and of Islamic finance education, all the way to PhD qualifications. And to the south, Indonesia has the largest Muslim population in the world, who are themselves actively growing their expertise and market in Islamic finance.


2. Know your values — Everybody’s values are different. Some may feel strongly about environmental causes while others are more concerned with social programmes. Rank your priorities. 3. Go beyond your values — Research the fundamentals and see if you really feel comfortable. Ask tough questions — are some of the green investments out there destroying the environment that they are supposed to protect? 4. Diversify — Think of SRI as a focused investment that, together with your other alternative investments, should occupy no more than 20 per cent of your retirement portfolio. Socially responsible investing suggests that you don’t have to compromise your values to make money. If you approach socially responsible investments like any other investment, you may be able to put your money into something that both supports your values and lines your pocketbook.

14 Investing in Commodities We are in the midst of the biggest commodities boom in three decades. Look at how the prices on this commodities index chart are going through the roof. You can see and feel the commodities boom all around — record prices reached on oil, rice, copper, platinum. With such a sharp and swift rise in prices, the obvious question is, “Is the bull run over?”

FIGURE 14.1. THE COMMODITIES BULL RUN AS SEEN THROUGH THE THOMSON REUTERS/JEFFERIES CRB INDEX

500 450 400 350 300 250 200 150 100 50 2010

2009

2006

2004

2002

2000

1999

1996

1994

0

Not so according to commodities guru Jim Rogers, a former partner of George Soros, who says that commodity bull cycles have historically lasted between 15 and 23 years, and predicted that “the current bull market will probably last until 2020.”

162

WHY ARE COMMODITIES BOOMING?


Many reasons. Let us cite three major ones.

The China Effect The China effect is real. Not only are there 1.3 billion people to feed, but China has been growing at 9–10 per cent every year for over 25 years and they now have a huge middle class of 100 million people clamouring for all sorts of goods and services. Management consulting firm McKinsey & Company expects 700 million Chinese to have joined the consumer class by 2020.1 It’s not a revolution, it’s a tidal wave. They are today the biggest users of mobile phones with 400 million subscribers. That’s only 30 per cent of the population. Think of the growth ahead. Galanz, a Chinese company, is the largest microwave oven maker in the world. It estimates that there are 200 million ovens in Chinese homes today and it is their dream to put a microwave in every kitchen across China, just as Bill Gates had a vision to put a computer on every desk and in every home. China’s boom is also a reflection of the Asian boom in general. Forbes reported that the number of billionaires in Asia jumped more than 30 per cent in 2007. In 2010, Forbes reported that a total of 64 people from the China made the list of the world’s richest billionaires, moving up to take second place behind the U.S. A lot of the fortunes in Asia have been made in real estate and infrastructure development. Global Property Guide reports that real estate price increases in Asia-Pacific should continue to impress in the coming years, while E.U. prices have moderated and the U.S. is mired in a housing crisis.

Tight Supplies There are tight supplies across many commodity markets. Take oil for example. There have been no major oil discoveries in the last 40 1

http://www.csmonitor.com/2007/0102/p01s02-woap.html

The Falling US$ The falling U.S. dollar, combined with tight supplies across many commodity markets, has fuelled the big run up in commodity prices. If the dollar is falling, commodity prices have to go up just to keep relative values the same. That’s because many non-U.S. commodity producers still price their exports in dollars, and a weaker dollar prompts them to seek higher prices. The interest rate cuts by the Federal Reserve have also helped push commodity prices higher. On the one hand, the cuts make a recession less likely as companies would continue to borrow to fund growth, thus bolstering demand for commodities. On the other hand, the cuts have also further encouraged currency investors to sell off dollars in the search for higher yield. Well, enough of these present day trends for now. In the end, we have to treat commodities as commodities whether the market is going up or down. What we need to do is find out if commodities make a good addition to a long-term portfolio. So let’s get back to some of the basics behind commodities.

WHAT IS A COMMODITY? A commodity is a basic, undifferentiated good such as sugar or oil. Whether a pound of sugar comes from a producer in the Philippines or another producer in Brazil makes no difference in terms of quality. A pound of sugar from anywhere in the world is pretty much the same product, regardless of the producer. They are generally

163 Investing in Commodities

years according to Jim Rogers, while the reserves in Alaska, Mexico and the North Sea continue to decline. Of the six top countries in the world with the largest oil reserves, five are in the Middle East, and politically volatile Iran and Iraq are at numbers three and four, where supply jolts can happen anytime and threaten production. In 2006, the U.S. consumed more than twice as much oil as did China, and we know that the gap can only decrease as China becomes wealthier and more industrialised.


real assets with intrinsic value because they are consumed on a regular basis. Commodities are also often used as inputs in the production of other goods or services. For example, sand, which Singapore buys a lot of, is a major component of concrete, glass production, brick manufacturing, landscaping and land reclamation. Is a Mona Lisa painting a commodity? Not the original painting by Leonardo da Vinci for sure. The reason is that the Mona Lisa is unique and differentiated from all other paintings. The iPod whose quality and features can be clearly differentiated from other MP3 products is also not a commodity.

Today’s Commodity Markets There are around 100 main commodities that are frequently traded and they are generally classified into three main groups: A. Energy B. Metals • Base Metals • Precious Metals C. Agriculture • Grains • Softs • Livestock Energy encompasses a basketful of products used to provide energy to heat and power homes and businesses. The most common are petroleum and its byproducts: crude oil, heating oil, propane, natural gas and coal. Base metals refer to industrial non-ferrous metals, excluding precious metals. These include copper, aluminium, lead, nickel, tin and zinc. Note: Ferrous metals contain iron while non-ferrous

Non-Traditional Commodities More recently, the definition of commodities has expanded to include financial products such as foreign currencies and indices. Technological advances have also led to new types of commodities such as carbon credits, weather and bandwidth.

THE TRADING OF COMMODITIES The trading of commodities is done mainly at commodity exchanges. A commodity exchange is an entity, usually an incorporated nonprofit set-up, that determines and enforces rules and procedures for trading. It also refers to the physical centre where trading takes place. Three of the world’s top exchanges are: 1. New York Mercantile Exchange (NYMEX) —Founded in 1872, NYMEX is the world’s largest physical commodity futures


metals do not. Ferrous metals are usually magnetic and rust. Precious metals are rare and have high economic value. They include gold, silver, platinum and palladium. Chemically, they are less reactive than most elements, have high lustre, are softer and have higher melting points than other metals. Historically, precious metals were important as currency, but are now regarded mainly as investment and industrial commodities. Grains or cereal crops are mostly grasses cultivated for their edible grains or fruit seeds. Maize, wheat and rice account for 85 per cent of all grain production worldwide. Other grains that are important in some places have little global production and do not show up on exchanges. These include durum (used to make pasta) and wild rice. Softs is a label for a set of commodities, usually including cocoa, sugar, and coffee, but also including cotton and orange juice. Livestock refers to animals used for meat production, and includes live cattle, pork bellies and lean hogs.


exchange for energy and precious metals. The prices quoted for transactions on the exchange are the basis for prices that people pay for physical commodities throughout the world. 2. Chicago Board of Trade (CBOT) — Established in 1848, CBOT is the world’s oldest commodity exchange for trading in futures and options. CBOT trades more than 50 different futures and options in agricultural commodities, financial derivatives based on U.S. Government bonds and notes, mortgage-backed certificates, and more recently, South American Ethanol futures. 3. The London Metal Exchange (LME) — Founded in 1877, LME is the world’s largest market in cash and futures for non-ferrous metals, including aluminium, copper, nickel, tin, zinc and lead.

COMMODITY INDICES Commodity indices provide investors with a reliable and publicly available benchmark for investment performance in the commodity markets, just as what the S&P 500 or MSCI Singapore indices do for their respective markets. Several unit trusts and ETFs are benchmarked against these indices. Four of the most quoted commodity indices are: 1. The Dow Jones-UBS Commodity Indexes (DJ UBSCI) is composed of futures contracts on physical commodities. Nineteen commodities are included in the index representing the following commodity sectors: energy, precious metals, industrial metals, livestock and agriculture. The represented commodities are traded on U.S. exchanges, with the exception of three, which trade on the London Metal Exchange (LME). None are based in Asia, which means that the index does not include rice, a staple of a large percentage of the world’s population.

3. The S&P GSCI Commodity Index (S&P GSCI) was created in 1992 and is made up of 24 commodity components from all commodity sectors: six energy products, five industrial metals, eight agricultural products, three livestock products and two precious metals. This broad range of constituent commodities provides the S&P GSCI with a high level of diversification, both across sub-sectors and within each subsector. The goal of the GSCI is to measure commodities in a way that reflects their current importance in the global economy. More weight is automatically allocated to commodities that have risen in price. 4. The Rogers International Commodities Index (RICI) RICI is the most diversified commodities index available and tracks 35 commodities. Jim Rogers created the index in 1999 and the index is weighted according to what he considers to be each commodity’s importance to the global economy. The index includes commodities that do not appear in other indices such as: rice, rubber and lumber.

BUYING AND SELLING COMMODITIES Spot Trading Buying and selling commodities can be done on the spot through “spot trading” where delivery takes place within a few business days.


2.The Reuters/Jefferies CRB Index (TRJ/CRB) was launched in 1957. The components of this index were, until 2005, equally weighted. This resulted, for better or worse, in orange juice having the same weight as crude oil. With the makeover, component weights are assigned and rebalanced monthly. For example, crude oil has a fixed weighting of 23 per cent. If its weight rises to 30 per cent because crude oil prices have gone up relatively more than other commodities, the weight is rebalanced back to 23 per cent.


Spot trading is not the main way in which commodities are bought and sold. If you consider the fact that commodities are almost always bought in large quantities, few buyers would want to take the risk of accepting whatever the spot price is at the time of purchase, and immediate delivery.

Futures Trading Instead, most commodities are traded on futures exchanges such as NYMEX and CBOT. The prices of commodities are efficiently and transparently discovered through the participation of thousands of buyers and sellers. Here are a sample of commodity contracts, where they are traded and how they are quoted. Not all contracts around the world are traded in US$ of course. We are only showing you contracts traded on the main exchanges we discussed earlier. At the Tokyo Grain Exchange, for example, corn is traded in Yen while it is traded in US$ on CBOT.

TABLE 14.1. EXAMPLES OF COMMODITY CONTRACTS Commodity

Exchange

Quote

Energy Light Crude

NYMEX

US$ per barrel

Heating Oil

NYMEX

US$ per gallon

Natural Gas

NYMEX

US$ per mmBtu

Unleaded Gas

NYMEX

US$ per gallon

Metals Gold

COMEX

US$ per troy oz

Silver

COMEX

US$ per troy oz

Platinum

NYMEX

US$ per troy oz

Copper

LME

US$ per tonne

Commodity

Exchange

Quote

Lean Hogs

CME

US cents per lb

Pork Bellies

CME

US cents per lb

Live Cattle

CME

US cents per lb

Feeder Cattle

CME

US cents per lb

Corn

CBOT

US cents per bushel

Soybeans

CBOT

US cents per bushel


Trading Strategies Those who participate in futures markets usually have two main trading strategies. One may speculate by taking a position such as buying a gold futures contract in the hope that gold would rise in price. Or one may hedge to mitigate the risk of a natural position in the commodity. For example, a farmer can insure against a poor wheat harvest by purchasing wheat futures contracts. If the wheat crop is significantly less due to bad weather, the farmer makes up for that loss with a profit in the futures contract, since the overall supply of the crop is short everywhere that suffered the same conditions. For most investors, trading directly in commodities has a high level of risk not only because of the volatility of commodity prices, but also because it requires sophisticated skills and dedicated time to follow a market that’s dominated by large commodity houses and financial institutions.

Commodity Index Funds For investors looking to diversify their portfolios without wanting to trade directly, commodity funds are a good choice. Some funds specifically track commodity indices:

Investing in Commodities

Agriculture

169


• The Lyxor ETF Commodities CRB, which is available in Singapore, tracks the RJ/CRB index. This exchange-traded fund began trading on SGX in January 2007.

Commodity Unit Trusts In Singapore, there are about a dozen unit trusts available for retail investors. These unit trusts are managed by fund management companies such as ABN AMRO, Deutsche Bank, Schroder, First State, Prudential, Lion Capital and UOB. These unit trusts generally invest broadly across the major categories of commodities or they focus on specific sectors of the commodities market, such as gold, energy and agriculture.

Commodity Stocks Finally, the investor can buy stocks that are linked directly to commodities such as palm oil, iron ore and energy. Singaporelisted Wilmar is the world’s largest processor and merchandiser of palm oil, and also the largest palm biodiesel manufacturer in the world. Australian company BHP Billiton is one of the world’s largest diversified producer of diamonds, coal, iron ore, aluminium, oil and natural gas.

COMMODITIES AS PART OF YOUR LONG-TERM PORTFOLIO There’s no doubt in our minds that an investment in commodities makes sense for our bottom line for several reasons: 1. Inflation hedge potential — Commodities has recognised value all over the world, and this value does not depend on any nation’s economy or currency. Over time, most commodities have held their values against inflation very well because anticipated trends in inflation are priced into them. The Consumer Price Index in Singapore, which is the key indicator of retail inflation, has been rising along with price increases in rice, bus fares, petrol and food at food courts.

3.Portfolio diversification — Commodities have been found to have a low correlation to stocks and bonds. In fact, commodities tend to do well when stocks and bonds are down. According to one U.S. study that looked at the correlation between commodities and various asset classes, it was found that each asset class had a negative correlation with commodities during the period 1970 to 2003.2 This means that commodities are a good addition to a portfolio as they reduce overall volatility. Two words of caution though. Commodities are highly volatile, even more so than stocks. If you cannot stomach huge, sudden losses, commodities should never occupy a large portion of your retirement portfolio. Our last word of caution is that commodities are subject to long up and down cycles. We are no doubt in the midst of a strong up cycle. As an investor in commodities, you cannot just buy, hold and sit back. You have to be more active in your monitoring. Just as up cycles can last 20 years, down cycles have been known to last just as long.

2 The asset compared with commodities were U.S. stocks, international stocks, U.S. government bonds, U.S. Treasury bills and small-cap companies. “Commodities as an Asset Class”, www.investorsolutions.com.


2. Participation in global growth — Demand for commodities keeps growing in industrialising and emerging markets such as China, India and the Middle East. As these regions grow economically, so will their demand for commodities sourced from all over the world.


Investing in Gold Thinking to get at once all the gold the goose could give, he killed it and opened it only to find — nothing. ~Aesop (620 b.c. – 560 b.c.), The Goose with the Golden Eggs

Man’s fascination with gold is timeless. Gold is beautiful and scarce. It does not rust or tarnish. It is easily shaped and easily divisible. Gold will always have a value. Over the years, gold has been recognised and accepted by almost everybody as an ideal medium of exchange and store of value. The reasons for investing in gold have remained much the same throughout history. Gold is a safe haven in times of economic and financial instability. It is a proven asset-diversifier that, when included in a portfolio, reduces the portfolio’s overall risk. Gold is also an excellent hedge against inflation over the long term. And gold is one of the few assets that are negatively correlated with the U.S. dollar. Besides being a highly reliable store of value, gold is widely used as jewellery and coinage, and in industries. Like other precious metals, gold is measured by troy weight and by grams and when it is alloyed with other metals, the term carat is used to indicate the amount of gold present, with 24 carats being pure gold. The purity of a gold bar can also be expressed as a decimal figure, known as the millesimal fineness, such as 0.995. The price of gold is determined on the open market, but a procedure known as Gold Fixing in London, originating in 1919, provides a twice-daily benchmark figure for the industry. Gold prices have been on a bull run. Prices rose to over US$900 in April 2008 from average prices of below US$40 in the early 1970s (see Figure 15.1.). Why have gold prices suddenly shot up in the last three decades? To answer this and other questions, we begin with a short history of gold.

173

FIGURE 15.1. GOLD PRICE SINCE THE EARLY ‘70S

GOLD PRICE, $ PER OUNCE (LONDON PM FIX) 1400 1300 1200 1100 1000 900 800 700 600 500 400 300 200

Source: Global Insight

100 0

Jan 71 Jan 74 Jan 77 Jan 80 Jan 83 Jan 85 Jan 89 Jan 92 Jan 95 Jan 98 Jan 01 Jan 04 Jan 07 Jan 10

Source: Courtesy of World Gold Council, www.gold.org

A SHORT HISTORY OF GOLD Egyptian hieroglyphs dating from 2600 b.c. have described gold as being “common as dust.” Gold is mentioned several times in the Old Testament. Exploitation is said to date from the time of Midas, and this gold was important in the establishment of what is probably the world’s earliest coinage in Lydia in 700 b.c. Gold has thus long been considered one of the most precious metals, and its value was used as the standard for many currencies (known as the gold standard) in history. The gold standard is defined as “a commitment by participating countries to fix the prices of their domestic currencies in terms of a specified amount of gold.” Money and near-money (bank deposits and notes) were freely converted into gold at a fixed price. A country under the gold standard would set a price for gold, say $100 an ounce, and would buy and sell gold at that price. This effectively sets a value for the currency; in our example $1 would be worth 1/100th of


an ounce of gold. Other precious metals could be used to set a monetary standard; silver standards were common in the 1800s. A combination of the gold and silver standard, known as bimetallism, also existed. During most of the 1800s, the U.S. had a bimetallic system of money. A true gold standard came about in 1900 with the passage of the Gold Standard Act. The gold standard effectively came to an end in 1933 when President Theodore Roosevelt outlawed private gold ownership (except for the purposes of jewellery). The Bretton Woods System, enacted in 1946, created a system of fixed exchange rates that allowed governments to sell their gold to the United States treasury at the price of US$35 per ounce. The Bretton Woods System ended on 15 August 1971, when President Richard Nixon ended the trading of gold at the fixed price of US$35 per ounce. At that point, for the first time in history, formal links between the major world currencies and real commodities were severed. The gold standard has not been used in any major economy since that time. Almost every country, including the United States, is on a system of fiat money, which is money that is intrinsically useless and is used only as a medium of exchange.

THE CONTINUING IMPORTANCE OF GOLD Given that gold no longer backs the U.S. dollar and other major worldwide currencies, why is it still important today? The reason is that while gold is no longer in the forefront of everyday transactions, it is still important in the global economy. Central banks and other financial organisations hold approximately one-fifth of the world’s supply of above-ground gold. In addition, several central banks have focused their efforts on adding to their present gold reserves as their currency reserves soar. Compared with paper money, gold has successfully preserved wealth throughout thousands of generations. The same cannot be said about paper-denominated currencies because the value of a dollar is constantly being eroded by inflation. And when investors

Demand and Supply The supply of gold is fairly constant from year to year although production has been slowing down slightly during the past few years.

FIGURE 15.2. WORLD ANNUAL GOLD OUTPUT

METRIC TONS

2600

2573 2518

2500

2469

2444

2400 2356 2300 2252 2200 2100 2000 1995

2000

2005

2006

2007

2008

Source: www.goldsheetlinks.com

TABLE 15.1. WORLD’S TOP FIVE GOLD PRODUCERS Year 1 2 3 4 1995

S Africa

USA

Australia

Canada

2000

S Africa

USA

Australia

China

2005

S Africa

Australia

USA

China

2006

S Africa

USA

Australia

China

2007

China

S Africa

USA

Australia

2008

China

USA

S Africa

Australia

Source: www.goldsheetlinks.com

5 China Canada Peru Peru Indonesia Peru

175 Investing in Gold

realise that their money is losing value, especially when inflation is rising, they will start positioning their investments in a hard asset that has traditionally maintained its value. The 1970s testify to this as gold prices largely rose as a result of soaring inflation.


One reason for the drop in world output is South Africa’s falling production in the past few years. As Table 15.1 shows, South Africa was the top producer year after year for over 100 years till 2007 when China overtook South Africa to become the world’s top producer. Most of China’s gold output stays in the country where it’s transformed into jewellery and industrial items. Along with China’s demand, which makes it the largest consumer in the world, India is the world’s number one importer as its increasingly wealthy middle and upper classes continue to buy and adorn gold. Gold’s role as a safe haven is indisputable as investors typically run to it during times of political and economic uncertainty — especially today amidst the subprime crisis, the falling U.S. dollar, Middle East tensions and rising inflation. During such times, investors in the past who held on to gold were able to protect their wealth successfully, and, in some cases, even use gold to escape from the turmoil. Consequently, whenever there are news events that hint at some type of uncertainty, investors will often buy gold as a safe haven. The cost to mine gold varies from US$150 to $400 per troy ounce, with South African mines at the higher end (10,000 feet or more) and Canadian mines at the lower end (1,000 feet or so). Added to the high cost of mining are the hundreds of millions of dollars and amount of time (three to five years) it takes to start a new mine. All these above factors help ensure that supply is unlikely to increase any more than 1 to 2 per cent each year and that demand is very likely to expand because of economic uncertainty and the rising wealth in gold-hungry countries such as China and India.

HOW TO INVEST IN GOLD Investors who wish to invest in gold can do so in five ways: 1. Gold bullion bars and coins, 2. Gold certificates,

3. Gold mining shares,

5. Gold derivatives. Prices for all these investment options are available daily from banks and brokerages.

Gold Bullion Bars and Coins You can buy physical gold bars in a variety of weights ranging from 1 gram to the popular kilobar (32.15 troy ounces) to the international “London Good Delivery” bar (400 troy ounces). Gold coins are legal tender in the country of issuance and their gold content is guaranteed. The bullion coin bears a face value that is largely symbolic. Its true value depends on its gold content and its numismatic value (or collector’s value). An example is the Singapore Lion Gold Bullion Coin, which ranges from one to 1/20 ounce. One disadvantage of buying physical is that you’ll have to pay GST, which is currently 7 per cent.

Gold Certificates If you do not want to hold gold physically, especially if you have a large investment, you can invest in gold certificates, usually of one kilobar each, up to a maximum of 30 kilobars. There is no GST on certificates. The gold is kept in the bank’s vault. These certificates can easily be exchanged for physical gold or cash. However, the bank charges an annual administrative fee of typically $30 per kilobar per annum, and $5 for each certificate.

Gold Savings Account You can buy and sell gold through a passbook at prevailing market prices. UOB introduced the first gold savings account in Singapore

Investing in Gold

4. Gold unit trusts and ETFs, and

177


in 1981. Gold savings accounts allow those who want to trade frequently to buy and sell in 1g lots.

Gold Mining Shares Some investors may be comfortable accessing the gold market by buying stock in gold mining firms. The capital appreciation potential of a gold share is dependent not only on the future price of gold, but also on the future prospects of the company, based on its management and operating strengths. Where these companies make the most is exploration, but that is also where one finds the highest risk. Some of the most established gold mining companies in the world are found on the NYSE. Denver-based Newmont Mining is one of the world’s largest companies producing eight million ounces annually, with a diversified number of mines in several parts of the world, including Nevada, South America, Australia, Russia and Indonesia.

Gold Unit Trusts and ETFs With gold unit trusts, investors are buying general industry and market risk instead of company-specific risk. Funds diversify their holdings among dozens of companies. The United Gold and General Fund is one such fund in Singapore. The United fund was launched in 1995 and is globally diversified across the industry. Not the entire portfolio is in gold as about one-third of the fund is typically in base metals (such as iron ore and copper) and about two-thirds are in gold and precious metals. Another way to invest in gold is through the SPDR Gold Shares ETF listed on the Singapore Exchange, where your ETF shares can be bought and sold at any time. The ETF is benchmarked to spot gold, which means that it is as good as buying physical gold, minus the fund’s expenses, and the transaction cost involved is lower than the cost of buying and safekeeping physical gold.

Gold Derivatives Gold futures and options are traded on established exchanges

THE RISK OF GOLD INVESTING As a tangible investment, gold is often held as part of a portfolio because over the long term, gold has an extensive history of maintaining its value. Still, gold, like all investments, involve risk. Gold prices have historically seen strong fluctuations that saw it hit a 20-year low in 1999. One reason for fluctuating prices is that the value of a bullion coin or a gold unit trust is directly affected by the current spot or market price of bullion. This price fluctuates daily and can be affected by a multitude of factors, such as the perceived scarcity of gold, current demand, market sentiment and economic factors. Therefore, the price of your gold investment can go down as well as up in value. Second, like all prices, the gold price reflects not only the inherent value of gold, but also the relative strength of the currency in which it is quoted. For example, the dollar price of gold may increase more in percentage terms than the sterling price, to the extent that the change in price is a reflection of dollar weakness (in this case, against the sterling), rather than an intrinsic change in gold market fundamentals. So if you purchase a gold investment in U.S. dollars and the U.S. dollar has increased 20 per cent by the time you sell it 12 months later, your investment would have fallen in value by 20 per cent — regardless of any change in gold market fundamentals. The strength of the U.S. dollar in the two decades between 1980 and 2000 was an important reason for gold prices not performing well during those years. It was in part the rapid rise in the dollar

179 Investing in Gold

around the world. At COMEX (New York Commodity Exchange, the leading U.S. exchange for metals futures and options trading), for example, each gold futures contract is for 100 troy ounces of not less than .995 fineness, and bears a serial number and the identifying stamp of a refiner approved and listed by the Exchange. A similar contract is available through SGX-DT, but trading is not very active.


that hurt the dollar gold price. Another reason for gold’s poor performance between 1980 and 2000 was the success of the world’s central bankers in fighting inflation. Gold’s role as a hedge against inflation is one of the main reasons people buy it.

MANAGING GOLD IN YOUR PORTFOLIO Despite the volatility of gold prices and its sensitivity to fundamental factors, the diversification benefits of gold in a portfolio are backed by strong evidence. Ibbotson Associates, a leading authority on asset allocation, performed a study with respect to the portfolio diversification benefits of gold, silver and platinum bullion, covering a 33-year period from February 1971 to December 2004. Ibbotson determined that of the seven types of assets covered in the study, the precious metals asset class is the only one with a negative correlation to other asset classes. What this means is that precious metals perform best during the years that traditional asset classes, such as stocks and bonds, had negative returns. Ibbotson determined that investors can potentially improve their portfolio risk-reward performance by including precious metals with allocations of between 7.1 and 15.7 per cent for conservative to aggressive portfolios respectively. Historically, gold has produced excellent long-term gains during up cycles; however, it may not be suitable for everyone. You should acquire a good understanding of gold products before you invest in them. Since all investments, including gold, can decline in value, you should have adequate cash reserves and disposable income before considering a precious metals investment. In the end, speculating in gold should be avoided at all cost by conservative investors. Speculating involves short-term trading and the early withdrawal from accounts or securities can result in substantial penalties or fees — in addition to any decrease in gold prices due to fundamental factors.

16 Investing in Hedge Funds How would you like to invest in a fund that makes money in a bear market as well as in a bull market? Hedge funds aim to do just that, and as consistently as possible, regardless of market conditions. What’s more, hedge funds can be very good for your portfolio. They can reduce overall risk and quite often, they can also increase returns. Look at Figure 16.1 (below), which compares three major indices. While the S&P 500 and Dow Jones World Index went on major roller coaster rides between Dec 1993 and Dec 2000, the Credit Suisse Hedge Fund Index (indicated by the arrow) chugged along very smoothly throughout the 17-year period. Compared with both indexes, the hedge fund index was not only less volatile, but it also provided higher returns, at lower risk.

FIGURE 16.1. COMPARING PERFORMANCE OF THE S&P 500, DOW JONES WORLD INDEX AND CREDIT SUISSE HEDGE FUND INDEX 350% 300% 250% 200% 150% 100% 50% 0% 12/2009

12/2008

12/2007

12/2006

12/2005

12/2004

12/2003

12/2001

12/2000

12/1999

12/1998

12/1997

12/1996

12/1995

12/1994

12/1993

-50%

Copyright C ight ht 2010, 2010 20 10 Credit C di ditt Suisse S i H Hedge d IIndex dg d LLC LLC. A All ll rights ight ht reserved d

This is the stellar reputation of hedge funds that many of you may have heard about. In this chapter, we will help you examine whether hedge funds are right for you, and how they can fit into your portfolio.

182

WHAT ARE HEDGE FUNDS?


To most investors, hedge funds are shrouded in mystery. When considering if a fund is a hedge fund, MAS looks at whether: • Non-traditional investment strategies such as leverage, short selling and arbitrage are used; or • Investments are in non-mainstream asset classes, that is, investments other than listed equities, bonds and cash.

Leverage Leverage is used to increase risk. It refers to the degree to which the fund is using borrowed money to invest. If a fund is leveraged 100 per cent, it means that it has borrowed $1 for every $1 that it actually has. Profits as well as losses are magnified 100 per cent as a result.

Short Selling This is an aggressive strategy of sell-high, buy-low rather than the traditional strategy used by unit trusts of buy-low, sell-high (called a long strategy). Short selling has unlimited risk. Here is an example that will help you understand how short selling works. Suppose you enter a contract to deliver a Toyota you do not own for $50,000. In other words, you are short-selling the Toyota. What you hope will happen is that Toyota prices will drop and you can buy a Toyota for a lower price of say, $40,000, and deliver the car to make a $10,000 profit. However, what happens if the price of the car goes up instead? Technically, prices could go up to $60,000, or $80,000 or beyond. You see, price, in theory has no ceiling, and that is why short selling is an unlimited risk strategy.

Arbitrage Hedge funds use arbitrage to exploit mispricings between related securities. For example, one can take a long position in Company

This suggests that hedge funds are not for everyone. A retail investor who is just starting out to invest, or a retiree wishing to protect her income, should not be placing money in hedge funds. These funds employ aggressive strategies and are exempt from many of the rules and regulations governing unit trusts. Individuals who buy hedge funds are usually deemed “sophisticated” and they usually have to pay high minimum investment amounts. In the U.S., an investment fund can be exempt from direct regulation if it is open to accredited investors only, and only a limited number of investors can belong to it. Because of an exemption from the types of regulation that apply to mutual funds, hedge funds can invest in more complex and more risky investments than a retail fund might.

HEDGE FUND STRATEGIES A wide range of investment styles and strategies are available to hedge funds. Table 16.1 lists some of the most popular. What makes hedge funds different is their diversity. The variety of hedge fund strategies far exceeds anything offered by traditional unit trusts.

TABLE 16.1. POPULAR HEDGE FUND STRATEGIES Strategy

Objective

Convertible Arbitrage

Exploit price inefficiencies between convertible securities and stock.

Dedicated Short Bias

Equity and derivatives portfolios with net short, “bearish” focus.

183 Investing in Hedge Funds

A’s convertible bonds and short its stock. An example would help. Suppose Sri Lankan crabs are selling at $50 a kilogramme at the Pasir Panjang Wholesale Centre. Over at the Telok Blangah wet market, the crabs are going for $80 a kilogramme. If you are able to buy crabs from Pasir Panjang and sell them at Telok Blangah, you would have, in essence, made a profit by exploiting a mispricing situation.


Strategy

Objective

Emerging Markets

Equity and fixed-income investments in emerging markets worldwide.

Equity Market-Neutral

Offsetting long and short equity positions that are beta-neutral, currency neutral, or both.

Event Driven

Corporate strategies focused on distressed securities, high-yield debt, and risk arbitrage.

Fixed-Income Arbitrage

Exploiting price inefficiencies between related debt securities.

Global Macro

Directional macroeconomic strategies.

Long-Short Equity

Directional equity and equity derivative strategies.

Managed Futures

Listed futures strategies often driven by technical or market analysis.

Multi Strategy

Multiple strategies.

Source: www.hedgeindex.com

Classifying Hedge Funds Some funds employ only one strategy; others may use several. Some funds are more speculative and comb the world for opportunities; others are less risky and offer protection for your invested capital. We can hence classify hedge funds in a broader way: 1. Single strategy funds, 2. Fund of funds, or multi-strategy, and 3. Capital guaranteed and protected hedge funds. Single Strategy Funds If a hedge fund adopts one main strategy, it is called a single strategy

Fund of funds A fund of funds invests in other hedge funds as a means of diversifying strategies and managers. The risk for such funds is generally lower than that of single strategy funds. For these funds to succeed, the manager’s ability to choose good funds is more important than his ability to execute any single strategy. Fund of funds do have some disadvantages. For one, investors have to pay two layers of fees — one for the individual funds and another for the fund of funds manager. Guaranteed Hedge Funds These funds work like their retail cousins. They invest a high proportion of their assets (say 70 per cent) in bonds that mature to provide 100 per cent of the capital guarantee and the rest of the money (30 per cent) is invested in other hedge funds, derivatives and other speculative securities to provide the upside kicker in returns. Guaranteed hedge funds have a fixed maturity of typically five to 10 years. If you invest in one of these funds, be prepared to stay the course. Asking for your money back after two years will cost you in terms of likely capital losses and redemption fees. They differ from retail guaranteed funds in two ways. The bonds invested in tend to be higher-yielding and are often not of investment-grade quality. While retail funds may have 90 per cent in bonds, guaranteed hedge funds may have 80 per cent or less because of higher yields. The second difference is that guaranteed hedge funds tend to make use of leverage. For example, a guaranteed hedge fund that has borrowed 40 per cent can be invested at 140 per cent of its capital: 80 per cent into bonds and 60 per cent into derivatives. Retail guaranteed funds in comparison would only have the remaining 20 per cent to invest in derivatives.


hedge fund. Single strategy funds clearly come with higher risk because if the strategy fails, the entire fund loses money.

186

Should You Invest in Hedge Funds?


Investors are drawn to hedge funds for many reasons, but are hedge funds right for you? Your decision should take into account these factors: 1. Diversification At the most basic level, hedge funds can be thought of as just another investment alternative, as are bond funds and REITs. For investors with the means and appetite, hedge funds can certainly help diversify a portfolio.1 Those strongly in favour of hedge funds often cite statistics that show hedge funds not only reduce portfolio risk, but also increase portfolio returns because of spectacular performance. Those who are fearful about hedge funds cite fudged statistics and underhand tactics. 2. The best talents are drawn to hedge funds The compensation of hedge fund managers is mostly tied to the fund’s performance. This attracts the best talents. Also, hedge fund managers themselves are usually one of the key investors in the fund. These are two very strong incentives for fund managers to perform. Unit trust managers, on the other hand, make money whether the fund goes up or down in price.

Investing in Hedge Funds in Singapore Investors can choose between domestic hedge funds and offshore hedge funds. Domestic hedge funds are organised within Singapore. Investors are protected by Singapore regulations. MAS has set guidelines for the minimum subscription amounts for hedge funds:

1 The CSFB/Tremont Hedge Fund Index has a 0.47 correlation with the MSCI World Index. Source: www.hedgeindex.com.

• Single strategy funds — $100,000

• Capital protected and capital guaranteed funds — no minimum subscription where certain criteria are met MAS in April 2010 announced that new regulations will require hedge-fund firms in Singapore that manage more than S$250 million to be licensed. Hedge-fund firms were previously exempt from holding a license provided they manage funds on behalf of no more than 30 qualified investors.2 Those that manage less than S$250 million would not need a license although they will have to maintain a base capital of at least S$250,000. Offshore hedge funds are structured under foreign law and are available only for accredited investors and not for retail investors. Since such funds are managed outside Singapore, they are regulated under foreign laws. While this does not mean no recourse for the investor should fraud or scandals occur, it does make things a lot more difficult for investors should something go wrong.

DIFFERENCES BETWEEN HEDGE FUNDS AND UNIT TRUSTS In considering whether hedge funds are right for you, there are a few important differences between them and unit trusts that you should be aware of (see summary in Table 16.2. on page 168): 1. Absolute performance Unit trusts are mainly measured on relative performance based on a relevant benchmark such as the S&P 500 index. Hedge 2 A “qualified investor” is an accredited investor, or a fund whose underlying investors are all “accredited investors”. An accredited investor is defined under the Securities and Futures Act as one earning at least $300,000 for the last 12 months or one who owns at least $2 million in net assets, or her aggregate consideration for the acquisition is not less than $200,000 for each transaction. An accredited investor may also be a corporation with net assets exceeding $10 million in value.

Investing in Hedge Funds

• Fund of funds —$20,000

187


funds on the other hand are expected to deliver absolute returns — they attempt to make profits in different market conditions, even when the relative indices are down. 2. Hedging risk in a downturn Hedge funds can protect against declining markets by using hedging strategies such as shorting. Unit trusts are not able to protect portfolios effectively against declining markets. 3. Performance-based remuneration Hedge fund managers are rewarded with performance-related incentive fees as well as fixed fees. Unit trust managers are generally rewarded based on the size of the assets under their management.

HOW MUCH DO TOP HEDGE FUND MANAGERS MAKE? Hedge fund managers can make a scary amount of money. John Paulson, founder of New York based Paulson & Co, was paid an estimated US$3.7 billion in 2007, according to Institutional Investor’s Alpha magazine. The average compensation for the top 25 fund managers was US$892 million in 2007. The “poorest” fund manager in the top 50 made US$210 million.

TABLE 16.2. SUMMARY OF DIFFERENCES BETWEEN HEDGE FUNDS AND UNIT TRUSTS Unit Trust

Hedge Funds

Performance measurement

Relative

Absolute

Asset classes permitted

Cash, bonds and stocks

Unrestricted

Hedge Funds

Regulations

Highly regulated

Less regulated

Investment strategy

Buy and sell only

Unrestricted

Performance fee

Usually none

Very likely

Liquidity (ability to sell easily) Daily

Usually monthly

Target investors

Retail

High-net-worth

Expenses ratio

Lower

Higher

Leverage

Prohibited

Allowed

Source: Authors' own compilation

BE CAREFUL WHEN YOU INVEST IN HEDGE FUNDS The assets under management of a hedge fund can run into many billions of dollars, and this is usually magnified by leverage. Their influence over the markets and even entire economies, whether they succeed or fail, can be substantial and there is an ongoing debate about how much they should be regulated or unregulated. When hedge funds fall, they fall hard and often take others along with them. Take the collapse of the U.S. hedge fund Long-Term Capital Management (LTCM) in 1998 for example. LTCM made a huge and wrong bet on interest rates in the form of Russian debt and caused the U.S. Federal Reserve to step in to negotiate a US$3.6 billion bailout plan. Investors should also be wary of potentially inflated returns. According to a study by Burton Malkiel, a Princeton University professor, hedge fund returns are inflated because failed funds that have been liquidated are often not included in key fund indices. This “survivor bias” means that dead funds such as LTCM are not reflected in the major indices. The study estimates that fund results are overestimated by an average of 3.74 per cent. For these and other reasons, investing in hedge fund can be tricky and here are a few guidelines you should follow to protect yourself:


Unit Trust


• Remind yourself that although the rewards can be tremendous, you take on substantial risk when you invest in hedge funds. Your due diligence and monitoring must be top-notch. Never place a major portion of your investment funds into hedge funds. Up to 20 per cent is about right. • When examining hedge fund returns using an index, make sure the index includes dead funds. If the index includes dead funds, subtract 3.74 per cent (based on Professor Malkiel’s study) from the illustrated returns to compensate for any potential inflation of returns. • Look for funds with at least 10 years of return information. Do not trust slick brochures that show only recent performance. • Seek a knowledgeable financial adviser to give you advice. Ask your adviser how he is compensated by the hedge fund managers he is recommending.

MANAGING HEDGE FUNDS IN YOUR PORTFOLIO If you want to invest in a hedge fund for retirement, look for lesserrisk fund of funds and capital guaranteed funds. Avoid single strategy funds. Make sure that hedge funds comprise no more than 20 per cent of your overall portfolio. If you wish to enhance risk in your overall portfolio, any type of hedge fund will do. We recommend you consider single strategy funds only if your total invested assets equal $500,000 or more (since one single strategy fund priced at $100,000 amounts to 20 per cent of a $500,000 portfolio).

17 191

We hear more and more these days about art and collectibles being auctioned for hundreds of thousands of dollars, or someone discovering that grandma’s stamp collection in the storeroom is worth a fortune. Whether you have a passion for Coca Cola bottles, vintage cars or Picasso paintings, you do need specialized knowledge to determine the value of a specific collectible. It is easy to pay too much for a collectible if you do not have the needed experience and knowledge. Unlike a stock exchange where thousands of buyers and sellers congregate electronically to provide the latest transacted prices, the collectibles market is informal, is illiquid (not easily convertible to cash) and has high transaction costs. There is no updated price list or regulatory authority to ensure that transactions are carried out in an orderly way. Many collectibles are bought and sold in auctions in which the prices for similar items can vary widely. Ultimately, when a collectible (even for something as seemingly mundane as a toy or a comic book) is highly desirable, splurging is not uncommon. Hello Kitty celebrated its 35th anniversary in 2009 with a limited edition platinum doll that sold for around USD 170,000 each. The first issues of Superman and Batman have sold for over USD 1 million each in 2010. In this chapter, we look at the glamorous pursuit of collecting paintings followed by some sensible rules on buying and selling collectibles.

PAINTINGS — GOING, GOING, GONE Expensive paintings seem to always take the spotlight when compared with other collectibles. It is understandable if you look at the highest prices paid at auctions (see Table 17.1. on page 192):

Understanding Basic Derivatives

Investing in Art and Collectibles

192

TABLE 17.1 LIST OF 10 HIGHEST PRICES PAID AT AUCTIONS1


Painting

Artist

Year Painted

Year of Sale

Original price (in millions)

Adjusted price (in millions)

No. 5, 1948

Jackson Pollock

1948

2006

$140

$151.2

Woman III

Willem de 1953 Kooning

2006

$137.5

$148.5

Portrait of Adele BlochBauer I

Gustav Klimt

1907

2006

$135

$144.8

Portrait of Dr. Gachet

Vincent van Gogh

1890

1990

$82.5

$139.0

Bal du moulin de la Galette

PierreAuguste Renoir

1876

1990

$78.1

$131.6

Garçon à la pipe

Pablo Picasso

1905

2004

$104.2

$119.9

Nude, Green Leaves and Bust

Pablo Picasso

1932

2010

$106.5

$106.5

Portrait of Joseph Roulin

Vincent van Gogh

1889

1989

$58 plus exchange of works

$101.3

Dora Maar au Chat

Pablo Picasso

1941

2006

$95.2

$102.3

Irises

Vincent van Gogh

1889

1987

$53.9

$101.6

Irises by Vincent van Gogh is tenth in the list valued at an astonishing USD 101.6 million. To give you an idea how prices have risen the last few years, consider that just five years ago,

1

This list, which is adapted from Wikipedia, is inflation-adjusted in US dollars. A list in another currency may be in a slightly different order due to exchange rate differences. Paintings are only listed once, for the highest price sold.

IF YOU CANNOT OWN ONE, STEAL ONE Some art thieves may have been inspired by Pierce Brosnan in the movie The Thomas Crown Affair where he orchestrates an elaborate New York museum heist to steal a Monet painting. Although Brosnan’s character does it for the thrill of it, most art thefts are performed for monetary gain. Which is the most expensive art theft in history? According to the Art Loss Register, a firm that maintains the world’s largest database of stolen and missing art, that may be the 1911 theft of the Mona Lisa. A more recent and embarrassing theft occurred in May 2010 when five paintings were stolen from the Paris Museum of Modern Art. The stolen pieces included ones by Henri Matisse and Picasso. It was embarrassing because it was a one-man heist. Dressed in black and wearing a mask, the thief merely cut a padlock on the gate, smashed a window to get inside and then carried off a stunning haul worth hundreds of millions of euros. While the thief ’s image was captured on CCTV, the museum’s security system had failed terribly as the break-in triggered no alarm. The guards were alerted only when they noticed the smashed window. While this may make art robbery seem like a good career choice for some people, art thieves rarely make big money off

193 Investing in Art and Collectibles

the “cheapest” painting on the top-10 list was just a little over USD 50 million. Prices of the top-10 paintings have doubled in the last five years. Table 17.1 is a list of the highest prices paid for paintings. Very valuable paintings, if sold, are usually not sold at auctions. Most of the world’s most famous paintings are owned by museums, which very rarely sell them. As such, they are quite literally priceless. If a painting like the Mona Lisa were to become available, it would almost certainly sell for much more than any of the paintings listed. Long ago in 1962, the painting was already assessed at US$100 million.


their crimes. That’s because the stolen pieces of art are easily recognisable, and difficult to offload at their actual value on the open market.

ART AND COLLECTIBLES CAN BE RISKY INVESTMENTS Unlike an investment in stocks, an investment in collectibles cannot be measured by time. In fact, the variables that govern price can be very unpredictable and volatile. One factor that can drive up the value of art is the artist. General interest caused by an exhibition, conference, the publishing of a book, or even the production of a major film (as in the case of Mexican painter Frida Kahlo and Amedeo Modigliani who was a struggling rival of Picasso), will bring with it a new wave of people wanting to know more about the particular artist and the necessary demand can cause a hike in price. It’s often said that if the artist is alive, her new fame might allow the artist to become more prolific by satisfying the demand while keeping the price at the same level. But when an artist dies, there is a tendency to see a sharp increase in price for works of her creation due to the publicity generated by the death of the artist, as well as what we might call the close of her artistic production. In the months immediately following Andy Warhol’s death, a frenzy developed for anything Warhol. Even his personal property was bid into the stratosphere at the famed 1987 Sotheby’s auction where his vintage cookie jars sold for thousands of dollars. But this posthumous popularity is not always the case. Some artists have a huge following only during their lifetimes because of their big personalities. The paintings of Pascal Cucaro, a colorful San Francisco artist for example, sold for around US$50,000 while he was at his peak in the 1950s. Today, those same paintings may sell for no more than US$1,000.2

2 www.artbusiness.com

1. Low price transparency — Buying securities usually occur at fair market value in large market places. But when buying a piece of art, it is much more difficult to confirm that a fair price is being paid. 2. Security — Investors are responsible for the safekeeping of the collectible. If the piece gets damaged or lost, its value is compromised. 3. Liquidity — Securities can be sold much more easily than art and collectibles because securities are traded more readily on organized networks and exchanges.

MAKING SENSIBLE INVESTMENTS IN ART AND COLLECTIBLES Most authorities agree that we should buy art and collectibles primarily because we like them. Their profit potential should be a secondary consideration. Here are a few sensible strategies to bear in mind when investing: 1. Buy from reputable dealers — Find a reputable dealer who has been in the business for many years, long enough to know about quality, market trends and pricing practices in the type

195 Investing in Art and Collectibles

What we often do not hear is that collectibles are risky investments and may be difficult and expensive to liquidate. Investing in arts and collectibles is rife with risk and, for most investors, doesn’t offer the returns afforded in the equities or traditional markets. The value of art rises and falls sharply with the economy and what’s considered valuable to one collector could be worth far less on the open market. If growth is an investor’s sole motivation, she will likely do much better investing in stocks or bonds than buying paintings, phone cards or antiques. Here are three other challenges investors may encounter:


of art and collectibles to be collected or invested. The dealer should also provide a written appraisal or certificate attesting to the quality and authenticity of the item. 2. Buy quality — Like buying homes in good locations, buying top-quality items while expensive, provide price protection even in poorer market times. 3. Maintain the item — provide appropriate environmental conditions and regular maintenance as well as insure the item adequately. 4. Limit the amount invested — Avoid putting more than 10 to 15 per cent of an investment portfolio into art and collectibles. Collecting things is a very satisfying pastime when you are passionate about the things you collect. But collecting for the sake of profit is seldom a productive activity unless you have pockets deep enough to invest in the rarest collectibles. So for many people, the collectibles they acquire may never provide much profit at all or are likely to decrease in value over time. Between ourselves, we collect coins, stamps, photos and books. Some cost us a few thousand dollars while most cost just a couple of dollars. In the end, we subscribe to what television producer Norman Lear said, “Life is made up of small pleasures. Happiness is made up of those tiny successes. The big ones come too infrequently. And if you don’t collect all these tiny successes, the big ones don’t really mean anything.” Happy collecting!

18 197

Over 92 per cent of the world’s largest 500 companies use derivatives to manage their corporate risk, according to a survey by the International Swaps and Derivatives Association (ISDA) in 2003. The percentage is probably even higher today. Derivatives are widely used today and this is why it is important that you have a good understanding of them and how each of the main derivative products differs. If you’ve ever owned a capital guaranteed product or just a unit trust, chances are that you too own or have owned derivative instruments although you may have done so indirectly. That’s because guaranteed products have a sizeable portion of their structure made up of derivatives, and unit trusts use derivatives to manage risks such as currency fluctuations. These days there are many new products that just a few years ago didn’t exist — such as protected funds, contracts for difference (CFD), currency-linked notes and call warrants. Why has there been such an increase in the use of derivatives and structured products by both companies and individuals? You guessed it. It’s all about risk and return.

WHY DERIVATIVES ARE EVER SO IMPORTANT FOR YOU TO KNOW TODAY The markets are very volatile these days. You saw in Chapter 8 how the STI tripled in value from 800 to 2500 in the 16 months between August 1998 and December 1999, then lost half its value in the next 21 months. You saw in Chapter 15 how gold went from US$270 in 2001 to over US$1,200 per ounce in 2010. You’ve seen the subprime crisis bring about shocking losses for many of the world’s largest banks, some of which have lost tens of billions of dollars. Now imagine you are two years from retirement and you have a portfolio of Singapore stocks worth $300,000 that you

Investing in Art and Collectibles

Understanding Basic Derivatives


plan to use for travelling and cruises. Bad economic news and a likely recession then destroy over 50 per cent of your portfolio’s value. Volatility can bring about returns that can be very good for your portfolio — or very bad. The problem is that you’ll never know for sure which direction the market is headed. In this chapter, we will to bring you through some of the most common derivatives and structured products around today so you’ll know that there are many more options available for you to consider when managing your portfolio. We will go over some of the foundation topics on derivatives that we covered in Chapter 2, but we will do so at a very conceptual level. We will not look too much under the hood of these very technically demanding instruments. Our advice is that you should leave those daunting details to your financial adviser and just focus on how these instruments may be important for your financial future.

IT ALL STARTED WITH FORWARDS 5,000 YEARS AGO If you had lived 5,000 years ago in Sumeria, which was situated in modern day Iraq and western Iran, you might have had the honour of participating in one of the first derivative transactions known to mankind called a forward. Let’s suppose that you did. Suppose it is June and you are a goat farmer hoping to sell one of your goats in three months’ time in September. While goats are selling at 100 gold coins today, and you would be happy with that price, your goat is not quite mature yet. You have what is called a natural position — you own a goat — which exposes you to risk because the price of goats could fall sharply by September. Now suppose there is also a shish kebab maker who wants to buy a goat for a village feast taking place in September. Like you, he doesn’t mind the price of a goat at 100 gold coins today, but he doesn’t want to look after a goat for three months. Like you, he is also exposed to price risk, but on the opposite side. He is worried that the price of goats will rise in three months’ time.

I, goat farmer, agree to sell one of my goats to shish kebab maker for 100 gold coins in three months’ time. I, shish kebab maker, agree to buy a goat from goat farmer for 100 gold coins in three months’ time. In three months’ time, if the market price of goats rises to 140 gold pieces, you are obligated by the contract to sell the goat for 100 gold coins. You would, of course, be upset for letting the goat go so cheaply at 100 gold coins when you could have sold it at 140 if you had not gone into the forward contract. But then, the market price of goats could just as easily have fallen to 50 gold pieces, in which case you would be happy because the shish kebab maker is obligated to buy it from you for 100 gold coins. The point of the forward contract is that you and the shish kebab maker are able to lock in a price three months ahead of time. By doing so, both of you have removed your price risk. As you have seen, removing your price risk also removes any chance of taking advantage of price movements that would have been in your favour had you not agreed to lock in a price. Forward contracts have three key features: 1. They can be customised since it is usually between one buyer and one seller, a special type of goat, a specific weight or colour can be specified. 2. Both buyer and seller are obligated to buy and sell at the specified price.

199 Understanding Basic Derivatives

What you and the shish kebab seller can do is to have a forward agreement with these terms:


3. Forward contracts are traded over-the-counter (OTC) rather than on a formal exchange such as SGX. These features of forward contracts do point to some challenges. Because forward contracts are agreements between two parties, counterparty risk can be high. If the market price of goats rises to 200 gold coins, the goat farmer may decide to scupper the agreement in order to sell it in the marketplace for 200 gold coins. Second, it is hard to guarantee the quality of the goat. It may arrive with a disease or one leg missing. And third, what if either the buyer or seller decides to get out of the contract for legitimate reasons? For example, the designated goat dies one month before delivery.

FUTURES CONTRACTS Futures markets began as a response to some of these challenges experienced with forward contracts. In a futures market, there are thousands of buyers and thousands of sellers who converge their interests into one marketplace (see Figure 18.1). As a result, the trading of futures contracts is different from that of forward contracts in the following ways:

FIGURE 18.1. A FUTURES EXCHANGE

Thousands of Buyers


Clearing House

Thousands of Sellers

Futures in Your Portfolio We often hear about the high risk nature of derivatives (especially futures). China Aviation Oil in 2004 ran up US$550 million in losses from oil futures. Nick Leeson’s trading of Japanese futures made his employer Barings Bank bankrupt in 1995 with losses of US$1.4 billion. But this occurred when futures were used for speculating with huge bets on the direction of the market. When used for hedging an existing physical position, they do a wonderful job of reducing, not increasing, risk. Take the case of the shish kebab maker who hedged against price rising in the future by agreeing to a price today. Now suppose you have $300,000 invested in ten Singapore stocks that you have held for many years. It is January, and you are


Futures contracts have standardised terms to facilitate trading. A corn futures contract would have specific details of contract size, origin of the corn, delivery times and acceptable moisture quality. Forward contracts do not have standardised terms and that is why they are difficult to get out of as it requires another buyer or seller who is willing to accept customised terms. Second, a clearing house sits between the buyers and the sellers. The role of the clearing house is to guarantee the trades that come through. If a buyer puts in a buy order and it is accepted, the clearing house guarantees that the order will be filled. This gets rid of counterparty risk, which is the risk that accepted orders are not filled for one reason or another. Like a forward contract, a futures contract obligates the buyer and seller to buy and sell. However, one difference is that because the contract terms are standardized and the exchange is open to thousands of buyers and sellers, it is very easy for someone to get out of a position before the contract matures. In fact, over 95 per cent of all futures contracts are “unravelled” in this manner.


concerned about a market decline over the next two months. You do not wish to liquidate your portfolio but you don’t want to suffer losses either should the market decline. What you can do is sell2 a number of STI futures contract so that if the market does fall, your profits from your futures position would offset your losses from your actual portfolio. (Note that the operational details of trading futures can be easily obtained from www.sgx.com and from other exchanges, and we are not focusing on those details here. What we are focusing on is the important concept that you can hedge (or protect your portfolio) with the use of futures.) Let us return to our example. The March STI futures contract is trading at 3,000 points. With a multiplier of $10 per point, the price of one March contract is: Price per contract

= 3,000 X $10 = $30,000

To protect the portfolio against a market decline, the number of futures contracts to sell is: Number of contracts

= $300,000 / $30,000 = 10 contracts

By hedging, you have greatly reduced or even eliminated the possibility of a loss from a decline in your Singapore portfolio. If the market indeed falls, the losses from your stock portfolio would be offset by the gains from the futures contracts. For example, if the STI index falls 50 points, your gain from your futures position would be: 2

Selling or shorting is useful when you have a pessimistic view of the market. For example, you agree to sell a car to John for $20,000 today to be delivered a week from today. Assuming you don’t already have the car, you hope to buy a car in a week’s time at a price lower than $20,000 in order to make a profit.

Gain

However, you would have also eliminated the possibility of a gain from a price increase. That’s because if the market went up instead, the gains from the market would be offset by the losses from your futures position. Finally, there are details on the STI futures contract that we have intentionally skimmed in order to focus on the concept of hedging. However if you are new to the STI futures contract, here are a few things to note: • Futures contracts generally have specified future expiry dates often going into 12 months or more into the future. For the STI contract, we chose the March contract because it still has two months remaining before expiry. • Futures contracts have to be “monetized.” Because the underlying asset is the STI with a points value, a $10 per point multiplier is used to give the contract a monetary value.

TRADITIONAL OPTIONS CONTRACTS Both forwards and futures obligate the buyer and seller to buy and sell. If you buy an options contract, you have a choice. This is the most important difference between options and futures/forwards. We’ve already discussed in Chapter 2 what call and put options are. To review, if the goat farmer and shish kebab maker were to agree to an options contract, it might look something like this: I, shish kebab maker, pay goat farmer two gold coins for the right to buy a goat from goat farmer for 100 gold coins anytime in the next three months.


= 50 points X 10 contracts X $10 per point = $5,000


I, goat farmer, accept two gold coins from shish kebab maker and give him the right to buy my goat for 100 gold coins anytime in the next three months. If shish kebab maker exercises his right to buy, I must sell. If he does not, I keep the two gold coins. You can see that the option to buy the goat is valuable, and for that, a price has to be paid. This is called the option premium, the calculation of which won its creators the Nobel Prize in Economics. It’s that sophisticated. We need to get more specific about the type of options that we are talking about because there is actually quite a variety of them. The options that we discuss here are traditional exchange-traded options. They give you the option to buy or sell a number of shares at a specified price (called the exercise price) within a period of usually three to nine months. They are issued by third parties such as a bank, rather than by the company itself. This means that if an option to buy is exercised, the third party delivers the shares to you from its own inventory of shares. New stock is not issued by the company. In fact, the company whose shares are being bought and sold is usually not at all involved in such transactions. Traditional stock options are popular in the U.S. and Australia, but they are not popular in Singapore. Stock options have been created on a few blue-chip companies in the past, but the options have been dormant because of lack of interest. The short-datedness of the option does have an impact on the exercise price in that it shouldn’t be too far away from today’s market price at the time of issue. To understand what this means, suppose we have the following: Today’s price of XYZ shares Strike price of call option Price of call option Expiration

= $10 = $16 = $0.20 = 3 months

TRADITIONAL WARRANTS Continuing with the last example, we now ask what if the expiration is five years and not three months? Does a strike price of $16 seem more reasonable to you if you had five years to wait this out? The answer should be yes, and this is one of the main differences between traditional options and warrants. At the time of issue, warrants have a lifespan of up to five years. Warrants are in fact often called “long-dated options” for this reason. The exercise price is usually far away from today’s share price at time of issue.2 One other difference with traditional options is that traditional warrants are issued by the company itself. When such companyissued warrants are exercised, new shares are released. There are two different types of warrants: call warrants and put warrants. Like a call option, a call warrant is what we just described. It gives its holder the right to purchase a number of shares from the issuer at a specific price, on or before a certain date. A put warrant represents a certain amount of equity that can be sold back to the issuer at a specified price, on or before a stated date. Warrants issued by companies entitle the holder to buy a specific number of shares in that company at a specific price at a specific time in the future. For example, AsiaWater Tech W110818

2

This is true more so when the company’s share price is considered low.


Does this make sense? Would you pay 20 cents for an option to buy XYZ for $16 when its price is trading at $10 today? If you buy the option, it means that you have very gigantic hopes that XYZ would rise at least 60 per cent during the next three months. Despite whatever optimism you have about XYZ, you can see that the strike price of $16 is not reasonable. So, the exercise price should be closer to, rather than farther away from, today’s price.


is an SGX-listed warrant issued by Asia Water itself. It listed on 23 February 2010 and expires on 18 August 2011. It had the following details in July 2010: Price of warrant = 3 cents Exercise price = 4.5 cents Underlying Stock Price = 6.5 cents Conversion Ratio = 1 share: 1 warrant Analysing this is not difficult at all. To own Asia Water, you have a choice of buying it directly at 6.5 cents or you can pay 3 cents for the warrant and exercise it by paying another 4.5 cents for a total of 7.5 cents. The conversion ratio of 1:1 means that it takes one warrant to purchase one share. Is this a good deal? First, by buying the warrant and exercising it, you’re paying 7.5 cents, which is 1 cent more than buying the stock directly. Why in the world would you want to do that? A good reason is that you’re paying a premium of 1 cent to be able to sit tight for over one year and hope that the underlying stock price shoots sky high. For example, if you buy the warrant at 3 cents and Asia Water stock rises to 10 cents in a year, you can cash in for a nice profit of 2.5 cents per share (10 minus 7.5 cents). And what if the underlying stock price falls to 1.5 cents or even lower? Then your maximum loss will always be limited to just the initial investment of 3 cents per warrant.

Warrants Compared with Options Warrants are similar to long-term options where they offer the opportunity for capital gain, which makes them interesting for speculative investing. The price movement of warrants tends to reflect the price changes in the underlying equity — but in an exaggerated fashion. For example, if the price of a share increases 10 per cent, the price of an associated warrant may increase 30 per cent. That is the bottom-line attraction for speculators.

TABLE 18.1. DIFFERENCES BETWEEN WARRANTS AND OPTIONS Warrants

Options

How long they last

Long dated. Usually issued with a 3-5 year life.

Short dated. Ranges from 1 month to 12 months.

Issuer

Issued by the company itself with a promise to issue new shares if the warrant is exercised.

Usually not issued by the company itself. A promise is made to deliver existing shares if the option is exercised.

Dilution

New shares are issued by the company when warrants are exercised. This results in earnings dilution for shareholders.

When an option is exercised, existing shares are delivered. This does not cause earnings to dilute.

Where they are traded

On an exchange.

On an exchange.


The Lure of Warrants Because warrants exaggerate the movements of the underlying equity, they tend to be more volatile than shares, which is why speculators love them. Warrants thus offer the opportunity for greater price gains than do the associated shares. This feature of warrants is called gearing and this is found commonly in financial markets. An example of gearing is if you borrow money from the bank and invest the money in the stock market, you are said to be “gearing up” your exposure to stocks. Similarly, if you arrange a mortgage from a bank to buy a house, you are gearing up your exposure to the property market.


But warrants are not exactly like options; there are a few differences, which are summarised in Table 18.1 for call warrants and call options.


The major attraction of warrants is this feature of gearing — they track, and magnify, share price movements. In bull markets, speculators will often flow into warrants, instead of shares, to gain from the turbo-charged performance of warrants. Hence, in bull markets, warrants will easily outperform most shares, and have the greatest price increases among securities. The advantages of gearing can also be its greatest danger, as gearing works both ways. While warrants can rise spectacularly fast, they can plummet just as quickly. Warrants are very speculative, capital gain plays. Warrant-holders get no dividends or any other type of income. They are therefore not appropriate for investors who are interested in income.

Structured Warrants Structured warrants and company warrants have many similar features. Their values are linked to an underlying asset. In the case of company warrants, the underlying asset is the company’s shares. Structured warrants are more flexible as their underlying asset is usually either a stock or an index. Both types of warrants are listed on an exchange and offer leveraged trading. Compared with company warrants that are issued by the company itself, structured warrants are issued by third-party financial institutions. This and other differences are summarised in Table 18.2. (page 209). Here’s an example of how a structured warrant is listed on the stock exchange and what each term means:

STI 3,700 ABC e CW 120328 STI 3,700 ABC e CW 120328 STI is the underlying asset Straits Times Index 3,700 is the Strike Price* ABC is the name of the issuer

* Strike price is the price at which the warrant holder is entitled to buy (for calls) or to sell (for puts) the underlying asset at maturity. ** Warrants with American maturity can be exercised at any time before maturity.

TABLE 18.2. DIFFERENCES BETWEEN STRUCTURED WARRANTS AND COMPANY WARRANTS Warrant issuer

Structured Warrants

Company Warrant

Issued by third parties such as financial institutions.

Issued by the company itself.

Underlying asset Any index or company Shares of the listed shares that are not related company. to the financial institution. On exercise

Does not result in dilution Company will issue of the underlying shares. new shares, which results in share dilution.

Maturity period

Short term, likely to be 12 months or shorter.

Source: Adapted from http://sg.warrants.com

Long term, can be as long as 5 years.


E refers to a European maturity which means that the warrant can only be exercised on the day the warrant matures** CW means Call Warrant while PW means Put Warrant 120328 is the maturity date — that is, 28 March 2012

19 Understanding Structured Products and Other Derivatives CFDs, structured deposits and equity-linked notes — these are just some of the names of securities that you might have heard of in the news, and have no doubt been intrigued, confused and enlightened by all at the same time. That’s probably because derivatives are such highly flexible instruments. They can stand on their own as a leveraged investment for speculators. They can be structured to mimic the behaviour of another asset. They can be added to your portfolio to provide temporary protection from an anticipated market downturn. And as you will see in this chapter, they can be attached to traditional investment assets such as bonds to become structured products. In fact, the number of combinations is limitless and like in the previous chapter, we will focus on some very technically challenging investment products at a conceptual level without digging too much into the details. In this chapter, we will touch on some of the most popular products in the market: • Contracts for Difference (CFDs). • Structured products such as guaranteed funds, structured deposits and equity-linked notes. In the end, your conceptual understanding will allow you to differentiate one product from another, and hopefully we will help you not only make informed decisions, but also ask the right questions to enhance and protect your bottom line.

CONTRACTS FOR DIFFERENCE (CFDS)

1

Phillip Securities is one of the top CFD brokers in Singapore, providing hundreds of CFDs in several markets, including Singapore, Malaysia, Hong Kong and even the U.S.

Understanding Structured Products and Other Derivatives

If you love BreadTalk and can’t seem to get enough of their buns and pastries, you might want to think about a CFD. A CFD allows you to take a leveraged position on a security such as equities or indices. This means that by taking a leveraged CFD position on a stock such as Breadtalk, and putting down $1,000 with a broker such as Phillip Securities1 you are able to hold a $5,000 position. CFDs are a very simple type of derivative that offers all the benefits of trading shares without actually having to own them. A CFD mirrors exactly the performance of the underlying stock where the profit or loss is determined by the difference between the purchase price and the selling price. A CFD is an over-the-counter (OTC) derivative that represents an agreement between two parties (you and the broker) to exchange at the close of the contract the difference between the closing and opening prices of the contract. A CFD thus allows you to trade on the outcome, or performance, of Breadtalk and other securities without owning the stock or security. You would not have voting rights or ownership entitlements such as warrant issues and rights issues. Because CFDs are leveraged, you trade on margin like what you would do with futures contracts. Margin trading gives you the ability to purchase, or gain an exposure to, a stock without putting up the full principal value. This lets you multiply your profits if the price moves in your favour. The opposite is true as well. If price moves against you, your losses are multiplied as a result. Margin is made up of two parts. The first is the initial margin, which is the initial amount required to open the position. In Singapore, the initial margin level is typically 20 per cent, which means a leverage of five times — every dollar you put down allows you to hold five dollars of assets. If the price of the stock moves in your favour, no additional margin will be required, but if the balance

211


goes below a maintenance margin (for simplicity, let’s assume it is also 20 per cent), then you will get a margin call to top up so your balance returns to at least the 20 per cent level. This principle is no different from buying a home with a loan. When you buy a home, you put down a deposit (for example, 20 per cent) and you borrow the rest (80 per cent). If the property market goes up in your favour, your profits are multiplied a few times relative to your initial deposit. Or if it goes against you, you can lose more than what you put down. CFDs can be risky and speculative, and you should know what you’re doing. Let’s look at a simplified example in Table 19.1 of a long trade in which you open a CFD position in XYZ stock which is trading

TABLE 19.1. SAMPLE CFD POSITION IN XYZ STOCK Opening Position: Price of XYZ

$10.00

Number of shares

$5,000

Value of shares

$50,000

Margin Required (20%)

$10,000

Commission (0.30%)

$150.00 (GST excluded)

Total Value of Transaction

$10,150 (margin plus commission)

Closing Position (5 days later) Price of XYZ

$10.50

Number of shares

5,000

Value of shares

$52,500

Commission (0.30%)

$157.50

Financing (5 days)

$50.00

Profit ($)

$2,142.50 ($52,500 minus commissions and finance charges)

Profit (%)

21.1% ($2,142.50 / $10,150)


CFDs in Your Portfolio There are two main ways you can use CFDs: • You can speculate — if you are convinced about the direction of a stock’s price, you could speculate by longing (you are bullish) or shorting (you are bearish) the CFD. • You can hedge — Suppose you own actual shares of XYZ that you don’t want to sell because your grandmother gave them to you. Even if you expect its value to decrease from a market downturn, you can maintain your filial duty by opening up a short position using a CFD on the individual share. If, in fact, the stock goes down from $10 to $9, you can compensate for the losses from your actual shares by the profit made with the short CFD position. CFDs are bad for your nerves if you are a risk-averse investor. If you can’t even stomach a 10 per cent drop in your favourite stock, imagine a 50 per cent drop as a result of the leverage feature.

213 Understanding Structured Products and Other Derivatives

at $10.00 per share. You put down an initial margin of $10,000 for a $50,000 position. Five days later, when XYZ has gone up to $10.50, you close out your position for a profit of $2,142.50 after subtracting commissions and other expenses. Since CFDs are margined instruments, any positions held overnight are subject to financing. This is to take into account that your broker is actually lending money to a client or borrowing money from him. Long CFD positions are required to pay financing since you are effectively borrowing 80 per cent of the total position like in a home mortgage. To simplify the example, we assume this is $50 for five days. The above example shows a 21.1 per cent return on the initial investment, given a five per cent move in XYZ’s stock price. Bear in mind again that as profits are magnified, so too will your losses be, if the price goes in the opposite direction instead.


CFDs aren’t very good for long-term investing either unless you are one of those investors who can stay on the roller coaster for six hours at a time without a break. Because of leverage, your returns can swing very wildly.

STRUCTURED PRODUCTS Suppose you have $1,000 to invest. You buy a high-quality AAArated zero-coupon bond for $864. The bond matures in three years’ time whereupon you will receive $1,000. Since your capital has been “guaranteed”, you now venture to take a huge risk with the remaining $136 or 13.6 per cent of your investment money. You invest the entire $136 on stock options that are tied to the performance of a technology index. In three years, if the technology index does poorly, you walk away with $1,000. Your return is zero per cent. Still, you are comforted by the fact that you did not lose any money. If the technology index does really well and your stock options go up 30 per cent, you earn a return of 4.1 per cent: Return

=13.6% x 30% = 4.1%

Congratulations! You have just created your own technology capital guaranteed fund, a type of structured product. Structured products are very popular with retail investors, and we will look at three — capital guaranteed funds, structured deposits and equitylinked notes.

The Appeal of Guaranteed Funds A basic structured product such as a guaranteed fund has a very simple structure: Capital Guaranteed Fund = Bonds + Higher-risk Investments

Defining Structured Products The term “structured products” in the market is somewhat unclear and frequently refers to the packaging of derivative products with traditional ones. A good definition comes from Michael Fraikin, Director of the Global Structured Products Group at INVESCO, who defined a structured product as “a systematic way of investing rather than one that centres on the use of derivatives”. In other words, structured products express an investment strategy. A guaranteed fund, for example, is an investment strategy that provides the investor with protection from a downturn, yet gives the potential of profits should the market go up. This is appealing to not only a risk-averse investor, but also one who has the view that while the market could weaken, there is hope of an upturn.


You can create a similar structure on your own. Now imagine if you had to pay a commission to someone to create the above structure. Would you ever buy a capital guaranteed fund? It is understandable if your answer is “no” since theoretically you can just do this yourself. However, the cost and transaction volume requirements of many derivatives are beyond most individual investors. As such, structured products were created to meet specific needs that cannot be met from traditional financial instruments. Structured products can be used as an alternative to direct investment, as a way to reduce portfolio risk, or to exploit a current market trend. In Singapore, billions of dollars have been invested in capital guaranteed funds. They were the rage when the first funds appeared at the end of 2000. At the time, the STI was in a slump. It fell from 2500 in December 1999 to lower than 1300 points 21 months later in September 2001. Hungry investors seized what was a great investment, an investment in which capital is guaranteed (net of commissions) and there was the potential of an upside tied to markets recovering in three to five years’ time.

Structured Deposits

FIGURE 19.1. BANK FIXED DEPOSIT AND SAVINGS RATE (1995 TO 2010)

6 5 4

Bank 12 Month Fixed Deposit Rate

3 2

Bank Savings Rate

1

Jan 10

Jan 09

Jan 08

Jan 07

Jan 06

Jan 05

Jan 04

Jan 03

Jan 02

Jan 01

Jan 00

Jan 99

Jan 98

Jan 97

Jan 96

0 Jan 95


The most serious risk associated with many structured products is that many investors buy them when they don’t quite understand their risk-return characteristics. Take structured deposits for example. They appeared around end-2001 and work just like capital guaranteed funds in that capital is often guaranteed and there is also the potential kicker in returns from risky investments. What is different is that structured deposits were sold as alternatives to fixed deposits. While capital guaranteed funds appeal more to investors, the appeal of structured deposits lies with depositors. Billions of dollars too have poured into structured deposits. It is easy to see why when we look at how low fixed deposit and savings rates have fallen over the years (see Figure 19.1). At the start of 2002, 12-month fixed deposit rates were around 2.46 per cent. Around mid-2010, the rate was 0.14 per cent. This is a very depressing rate for depositors.

Percent (%)

216

• There is often a high early payout (the earliest versions offered lower, regular payouts) Whatever the amount or the regularity, remember that this is just the income portion. • The capital is usually protected Capital protection is a little different from capital guarantee. A capital guarantee is a guarantee that you will get your capital

REMINDER — TWO BASIC TRUTHS ABOUT INVESTING First, the most sacred investment truth of all — the lower the risk, the lower the returns. And the higher the risk, the higher the returns. If an investment makes guarantees, it does so by offering lower returns. Second, returns consist of two components: Return = Income + Capital Gains So, if you are getting a lot of “returns” upfront, for example 8 per cent or $80 for every $1,000 invested, do not be too happy yet. That is just the income portion of your returns. Please ask the salesperson about the capital gains portion. Chances are that if the income portion is guaranteed, the capital gains portion is not. And very often, you could even suffer capital losses.


What many structured deposits offer are high early payouts. For example, a structured deposit may offer 8 per cent returns in eight months. If you are thinking that this is a great deal, so are thousands of depositors. Here are a few characteristics about structured deposits that you should know about:


back. If the bank buys a bond and the issuer defaults, the bank will pay you your money. With the guarantee, the bank takes on the risk. With protection, the bank passes the risk to you if the issuer defaults. So while capital protection is still low risk to you (the bonds purchased are usually good quality), it is not risk-free. The next time you read a product brochure and you are confused, think about it this way. If the income portion is guaranteed, the capital portion is probably not guaranteed. Or, if the capital portion is guaranteed, the income portion is probably not. If they are both guaranteed, which is unlikely, you can't then expect the returns to be great. • Long lock-in period Some funds lock you in for up to 10 years and there is a penalty for early withdrawal. The worst that can happen is when you get a high early payout and get locked in for 10 years. And then at the end of the period, you find out that you would not be getting any extra returns because the options and other higher risk investments failed to perform. There have been plenty of complaints by investors about structured deposits and how they were being sold. Some investors complained that they were lured by the high early payouts. But when they learned that they needed cash and wanted to liquidate, they got upset by the penalties for early withdrawal. There were also complaints that banks were selling structured deposits as if they were simple deposit products. They are not. MAS has issued a notice that “Unlike traditional deposits, structured deposits have an investment element and returns may vary.”2

Equity-Linked Notes An equity-linked note (ELN) is a structured product. It starts with a debt instrument, usually a bond. It is different from a bond, 2

MAS Guidelines on Structured Deposits, www.mas.gov.sg, 7 October 2004.

MANAGING STRUCTURED PRODUCTS IN YOUR PORTFOLIO Structured products may be suitable for you if you have sufficient cash elsewhere so that the possibility of an early withdrawal is remote. If you want to enhance returns on your fixed deposit, which you have set aside for emergency funds, you can consider putting up to 30 per cent of your emergency funds in structured products that mature in no more than three years’ time. Capital guaranteed/protected investments are generally low risk and should not really occupy a large proportion of your retirement portfolio. However, if you strongly believe in a market recovery, but you still want some returns from income payouts, you might consider such funds. Invest no more than 20 per cent of your retirement portfolio in such funds.


however, in that the final payout is typically based on the return of an underlying equity instrument, which can be a basket of stocks or an equity index. A typical ELN is capital-protected, which you now know, is different from being capital-guaranteed. A common feature is that the final payout is the amount invested, times the gain in the underlying stock basket, or index times a participation rate, which can be more or less than 100 per cent. For example, if the underlying basket gains 50 per cent during the investment period and the participation rate is 60 per cent, the investor receives 1.30 dollars for each dollar invested. If the underlying basket remains unchanged or declines, the investor still receives one dollar per dollar invested as long as the issuer does not default. You can see that this payoff is no different from that of a capital-guaranteed fund.

20 Understanding Currency Currency movements seem to be favouring Singaporeans these days. The US$ is weak. The SGD is strong. Suddenly, we hear many of our friends wanting to visit, eat and shop in the U.S. It’s a great time, but that’s true only if you’re buying and shopping, and bad if you own U.S. assets or you are selling goods to the U.S. (you may be forced to raise prices which would make your customers unhappy). If you hold lots of U.S. assets or US$-denominated assets such as real estate and unit trusts, your investment would have gone down 25 per cent between 2002 and 2010 from just the currency movement itself.

FIGURE 20.1. USD VS SGD MOVEMENTS BETWEEN 1994 AND 2010

USD / SGD 1.9

Exchange rate

1.8 1.7 1.6 1.5 1.4 4 1.3

Jul 10

Jan 09

Jul 07

Jan 05

Jul 04

Jan 03

Jul 01

Jan 00

Jul 98

Jan 97

Jul 95

Jan 94

1.2

Figure 20.1 shows that in 2002, US$1 exchanged for S$1.85. In mid-2010, the exchange rate had gone down to less than S$1.40, a drop of over 25 per cent for the US$.

INCREASING INTEREST IN CURRENCY INVESTING Investing in currencies is becoming quite popular these days. Everyone from housewives to doctors seem to have a view of where

CHANGING ON THE SPOT We Singaporeans are quite seasoned when it comes to exchanging Sing dollars for a foreign currency. Many of us love to travel and we can take off from Changi airport and land almost anywhere in the world. If you are going to the U.S. in a few days’ time and you want US$10,000 exchanged to spend on luxurious spa treatments, the money changer would quote you a “spot exchange rate”, so called because the exchange is made on the spot for immediate delivery. The price you pay to buy US$ is the US$/S$ rate or “the price of US$ based on S$”. For example, if the US$/S$ rate is 1.5, then you would pay S$15,000 for US$10,000. Now suppose you are going to the U.S. in one year’s time instead. As you know, exchange rates change all the time and are actually quite volatile. Which would work more in your favour — a stronger or weaker US$ when you need to exchange your S$ for US$ in a year’s time? The answer is that you would want a weaker US$ because it means US$ are cheaper to buy using S$. For example, if the US$/S$ rate goes down to 1.3, then you would pay S$13,000 for US$10,000 — a savings of S$2,000.

221 Understanding Currency

the S$ or US$ is headed, and every other person we know seems to have traded currencies or bought currency-related investments. Currencies can be considered an alternative investment because their returns are not well correlated to stocks and bonds, but they can be very risky investments too; hence they should fit into your supplementary bucket. Each country has its own currency. Singapore’s official currency is the Singapore dollar. Switzerland’s official currency is the Swiss franc, and Japan’s official currency is the yen. An exception would be the euro, which is the currency for several European countries. In this chapter, we will look at several ways in which we commonly deal with currencies, whether to invest, speculate or simply exchange on the spot for a vacation.


Of course, the exchange rate could work against you too. If the rate goes up to 1.7, then it means you’ll have to pay S$17,000 for US$10,000. You may be asking whether or not it is possible to “fix” the rate you pay one year ahead of time? By doing so, you will know ahead of time what rate you will pay exactly, thus removing the uncertainty of rates moving against you.

Fixing Rates Ahead of Time There are a few common ways to fix rates ahead of time. One way is to open a 12-month foreign currency time deposit by accepting the spot exchange rate that the bank is offering today. Of course, you would opt for this only when you are comfortable with today’s exchange rate and you don’t mind locking this in today. So if the US$/S$ exchange rate is 1.5 today, you would pay S$15,000 for a US$10,000 time deposit that pays interest in US$. In 12 months’ time when you need the money for your holiday, there will be no surprises — whether positive or negative. You will get exactly US$10,000 plus interest. If you did not fix the rate, then you would face the risk of the US$/ S$ going against you in the next 12 months to 1.7 or even higher, which means you would have to fork out more S$ for US$. Banks typically offer time deposits based on maturities of between one week and 12 months. If you need a more flexible time frame, you may consider a customised contract called a forward contract where you and the bank can agree to a schedule of fixed exchange rates, even for several periods into the future. Of course, the amount that you are dealing with should be big enough to interest the bank and you are also willing to accept whatever rates the bank is offering. For example, if you have a recently deceased wealthy relative from Australia who left you A$5 million and her will instructs that A$500,000 be transferred to you every six months for a total of 10 payments, then this might be a good situation in which to approach the bank to structure a forward contract to lock in a series of 10 exchange rates.

WHAT AFFECTS EXCHANGE RATES? The most fundamental factor that affects exchange rates is demand for the currency. If the demand for a currency is high, then the currency tends to be strong. So when you are trying to figure out whether the US$ is going to strengthen in the next 12 months, you need to find out if demand for the US$ is going to be strong or weak. Here are some rules of thumb on what cause currency rates to rise and fall. Bear in mind that rules of thumb work and make sense in general, but not all the time. We will use Singapore as a reference point: 1. Interest rates — If interest rates in Singapore go up, the demand for Singapore bonds, especially from overseas investors, would go up as well. This increases demand for S$ as overseas investors sell their currencies to buy S$ in order to invest. 2. Trade balance — If Singapore experiences a trade surplus, it means that it is selling (exporting) more goods and services than it is buying (importing). A trade surplus causes a strengthening of the currency as S$ is bought up in order to buy Singapore exports. 3. Commodity prices — Major commodities such as oil have a strong influence on currencies. A rise in the price of oil will positively affect the currency of an oil-exporting


What we just discussed is called hedging your currency risk, where you manage your risk by locking in an exchange rate today to buy or sell a currency in the future.


country such as Saudi Arabia and Canada, and negatively affect oil-importing countries such as the U.S. High global demand for non-oil commodities such as iron ore and wheat has also benefited major commodity exporters such as Australia. 4. Stock market performance — The overall direction in stock prices has an impact on currencies as money flows into countries with rising stock markets. This makes sense as a rising stock market is an indication that the country’s economic prospects are positive, and hence the greater the demand for the country’s assets and currency.

SPECULATING IN FOREIGN CURRENCY If instead you want to speculate and take on risk because you have a certain view about where a currency is headed, then you may wish to open a currency trading account. But do be very careful because currency trading institutions such as banks and brokerages are usually very happy not only to accept your application (typically if you have at least US$50,000 to start), but also to grant you a trading line that is five, 10 or more times what you deposit. For example, suppose your bank offers you a currency trading account with a trading line of up to 10 times the size of your initial investment deposit of a minimum of US$50,000. This means that you will receive a US$500,000 trading line. Such accounts are called leveraged accounts because you are able to trade using “borrowed” money. The risk of leveraged accounts is that they magnify your gains as well as your losses by the amount of leverage. If you obtain a trading line with a leverage of 10 times, then your losses and gains can be magnified 10 times. To see how this works, suppose you have a trading account with an initial deposit of US$50,000 and a leverage of 10 times. On

Exchange Rate

Buy

Sell

JPY 100 / US$1

JPY 50,000,000

US$500,000

Two possible outcomes can happen: Outcome 1: US$ Strengthens — You lose money On 1 July, the US$ strengthens to JPY 110. US$1 now buys more JPY or said another way, more JPY are now needed to buy US$1. Exchange Rate

Buy

Sell

JPY 110 / US$1

US$454,545.45

JPY50,000,000

Your loss is US$45,454.55 (US$500,000 minus US$454,545.45). This represents a loss of 91 per cent on your initial deposit of US$50,000. Had your account not been leveraged, your loss would be 10 times less or 9.1 per cent. Outcome 2: US$ Weakens — You make a profit On 1 July , the US$ weakens to JPY 95. US$1 now buys fewer JPY or put another way, fewer JPY are now needed to buy US$1. Exchange Rate

Buy

Sell

JPY 95 / US$1

US$526,315.79

JPY50,000,000

Your gain is US$26,315.79 (US$526,315.79 minus US$500,000). This represents a return of 53 per cent on your initial deposit of


1 June, you have the view that US$ will weaken against the Japanese Yen. You decide to buy Yen against US$500,000 based on a rate of JPY 100 = US$1 to be settled one month later on 1 July. On 19 March, you commit to buy US$ 500,000 and sell YEN for settlement on 19 April (1 month forward).


US$50,000. Had your account not been leveraged, your profit would be 10 times less or 5.3 per cent. Your potential losses and profits in foreign currency trading can be substantial because of the volatility of exchange rates and the leverage offered on trading accounts. And in certain cases, the losses can be extreme, a case in point being the foreign currency trading losses of SembCorp of US$248 million, which came about from just one individual. Not only were there exchange losses but also, its mother SembMarine shares, fell more than 15 per cent when the news broke.

CURRENCY UNIT TRUSTS If you still want to take on risk and benefit from currency movements, you can consider unit trusts that take positions on currencies. These funds are managed by currency specialists who follow the market very closely with research and analysis. They generate absolute returns in the sense that their returns are not correlated with stock market returns because currency movements can be independent of stock market movements. So, whether the stock market is headed up or down, currency funds are able to generate positive returns.

DUAL CURRENCY INVESTMENTS Suppose for the last few years, you’ve travelled to Hong Kong several times a year to shop, and each time you go, you visit the money changer to get HK$ for whatever the spot HK$/S$ rate is. The actual dates on which you travel are not known ahead of time and you’ve travelled on short notice a few times. You’ve set aside S$50,000 in your savings account for this purpose, separate from your other monies. You’re fine with this arrangement except that you get a very low return on your savings account. Also, you have to accept whatever the exchange rate is at the time you travel and the risk each time is that if the S$ falls in value, the HK$ becomes costlier to buy. The relationship manager (RM) at the bank calls you one day about a dual currency investment (DCI). From what she described,

S$50,000 X 4.8% X 1/12 = S$200 You next invest by choosing two currencies, one as the base currency (in this case, S$), and the other as the alternate currency (the HK$). You then select a suitable maturity date, ranging from a few weeks to up to six months; you choose one month. On maturity, you get paid in either the base or alternate currency, depending on which is the weaker currency when measured against a pre-determined exchange rate (called the strike price). To see how this works, say you invest S$50,000 at a strike price of HK$/S$ = 0.20. Note that this strike price is a value that you agree with the bank, and one that you are comfortable with if you had to exchange S$ for HK$. On maturity, suppose the S$ weakens or strengthens as follows:

TABLE 20.1. S$ SCENARIOS Scenario 1 Rate on maturity date S$ weakens to 0.25

Scenario 2 S$ strengthens to 0.15

Payout currency

Principal & interest to be paid in S$

Principal & interest to be paid in HK$

Principal + interest received

S$50,200

HK$251,000 (S$50,200 / 0.20)


In sum, if the S$ weakens against the HK$ as in Scenario 1, you would get an attractive S$200 worth of interest, which is far more than you would have achieved leaving it in your savings account. If the S$ strengthens as in Scenario 2, you get HK$251,000, based on an exchange rate of 0.20, which was an exchange rate you were


the DCI seems to fit your needs. First of all, it provides an attractive return of 4.8 per cent, which is far higher than what you are getting from your savings account. The interest earned based on a S$50,000 investment would be:


comfortable with at the start. And if you want to take advantage of the fact that the HK$ is now cheaper, you could buy more at S$0.15. Note that if you had not gone into the investment, you could have exchanged your S$ at a more attractive rate of 0.15. Based on an amount of S$50,200, you would have obtained HK$313,750 rather than HK$251,000, a huge difference of HK$62,750. With Scenario 2, you can actually lose quite a lot of money if you decide to convert the HK$ back to S$: HK$251,000 x 0.15 = S$ 37,650 This translates to a loss of S$12,350 or nearly 25 per cent. But again, since you do plan to have HK$ anyway, converting the HK$ back to S$ is not a consideration for you. Some financial commentators have written against DCI, calling them attractive investments that are without much bite. While the high interest rate is attractive, the rest of the deal is not attractive. If your foreign currency goes down (the HK$ weakens as in Scenario 2), you must take all the losses — but of course, only if you choose to convert the HK$ back to S$. But if the S$ weakens (the HK$ strengthens as in Scenario 1), you don’t get all the profits except a higher-than-market yield, 4.8 per cent in our example. So the bottom line is that if you are planning to speculate because you have a view on a pair of currencies, you would get limited profits with unlimited losses. But if you are comfortable holding money in either currency, and wish to earn an attractive return on your principal, then DCI may be suitable for you.

FINAL WORD As you have seen from the examples above, currency investing can be mind-boggling. But if you are a maturing and increasingly sophisticated investor, understanding currency products is a must. Having a globally diversified portfolio means that most of your money is invested outside, not inside Singapore. The reason you may not see


this is that, if you are a unit trust investor, the currency translations and movements are hidden away from you for convenience. Singaporeans are becoming more interested in direct investments in other countries and alternative investments such as real estate and wine. As you make more of such investments, you will need to deal with foreign currencies. Having a good understanding of what makes foreign currencies move is absolutely necessary.

PART

4

SPECIAL TOPICS We have covered a fair bit of ground in the first three parts, from basic investment concepts to investing in traditional and alternative products. In this last section, we turn our attention to special topics such as investing for kids, during retirement, your rights as an investor, and whether or not you should get professional financial advice. In the final chapter, we discuss what we can do to protect our portfolios more actively whether the market is in an upturn or downturn.

21 231

If you have young children like we do, you have probably already tried to get a sense of how much it will cost to send them to university. Unfortunately, by the time our children are ready for university, it is usually about the time we retire. There will be a tussle for money — should you provide for your kids first or for your own retirement? Parents have this perpetual set of worries: • How to pay for their kids’ university education? • How to teach kids about money and investment? We want to teach them to be financially responsible so that we won’t have to support them in our old age.

GOLDEN RULE OF INVESTING FOR KIDS Back to the question above — in the tussle for your money, who will win? Your kids, or yourself? Most of the time, you will give in to your kids and that will mean less for your retirement. Many people often go the distance for family members and forget to take care of themselves. When you are faced with the monumental task of saving for your child’s university education, it is easy to forget about saving for your own retirement. That is a big mistake. Saving for retirement always comes first. Your child’s education comes second. You and your child can figure out ways of getting him through school when the time comes, whether this be through loans, co-payment or some other means. What you want to avoid is find yourself broke after having taken care of all your children’s educational needs, thereby placing yourself in a position of dependency. So when putting together a strategy for your child’s education, consider these three steps:

Investing

Investing for Kids


1. Set a goal to save for up to two years of university expenses, and no more. 2. Every month, set aside the minimum needed for education funding and no more. 3. The rest of your savings should go into your retirement account. Remember: Do not give them everything. Make them work for part of it. By teaching them financial responsibility, you will be doing them a favour. So set them up for some personal accountability and let them learn how to fend for themselves.

HOW MUCH IS NEEDED? Whenever the newspapers report on how much it will cost to educate our kids, we get depressed. As far we can see, it will cost the equivalent of half a three-room HDB flat to educate one child in Singapore today, and one entire four-room flat if your child furthers his/her studies overseas. If you have two or more children, it will require putting aside more money than you could possibly afford. Tertiary expenses include tuition, books, travel and accommodation. How much does a basic four-year science degree cost all-in? Based on our compilation,1 the cost of a four-year science degree from a Singapore university was S$140,000 dollars in the 2010 academic year. Going to Canada, the cheapest overseas location popular with students, would cost $185,000. If we project an education inflation rate of six per cent, the cost of educating your child in Singapore starting in 2020 is $250,000. To send your children overseas, you’ll have to be a millionaire probably a few times over.

1

Basic cost information was taken from the 13 April 2010 Straits Times article “Fee hike unlikely to deter foreign students,” and then projections were made.

TABLE 21.1 COST OF FOUR-YEAR SCIENCE DEGREE Country 2010 2020 Singapore

$140,000.00

$250,000.00

Canada

$185,000.00

$330,000.00

Britain

$220,000.00

$400,000.00

Australia

$230,000.00

$410,000.00

USA

$320,000.00

$570,000.00

Source: Authors’ own compilation. Note: Figures are rounded to nearest five thousand and includes cost of living expenses.

Investing for University How you invest depends on when the money is needed. Assuming the university going age is 18, the nearer your child is to university, the less risk you can afford to take. Let us assume traditional investments such as unit trusts and bonds are used in the following examples: 1. Investing for pre-teens If your child is under 13, invest your money aggressively with as much stock funds as your risk tolerance allows. 2. Investing for teenagers By this time, you would have begun to switch gradually out of stocks and into bonds. You do not want to have too much money to stay in stocks in case there is a market tumble just before the money is needed. Table 21.2. (page 234) shows a framework for managing your asset allocation as time moves forward.

233 Investing for Kids

It’s not possible to project what it will cost exactly. But you can at least use the figures in Table 21.1 to obtain an idea of what your children’s education would cost, and it is hoped this will stir you into action.

234

TABLE 21.2. ASSET ALLOCATION IN RELATION TO CHILD'S AGE


CHILD'S <9 AGE

9

10

11

12

13

14

15

16

17

18

10

0

Stock funds %

80

80

70

70

60

50

40

30

20

Bond funds %

20

20

30

30

40

40

30

20

10

10

20

30

50

70

70

10

20

20

20

30

100

100

100

100

100

Short-term bonds % Cash % TOTAL

100

100

100

100

100

100

Source: Authors’ own calculations

Table 21.2. shows: • The exposure to stock funds gets lower and lower as time passes. • Bond funds fill the difference initially, but start to be drawn down as short-term bonds and cash increase as time passes. • We suggest short-term individual bonds that are held to maturity. Holding bonds to maturity offer a known yield and certain cash when the money is needed.

SOME OTHER MATTERS TO CONSIDER Here are some other options and matters to consider:

Borrow From Your CPF (Ordinary Account) Your child can borrow against your CPF, and pay it back as soon as he starts working. The scheme only covers full-time courses offered locally. What if your child decides not to pay up? Well, the CPF Board will actually take action to recover the money borrowed, plus interest. There are many conditions to satisfy, however, so please do your homework, or get financial advice.

Investments to Avoid

Teaching Your Kids about Investing In the old days, parents used to be able to rely on their children to support them in their old age. Things have changed. Because we marry later and have children later, it is entirely possible that by the time we retire, we will still be supporting our kids. We figure that the more financially literate our children are, the better off everyone will be.

Youngsters We have a friend Ken, who bought his eight-year-old daughter Sarah a piggy bank. Ken told Sarah that her university tuition cost is going to be shared 50-50, so she should start saving up part of her allowance. To give Sarah the incentive to save, Ken deposited twice what Sarah managed to save each day. So if Sarah saved $1, Ken would put in $2. When the piggy bank was full, Ken opened a POSB account. With the interest from POSB, Sarah learned that money that is wisely put away can grow. This was an important lesson. It took Sarah some time to get used to the new habit, but very soon, she was filling the piggy bank happily, jiggling it ever so often to hear if it was full. Think how absolutely thrilling it is for children to be able to watch their money grow!

Teenagers Most teenagers, if they have been exposed to the mechanics of saving, will sooner or later show an interest in investing. If your son

Investing for Kids

Cash value life insurance serves a great purpose in providing protection for the whole of your life. But as a savings tool, it just does not generate sufficient returns. Real estate is too risky for such a near-term objective. If you take a large loan and the market collapses, you may not even have money to cover the first year of your child's education.

235


has $2,000 in the bank, try signing up for a joint beneficiary account with one of the online fund distributors and buy a unit trust or two. Better still, let him choose which fund to buy and ask him why. Do not discourage him. Investment, like any other skill, is best learnt while young. You will soon see them going to the newspapers for the latest prices. Even if the chosen fund bombed out, they would have learned one of the most important rules in investing: that even the best investments may hit a snag.

ONE LAST THOUGHT Whether your child is five, 15 or 30, always discuss family investments in their presence. You don’t need a huge portfolio, but regular discussions will show the next generation that financial planning is fun and should be part of everyday life.

22 Investing During Retirement Contrary to what many people think, retirees need not make major changes to the way they invest. As they move towards retirement, they will have started to adjust their portfolios along the way by switching to bonds and withdrawing from riskier instruments. What is really important now is to find ways to satisfy their need for both income and growth, in order to meet their near-term and long-term needs. It is a balancing act. How is one to achieve growth, which is essential to meet rising future income needs, without taking too much risk? There are three main questions on their minds: • How much money can I safely withdraw? • How can I make my nest egg last forever? • How can I hedge my portfolio against inflation?

HOW INFLATION CAN CREATE AN UNHAPPY RETIREMENT When I hear retirees talk about how their portfolios consist mainly of fixed deposits, we cringe. Why? Because we know inflation will cause them to end up with less money to spend. Looking at history, we know that inflation has frequently been higher than fixed deposit rates. The fact is that while retirees need income and safety from their investments, they also need growth. Take a look at Table 22.1. (page 238) which shows how much living costs can increase over a long retirement, based on an inflation rate of 2 per cent. If you are not growing your money during retirement, how will you have enough to last you through your retirement years?

238

TABLE 22.1. LIVING EXPENSES DURING RETIREMENT ADJUSTED FOR INFLATION


Age Annual Living Expenses Adjusted for 2% Inflation 60

20,000

30,000 40,000 50,000

60,000

70,000

80,000

65

22,082

33,122 44,163 55,204

66,245

77,286

88,326

70

24,380

36,570 48,760 60,950

73,140

85,330

97,520

75

26,917

40,376 53,835 67,293

80,752

94,211

107,669

80

29,719

44,578 59,438 74,297

89,157

104,016

118,876

85

32,812

49,218 65,624 82,030

98,436

114,842

131,248

90

36,227

54,341 72,454 90,568

108,682

126,795

144,909

95

39,998

59,997 79,996 99,994

119,993

139,992

159,991

100

44,161

66,241 88,322 110,402

132,482

154,563

176,643


Let us go through an example. Suppose Daniel, aged 59, is getting ready to retire and he estimates that his living expenses in his first year of retirement will be $40,000. By age 80, Daniel will need $59,438 a year or 50 per cent more than he started out with. While inflation in Singapore has been low, it can quickly add up over a long retirement.

HOW LONG WILL YOUR MONEY LAST? This is the big question. Let us consider Table 22.2. (page 239) which shows the number of years money will last at a given rate of return, and a withdrawal rate. Table 22.2 shows that if your retirement dollars can earn 5 per cent a year and you withdraw 10 per cent of your money each year, your money will last 13 years. If you have $300,000 in your retirement fund, you can withdraw $30,000 per year for 13 years. Now suppose your buddy Joe invests his money at 8 per cent. He could withdraw 12 per cent or $36,000 per year for 13 years. That is $500 more per month. Keeping most of your money in a fixed deposit is not a good long-term retirement plan.

239

TABLE 22.2. HOW LONG WILL YOUR MONEY LAST?

5% 6 7 8

6

7

8

9

10

11

12

13

14

15

16

35

24

19

15

13

11

10

9

8

8

7

32

22

17

14

12

11

10

9

8

7

30

20

16

14

12

10

9

8

8

27

19

15

13

11

10

9

8

25

18

15

12

11

10

9

24

17

14

12

10

9

22

16

13

11

10

20

15

13

11

9 10 11 12 Source: Authors' own computations

SHOULD YOUR PORTFOLIO HAVE ZERO EQUITIES? Bonds are less risky than stocks. But that does not mean the retiree should invest 100 per cent in bonds. In fact, studies show that retirees should have a healthy amount of stocks in their portfolios, or about 20 per cent. While bonds are less volatile, they are not totally immune to volatility. A sudden rise in interest rates near the time you need the money can ruin your retirement party. By adding equities to your portfolio, you obtain: 1. Lower overall portfolio risk This sounds weird, but it is true. When you add riskier investments such as equities to your bond portfolio, you can reduce your portfolio’s overall risk. The reason is that equity and bond prices do not move together. The volatility of equities balances out the volatility of bonds. Together, they usually lead to a reduction of overall portfolio risk.

Investing During Retirement

Rate of Capital Withdrawal (% per year)

240

FIGURE 22.1. HOW EQUITIES AND BONDS TOGETHER REDUCE PORTFOLIO RISK


Equities

Bonds Portfolio becomes less volatile


2. Higher overall portfolio returns Equities will offer you the growth to counter inflation as well as increase your income for a nice, long retirement.

BEGIN YOUR RETIREMENT PLAN TODAY Now that you have some idea about what it means to retire, let us formulate a plan of action. First, begin by stating your number of retirement years. You obviously would not know how many years of life you have after 60. To be safe, expect to live till 90. So if you plan to retire at 60, you will have 30 years of retirement. Second, what lump sum will you have at retirement? Let us suppose you expect to have one million dollars. This amount invested at 6 per cent will last 30 years if you withdraw 7 per cent or $70,000 annually.

IF YOU HAVE NOT INVESTED MUCH — HOW TO CATCH UP You had wanted to start investing for retirement years ago. But monthly bills, unexpected expenses and your children’s education got in the way of a regular savings plan. Or maybe you are counting on your CPF money. But you now know that your CPF funds are not going to be enough to support you comfortably through 30 years of retirement. If you are now in your 40s or 50s and have yet to start building a retirement nest egg, you cannot afford to wait any longer.

Avoid “Get Rich” Traps The newspapers and internet are filled with get-rich, low-risk schemes. We have seen more than a few of our middle-age friends get hoodwinked by these schemes. Even when you are anxious, do not dispose of your common sense. With only 10 to 15 years till retirement, you need to choose investments that will provide growth potential as well as security. A balanced portfolio of 40 per cent in equities and 60 per cent in bonds would be a good start. If you are on a late start, don’t further endanger your future.

Consider Getting Professional Advice If choosing investments that strike the right balance between growth and protection seems too daunting for you at this time, you could benefit from the advice of a financial adviser. A financial adviser can help you choose funds, stocks and bonds, and help determine the most appropriate asset allocation to meet your retirement goals.

241 Investing During Retirement

Third, save and invest like crazy. None of us wants a scaled-down lifestyle during retirement. Stash the money aside today so that you can live it up during your retirement.

242

Finding the Money


Finding the money to invest is a big challenge because you do not have the luxury of time. Most likely, you would have to cut back on your current spending to find money to invest. Make a commitment to live more frugally. You do not have to go hungry, but you can go to fewer expensive restaurants, go for cheaper holidays and look out for bargains when you shop. If one of your challenges is funding your children’s university, consider getting them to take a loan instead. They will have a long time to pay it off , while you have a short time to prepare for retirement. If cutting your expenses is not finding you enough money, consider selling your car. It is one of the most financially draining things to own. You could also consider a second job. The income from a second job for a few years could get you back on track. And finally, consider postponing your retirement by five years. Working past your 65th birthday is nothing to dread when you need money. It can be fun especially when you have a job you enjoy.

23 243

You might be asking why we are talking about insurance in an investment book. Well the reason is simple. You have worked hard to build wealth and put your finances in order, and you don’t want to leave your financial security to chance. Saving, investing and planning for the future won’t mean much if an unforeseen event such as an accident or business failure leaves you financially devastated. This is where protection is needed. Like most people, you probably already have a fair amount of insurance to protect your home, income, health and life. You understand that while insurance may seem like an added expense in your budget, it’s necessary to your financial plan. You can insure almost anything under the sun, but certain things absolutely need to be properly insured. These include your life, health, car and home as indicated by the bottom layer of the pyramid shown below (see Figure 23.1.) We will assume that you have already taken proper care of those basic insurance needs.

FIGURE 23.1 INSURANCE: THE FOUNDATION OF FINANCIAL SECURITY EC SP UL N IO AT

Higher possibility of loss

IN VE IN

ST NG VI SA S

Principal is safe Save 6 months’ salary for emergencies

G

Principal not guaranteed Diversify your Investments

IN SU RA NC

Foundation of your Financial Security Protect your life, health and wealth

Protecting Your Wealth with Insurance

Protecting Your Wealth with Insurance

E


The type of insurance we are discussing in this chapter deals with protecting wealth that you already have acquired. That’s right. We are assuming that you are affluent with a fair amount of wealth accumulated or you are steadily on the way to becoming financially comfortable. In fact, even if you are still busy building wealth for your financial security, the insurance concepts in this chapter will be useful to you too.

CAN YOU IDENTIFY WITH SALLY? Sally has spent years taking risks and attaining wealth, and now at age 50, she is looking for ways to preserving her wealth while earning a good return without incurring major losses. Affluent individuals can easily identify with Sally’s situation. After achieving success in their careers and businesses, they begin to have this increasing desire to protect what they have accumulated. The reasons for protection usually range from wanting to pass on as much wealth as they can to their families to funding a charity. They want to meet these goals without causing a huge drain in their wealth or affecting their ability to continue their present lifestyles. For these reasons, affluent individuals like Sally should consider life insurance; a vital component of their long-term planning.

INTRODUCING UNIVERSAL LIFE These days, affluent individuals have an insurance tool called Universal Life (UL) insurance. One of the best ways to understand UL policies is to compare it to Term and Whole Life (WL) policies, which you are likely to be familiar with — see Table 23.1 (on page 245) for a summary of differences. Universal life insurance is a form of “interest sensitive” type of WL that offers a death benefit, and because of its flexible premium feature, it provides the opportunity to build cash values that the policy holder can borrow from or withdraw. The policy cash values earn interest at a declared rate, which may change over time. Most

TABLE 23.1. SOME DIFFERENCES BETWEEN TERM, WHOLE LIFE AND UNIVERSAL LIFE INSURANCE Term Insurance

Whole Life

Universal Life

Duration

Fixed such as 10 or 20 years.

Permanent, all of life.

Permanent, all of life.

Premium

Usually fixed.

Guaranteed fixed.

Flexible.

Cash Value

None.

Projected cash value.

Guarantee minimum interest crediting rate.

For those who are conservative savers and want protection all of life.

For those who want a large amount of protection and access to cash values that grow at competitive interest rates.

Suitable For those who for Whom seek pure protection for a fixed period and because it’s affordable.

245 Protecting Your Wealth with Insurance

UL plans guarantee a minimum interest crediting rate. Within certain limits the policy holder can choose the amount, method and timing of the premium, payments. There are three areas where UL differs from WL. Firstly, UL insurance offers a more transparent fee structure. That means you will be make known of the cost and how much you are paying. It also allows you to know how much you will be earning from the policy. Secondly, the policy can be surrendered at any time and access to cash values that grow at competitive interest rates. Thirdly, UL policies have sums assured typically in the millions of dollars. For families of the affluent, the only thing more challenging than attaining wealth is protecting it, keeping it for a lifetime and for the next generation. This is where UL can help you by providing a solid tool in preserving your wealth. UL is a relatively predictable asset since the amount of death benefit is usually guaranteed. It also serves as form of diversification to other investment assets. This means that despite the occasional declines in the stock and bond market the value held in a UL policy may remain unaffected.


Let’s now turn to two situations in which affluent individuals can use UL insurance to protect their wealth. We look at Kim, a business owner, and John, who wants to leave a donation to his favorite charity when he passes away. Kim the Business Owner Kim left her IT job when she was 35 years old to strike out on her own. She set up SoftTech to sell IT services to multinational companies. Fifteen years later, Kim’s company has an annual turnover of $50 million and a healthy looking balance sheet with $15 million in net assets.

TABLE 23.2. SOFTTECH’S BALANCE SHEET ASSETS (in Millions) Cash

LIABILITIES (in Millions) 5

Accounts receivables

10

Commercial property

25

TOTAL ASSETS

40

Accounts payable Property loan

5 20

TOTAL LIABILITIES 25 NET ASSETS

15

SoftTech has total assets of $40 million of which $5 million is in cash and $10 million is owed by customers. Kim bought a commercial property worth $25 million a year ago. It has a $20 million loan outstanding against it. SoftTech owes its suppliers $5 million. Overall, the company has net assets of $15 million. With such a glowing set of financials, Kim felt at ease since $15 million would surely take care of her family, employees and the business should something happen to her. What’s more, she exercised regularly, ate well and was very healthy. One day while driving to work, Kim became physically disabled from an accident. Her mental abilities deteriorated and she was unable to run the company like before, and subsequently died from the accident. She had not appointed or trained a successor. The

John Leaves a Legacy to His Favorite Charity Affluent people are some of the most generous givers to charitable causes. To them, giving back can be one of the most fulfilling experiences of their lives, but they want to do so without wrecking their retirement plans. This is where life insurance can help.

247 Protecting Your Wealth with Insurance

company’s creditors and customers lost confidence in the company. Suppliers demanded to be paid. The commercial property market sank, and the property’s valuation fell below the loan amount — the bank called for $5 million to be topped up. In this situation, there may be little choice but to sell the company’s assets very quickly at fire-sale prices in order to generate liquidity to pay off creditors. Business owners like Kim really do need to have business continuation plans in place from day one, and life insurance is one of the most cost-effective ways of funding such plans. Yet business owners often shy away from insurance. When Kim first took out a loan to buy the commercial property, her financial adviser recommended life insurance to pay off the loan in case she passed away or became disabled before the loan was paid off. Kim not only felt she had enough money, but that life insurance was expensive and an unnecessary cost to incur. She believed that should she pass away, her family could sell or liquidate the business to cover the loans and provide financial security for them. In reality, this rarely happens. When the family is forced to sell the business quickly, they may have to sell at a discount or may experience poor market conditions that make the business less attractive. In most cases, the business is worth very little without the founding owner around. Individual life insurance can protect your family by providing funds to cover debts, ongoing living expenses, and future plans in the event that something happens to you. Insurance can also protect the business by helping to make up for lost sales and earnings, and to cover the cost of finding and training a replacement.


Suppose John wants to give away a sum of $1 million to his university but does not have the liquidity to do so today. He can buy a life insurance policy and make his university the beneficiary of his policy. The price of a $1 million UL policy for a 40-year-old male nonsmoker would typically cost a one-time premium of around $250,000. In other words, John’s university will receive his desired donation of $1 million upon his death and he need only fund his donation with about 25 cents to the dollar today.

CONCLUSION UL policies have a place in your portfolio even when you are affluent. But before you buy a UL policy, there are a few questions you should keep in mind. 1. Do you need such a policy? Go through a thorough fact find with your financial adviser to examine your financial situation and life goals. 2. What happens to your policy if market conditions become extremely poor? Are there guaranteed returns or might you be expected to pay higher premiums? 3. Where is the policy is administered? Is it onshore in Singapore or offshore in another country? Some people prefer UL policies administered in Singapore so that they are subject to the rigorous regulations of the Monetary Authority of Singapore regarding the arrangement of life insurance policies. If your policy is administered offshore, you need to be aware of any jurisdictional risks found in that country. You also have to consider the proximity to after-sales services. Remember that it’s a permanent policy and you will probably use the flexibility of UL policies to make adjustments as your circumstances change.

24 When Things Go Wrong You went to the bank to deposit money into your savings account. While there, a relationship manager tried to interest you in an Asian unit trust. Despite being new to investing, you were won over by the relationship manager’s convincing presentation. You decided to invest the money that was meant for your savings account. One month later, the price of the unit trust falls 30 per cent. You’re very upset. You feel you should not have bought the unit trust. You think the relationship manager pressured you into buying. This is a common story — investors losing money from investments that have gone sour. What can you do when things go wrong? While there will always be cases of unscrupulous salespersons who take advantage of unwary consumers, the fact is that many of us are capable of making appropriate investment decisions. There are countless opportunities to pick up investment tips, including the many educational programmes and seminars sponsored by the government as well as investment companies. You can learn more from consumer guides, TV programmes, newspaper articles, web tools and other seminars.1 Fortunately for consumers, most financial services companies — banks, financial advisers, insurance companies and stock brokerages — are fair and even-handed in their dealings with the investing public. Constant scrutiny by the media and regulatory watchdogs such as MAS have contributed to this practice of fair dealing. In this chapter, we will discuss your rights as an investor and what you can do when things go wrong.

1

Visit MoneySENSE at www.mas.gov.sg

250

YOUR RIGHTS AS A SHAREHOLDER


As a shareholder, whether you own 1,000 shares or 10,000 shares, you have certain rights. You own part of the company and the company’s management board is answerable to you.

The Right to Information One of your most important rights is that the management keeps you informed about the progress of, and the material developments that affect the company as it is required by law to do. Of course, the law has to strike a balance. You should understand that disclosure aims to put you on equal footing with every other investor, big or small, and that even the most transparent disclosure provides no guarantee against loss.

The Annual General Meeting (AGM) The annual general meeting (AGM) is an important occasion for shareholders, especially minority ones, to meet and ask questions. Attending the AGM is something few investors do although it is one of the basic rights that come with stock ownership in a public company. Every investor should attempt to attend annual meetings as they give a clearer insight into how the affairs of companies are conducted. Looking at the glossy pages in an annual report or the numbers in the financial statement seldom gives a clear understanding of the management’s style and objectives. If you are investing a large sum of money in a company, it makes sense to meet the management team face-to-face for they are the ones who will ultimately determine the returns on your investment.

The Proxy Statement The proxy statement is a document that a company is required by law to provide to shareholders containing information that will be brought up at the AGM.

WHEN SOMETHING GOES WRONG Most problems investors face fall into one of two categories. The first consists of outright criminal activity such as stealing and cheating of money through some sort of scam or phony transaction. If the investment was related to securities, you should contact MAS or the police. The second and more common category of problems encountered by individual investors has to do with the execution of a trade, or the way an account was handled. For example, you may be surprised to receive a confirmation via e-mail about a stock you have sold, although you never gave such an order. Or you may be surprised at the price at which your unit trust was sold when you had told your financial adviser to transact at a distinctly higher price. Most financial advisers and institutions are honest and fair in their dealings with investors. Errors that occur are simply errors

251 When Things Go Wrong

There is usually a section on the voting of resolutions, which may include issues such as approval for financial statements, declaration of dividends, proposals for additions to the board of directors and remuneration for auditors. In essence, a proxy statement is a ballot sent to a company’s shareholders whereby the company requests that shareholders vote in favour of its officers and directors continuing in their positions. A proxy also provides for a negative vote. As a shareholder, you can vote against re-electing the present management. It is generally difficult for individual shareholders to get rid of the existing management unless it has openly performed flagrant acts such as fraud. Hence, it is not uncommon for a law-abiding, but mediocre management to continue running a public company for a number of years, particularly if ownership of the company’s shares is fragmented. So unless you own a substantial amount of shares (5 per cent or more), your best option, if you feel a company’s management is doing a poor job, is to walk away by selling your shares.


and there is rarely an intention to cheat. Such errors are generally corrected as soon as they are brought to the attention of the company representative who sold you the investment.

Where to Turn for Help Should you still feel that you have been unfairly treated, there are several ways to seek redress. You can submit an official letter of complaint to the financial institution. If this does not resolve your problem, you can consider a dispute resolution scheme.2 The Financial Industry Disputes Resolution Centre Ltd. (FIDReC) is an independent institution specialising in the resolution of disputes between financial institutions and consumers. FIDReC was created from the merger of the Consumer Mediation Unit (CMU) of the Association of Banks in Singapore and the Insurance Disputes Resolution Organisation (IDRO) to streamline the dispute resolution processes across the entire financial sector of Singapore. FIDReC provides an affordable and accessible one-stop avenue for consumers to resolve their disputes with financial institutions without having to go to court, which is a costlier and more timeconsuming option. For example, consumers can go to FIDReC in the following situations: 1. For claims between insured consumers and insurance companies: up to S$100,000. 2. For disputes between banks and consumers, capital market disputes and all other disputes (including third party claims and market conduct claims): up to S$50,000. At present, FIDReC’s services are available to all consumers who are individuals or sole-proprietors. Consumers pay a 2 For a more detailed explanation on dispute resolution, please see “Getting it Right: How to Resolve a Problem with your Financial Institution”, a MoneySENSE Consumer Guide at www.mas.gov.sg.

3 For more information, please visit these websites: www.mas.gov.sg; www.case.org. sg; www.sias.org.sg; www. sgx.com; and www.fidrec.com.sg

253 When Things Go Wrong

nominal administrative fee of S$50 when their cases proceed for adjudication, and the financial institution pays S$500. You may even go one step further by seeking the help of a panel of mediators appointed by FIDReC. The panel will give you access to a pool of industry experts and professionals. The panel has the authority to order the financial institution to do certain things, such as perform their contractual obligations or make monetary awards. Its rulings are binding on the financial institution, but not on you. If you do not accept the panel’s ruling, you can choose to pursue legal action or approach the Consumers Association of Singapore (CASE), the Singapore Mediation Centre (SMC) or the Small Claims Tribunal (SCT). These organisations handle disputes across all types of products and services, and not just those on financial matters. In general, taking legal action should be the last resort as it is usually time-consuming and costly. If you have a problem with your remisier, you can approach Securities Investors Association of Singapore (SIAS) Disputes between retail investors are handled by the Dispute Resolution Committee whose members meet from time to time when complaints are received. Not every complaint is heard by the committee. If the complaint is justified, the committee will seek a cordial settlement with the broking house concerned. If the complaint is serious and it contravenes the bye-laws of SGX, the matter is referred to SGX. As with FIDReC, legal action is avoided.3

25 Getting Financial Advice Are you a DIY (do-it-yourself ) investor? Or do you prefer to work with a financial adviser and let him help with the analysis? As it turns out, your answer could very well depend on market conditions. If you were invested in the U.S. market between 1995 and 2000, your answer would have been “no”. That is because during that time, the S&P 500 tripled in value, from 500 to 1500 points, offering a very nice return of 25 per cent annually over five years.

FIGURE 25.1. S&P 500 BETWEEN 1985 AND 2010 2000

1500

1000

500

0 1985

1990

1995

2000

2005

2010

Source: Standard & Poor’s

As the market rose, people started to liken the market to a moneymaking machine. In such an euphoric environment, according to a survey, investors felt that financial advisers were unlikely to be able to add further value.

DO YOU NEED A FINANCIAL ADVISER? Before deciding whether you need a financial adviser, answer these two questions: 1. Are you worried about how to handle market volatility? Markets will sometimes go crazy. Have you a game plan when that happens? 2. How much time are you willing to spend constructing and monitoring your portfolio, as well as following the market and reading up on new products? If these questions make you feel uneasy, or suggest that you could use some help, a financial adviser can be a great ally. Working with a financial adviser offers three important benefits: 1. Time Investing on your own takes time. This is time that is taken away from your family, your work and hobbies. Some of the smartest people around have financial advisers. Daniel Kahneman, who shared the Nobel Prize in Economics with Vernon L. Smith in 2002, admits that he gets advice from his financial adviser. 2. Discipline Financial advisers use a structured process to manage your investments. Every six months, or at some fixed interval, your adviser will meet you to update you on your portfolio and the

255 Getting Financial Advice

By 2003, when the S&P fell 50 per cent, many investors lost large fortunes. A second survey done by the same company then found that over 90 per cent expressed interest in working with a financial adviser.


market. If your adviser is worth his salt, he will also consistently nag you to invest smartly to keep you on track. 3. Expertise Financial advisers have the expertise that most investors may not have to do an effective job. This is not to say that investors are not capable of attaining this expertise. We have spent chapters of this book saying you can. But the fact is that financial advisers have made the commitment to attain a level of expertise that most investors are not willing to make. Financial advisers go through rigorous exams to get licensed. Some financial advisers even take professional exams to get more expertise. As a result, they have the latest knowledge of the markets, products and solutions to help you.

ARE ALL CERTIFICATIONS CREATED EQUAL? If you have trouble sifting through the alphabet soup to tell the difference between a CFA, ChFC and CFPCM, here is some help. Below is a list of five popular designations and what each one does: Chartered Financial Analyst (CFA) This is the Rolls-Royce designation for investment professionals. A CFA holder is a specialist and he has to demonstrate competence by passing exams on accounting, economics, money management and security analysis. CFAs tend to work with institutions rather than directly with individuals. Certified Financial Planner (CFPCM) A CFPCM holder has overall expertise in personal financial planning in these areas — risk management, insurance, tax,

Chartered Financial Consultant (ChFC) The ChFC is similar to the CFPCM. The ChFC holder has also not demonstrated specialist knowledge in any one area. Where they differ is that the ChFC requires the candidate to pass two more exams compared with the six the CFPCM candidate has to take. The two exams deal with planning for business owners and wealth management. Chartered Life Underwriter (CLU) This designation is for a specialist in insurance. Certified Public Accountant (CPA) CPAs are specialists in tax and accounting. Their title does not indicate training in other areas of financial planning.

How Meaningful are These Letters? Certifications are a mark of professionalism. A professional has gone the distance to acquire expertise. He conforms to a strict code of ethics to provide advice for your benefit rather than his own. Certifications are conferred on individuals with a certain number of years of relevant work experience. This ensures that the ChFC or CFP sitting across the table is not fresh out of school. While certifications are not everything, you should give credit to an adviser who has any of these designations. Many of these certifications require many hours of study to meet high standards.

WHERE DO FINANCIAL ADVISERS COME FROM? There are some 13,000 financial advisers in Singapore and they come from two main sources:


estate planning, investments and retirement planning. Unlike a CFA holder, a CFPCM holder has not obtained the knowledge to be a specialist in any one area.


1. Financial advisers who are “tied” to a specific company and its products Tied advisers such as those from Prudential and AIA can only sell financial products created or distributed by their companies. If you are looking for an investment product, your AIA adviser can sell you only products that AIA distributes. Tied advisers usually come from four large companies — besides Prudential and AIA, there is also Great Eastern and NTUC Income. There are about 12,000 tied advisers in Singapore. 2. Financial advisers who are not tied to a specific company and its products These untied financial advisers can advise and sell you products from several product manufacturers. So if you are looking for an investment product, an untied FA will have access to many of the fund management houses in Singapore. There are around 30 untied companies in Singapore with about 1,000 advisers in total. Does this mean that you should only go with untied financial advisers who can offer you products from many companies rather than a tied financial adviser who can offer products from only his company? This is a huge, ongoing debate that is not about to cease. Depending on which side of the fence an adviser sits — tied or untied — you will hear an impassioned endorsement for the side he sits on. This is the bottom line — products do not make the valued adviser, good advice does. If you take the trouble, you can buy many investment products directly on your own. Products are always available, but not good advice. One study by CEG Worldwide in 2003 by Russ Alan Prince, a renowned researcher on the wealthy in the U.S., showed that investors are generally starved of good advice and that a mere 26.7 per cent of investors surveyed were very satisfied with their current advisers. The remaining three-quarters regard

FINDING A GOOD ADVISER Just what should you look for in a good adviser? Here are three “must-have” factors to look out for.

The Adviser is Licensed Financial advisers are licensed by the Monetary Authority of Singapore when they pass the required regulatory exams and are registered as advisers with a financial advising company. Registered financial advisers have a fiduciary responsibility to provide financial advice that is in your best interest. They typically have to sit you down and take you through the seemingly tedious process of answering questions from a form called the Financial Needs Analysis. It would be silly of you to take this lightly. The questions help you and your adviser learn about your financial objectives and risk profile — two critical components to finding suitable investment products for your portfolio. Just as your doctor would not know what is wrong with you unless you tell him, your financial planner will not know how best to help you if you do not tell him your financial goals.

Comfort Zone If you come across an adviser who annoys you no matter how clever he is, you might want to drop the fellow. While you and your adviser need not be soul mates, you need a basic level of comfort and rapport to get anything done. When we present lectures to financial advisers on investing, we convey this important message — it is not worth the money to work with a client that you do not like, or do not get along with.


their advisers as “fair” or “poor” and are willing to work with someone else.

260

Making Sense


Do you generally agree with how your adviser thinks? Or are you always arguing with the recommendations your adviser makes? The fact is that if you are always in disagreement with him, there is probably some fundamental difference between the way both of you think. Whether you or your adviser turns out to be right in the end is secondary. What matters more is that you and your adviser have a fundamental difference in thinking about an important issue — how you manage your assets.

PREPARING TO TALK TO YOUR FINANCIAL ADVISER Financial advisers cannot make decisions for you. You give them the facts, they offer advice and you have to decide what to do. It is a mistake to assume that they can take away the risks and make predictions. That is why it is a good idea to do some preparation before you meet. If you only have 10 minutes to spare, here are five questions we recommend you ask: 1. Do you invest yourself? Tell me about your investing experience. 2. What kind of expertise does your company have to help me? 3. How are you being paid to give me advice? 4. How can I lose money if I follow your investment plan? 5. What problems can I face if I need my money back earlier?

HOW DOES YOUR ADVISER EARN WHEN YOU BUY INVESTMENTS? Your adviser earns from the investments you buy. He could earn from upfront, one-time-only commissions, or he could earn

TABLE 25.1. TYPICAL PAYMENT MODES FOR ADVISERS Commission Upfront commission Recurring fee structure Traditional commission-based

5%

None

Recurring fee-based

2%

1%


Example of Traditional Versus Recurring Fee Structure The traditional commission-based adviser gets paid a lump sum when investment purchases are made. These purchases can be either outright new purchases or switches (where you sell out of one investment and buy into another one). The recurring fee-based adviser often charges a lower upfront fee, plus a low, recurring annual fee based on the value of the investment assets under advisory (AUA). For example, your adviser may charge you an upfront 2 per cent (as opposed to 5 per cent) and subsequently on an annual basis, he charges you 1 per cent based on AUA. You will see that it will take about three years before you will have paid a total of 5 per cent (2 + 1 + 1 + 1) in terms of fees. In the meantime, you can evaluate whether your adviser is doing a good job or not. Your adviser does well when your investment portfolio does well. So he has the incentive to do a good job over many years rather than just during the first year. If you are planning to pay your adviser annual recurring fees, do ask about a wrap account. Wrap accounts offer free switching. When you sell one investment and buy another within a wrap


a recurring fee based on the amount that you have invested with him. What? Keep paying your adviser year after year? If that sounds crazy to you, then you will be surprised to hear that this is actually becoming a popular way of managing investments.


account, it will not cost you any money and your adviser does not earn from the switching.

Paying for Financial Advice You have found your ideal adviser. He is competent, has a team of experts and he even has a great sense of humour. Would you pay him a fee for financial advice? NTUC conducted a survey in 2002 and found that seven out of 10 people were not willing to pay for financial advice. Are you one of the seven? Suppose you have $100,000 to invest. Here are two questions you should ask yourself: 1. Would you value free financial advice? Imagine going to a dentist who says he will not charge you for the time and advice he gives you. You will be worried if he might pull your teeth out to sell you dentures. You see, paying a fee helps ensure that the financial adviser does his best. 2. Would you be doing the best for yourself? Suppose you want to learn Chinese. Your colleague offers to teach you for free every Saturday afternoon. Good deal? Bad deal. When things are free, you just will not take things as seriously. When you pay a fee, you take greater responsibility for your own affairs.You will ask better questions. You will keep better records. You will take greater interest in what is being said and done. Your financial adviser will serve you better if he is paid. There are exceptions, of course, because paying a fee does not make sense in certain situations. You may know exactly what you want — for example, a mortgage. Or the amount may be small — you want to invest $2,000 in a balanced fund. In both situations, a simple product purchase will do the job. A fee is not paid for any advice, and the financial adviser earns a commission from the product sold.

ARE YOU A GOOD CLIENT? A lot of the success of an investor has to come from the investor himself. Sure, we know that financial advisers have a responsibility to act in a prudent manner with regard to your money. They have to go through a fact find with you, ask a zillion questions and then crunch all sort of numbers. But how prudent are you yourself in making sure you succeed with your financial objectives? Let's look at three activities that will help you help yourself — and better your relationship with your rep. 1. Keep Up-To-Date Records — Do you keep your investment accounts in a special file or do you put them anywhere you can stuff paper, such as under your car seat or your messy work table? Do you even know what investments and insurance policies you own? You’ll be surprised how many people don’t even know this. 2. Take Detailed Notes — When you communicate with your adviser on the phone, via email, or in person, take notes. This


As a rule of thumb, paying a fee makes sense when the amount invested or managed is large, such as $100,000; the situation is complex enough that analysis and advice are needed, such as creating a comprehensive financial plan; or the objective is a longterm one that requires regular monitoring and adjustments, such as managing a portfolio of investments for your retirement. What is generally true is that many of our financial needs are long term and they have to be managed over the course of our lives. We need a structured process to look after these matters. In return for getting a regular dose of good advice, you should consider paying a regular fee. Your financial adviser may give you good advice for free today, but he may not be around too often to help you in future. Be mindful, though, that paying for advice does not necessarily mean you will get good advice.


will give you a hard copy of the experience, and if you are not so savvy with investments, you will have your notes to reflect on and learn. And if there is ever a conflict between you and your adviser, these notes will serve as evidence of what transpired. 3. Track Commissions — Commissions can take a big bite out of your investment returns, and can be very painful when the market is going down. So make sure you are being charged what you are supposed to be charged. Don’t assume that just because your financial adviser uses a large, fancy computer programme to generate reports, mistakes can’t happen.

THE BOTTOM LINE One of our mutual friends who is a very successful adviser was asked how he became so successful. He replied that 25 per cent of his clients were, in his words, super-charged investors. They would constantly hound him for information, question his advice, expect regular updates on the economy, and quite often, even give him really useful insights on investments. His super-charged clients keep him on his toes and as a result, he does know more than other advisers. Are you a super-charged investor yourself?

26 Protecting Your Portfolio in Downturns and Upturns We have advocated many of our long-held beliefs about how successful investing should be carried out in this book: • Place most of your retirement funds into a diversified portfolio. • Buy and hold because you can’t time the market. • Get a professional to help you. If you have done this throughout the years running up to your retirement, you will have done fine. When the subprime crisis began unravelling, many people found their portfolios drop by 30-50 per cent in a matter of a few months. In the five months between October 2007 and March 2008, the STI fell over 1,000 points. If you were one of the unfortunate ones whose portfolio fell by 50 per cent or more, here are three points to consider: 1. Your portfolio will now have to rise by 100 per cent in order for it to go back to its pre-crisis level.1 2. Where was your financial adviser when all this was happening? 3. What can you do to make sure you don’t get into such a mess again?

1 If you had a $100,000 portfolio that fell by 50 per cent to $50,000, your portfolio would have to go up 100 per cent in order to get back up to $100,000.


Let us take the first point. With a 100 per cent climb ahead, you would be asking when your portfolio would regain its value and continue its long-term upward trend. We’ve seen that markets do adjust quickly and with more governments working together to avert and manage disasters, it might even be faster. But suppose you don’t have the time because you were planning on retiring when the crisis hit. Or your children are going to university next year, and you just lost two years of tuition fees. This would be a very bad situation to be in and not uncommon at all whenever a crisis hits. Now what if you do have time to recover because you’re still young? Well-meaning financial advisers are apt to say that given time, your portfolio will recover, so don’t sell … hold. Well, you may be surprised to know that this does not work all the time and when it does not work, the pain can be excruciating and last a long time. Look at the STI during these two periods: Year Level 1996 2400 2006 2400 The STI hit 2400 in 1996 on the heels of the Asian financial crisis. While the STI recovered to pre-crisis levels in 2000, it didn’t go much higher than the 2400 level. It was only in 2006 that the STI went appreciably beyond 2400. You see, even when you have time on your side, you may also have pure bad luck. The next question is how well your financial adviser served you during this time. Did he contact you when the crisis hit or did he hide away to avoid your anger? Did he have the ability to distinguish between safe and unsafe market conditions?2 And even if he did, would he have asked you to liquidate your positions when the crisis hit? 2 Judging from their huge multi-billion losses, you’ll see that the largest banks in the world had a tough time figuring this out too.

PROTECTING YOURSELF IN AN UPTURN There’s no typo here. Many people get euphoric and blind when the market is doing well. They get into riskier instruments, ignore their financial advisers, give everyone they meet investment tips and throw their long-term asset allocation down the canal. When your portfolio is rising in value, there are a few things you can do to keep it structurally safe.

267 Protecting Your Portfolio in Downturns and Upturns

Probably not. Financial advisers and financial institutions rarely emphasise selling strategies. Everyone from banks and brokerages to private bankers and financial advisers all emphasise buying strategies. And once you have bought, they try their best to have your funds stay with them since assets under management (AUM) are a recurring source of income for them. Even when prospects for an investment have turned very poor, advisers rarely downgrade its rating from “buy” to “sell”, but instead downgrade them from “buy” to “neutral”, or from “buy” to “hold”. Tune in to the business news to listen to analysts and corporate executives, and try counting the number of buy versus sell recommendations. Professional advice is often tainted by conflicts of interest and you have to understand that. In the end, we all need professionals to do the things we cannot do, but you have to keep both eyes and ears open. The important rule is that you really can’t trust anyone 100 per cent, not even your own spouse or your parents, to monitor your portfolio the way it should be monitored. It is you who has that ultimate responsibility. So the question really is, “Where were you when the market was falling?” Did you keep up with the news? Did you contact your financial adviser? Did you speak to your friends in the know about what was happening? Did you take care of your own financial well-being? Finally, what can you do to avoid such situations in future? We will examine this very question the rest of this chapter.


1.Rebalance your portfolio regularly When your stock allocation rises above the recommended longterm allocation, rebalance the portfolio. If stocks have outpaced bonds, it means you should sell stocks and buy bonds to return your portfolio to its long-term allocation. Buy-low, sell-high always works. Studies show that rebalancing not only produces better results than not rebalancing, but also reduces your portfolio’s risk. 2. Try a short-term momentum strategy One criticism of rebalancing is that you are selling investments before they reach their highest point. Here’s an alternative. Studies have shown that when funds do well in the recent past, chances are that they will do well in the near future as well. This is a short-term momentum strategy of “buying high” that appears to be quite opposite to the buy-low sell-high tactic of rebalancing. According to a study by Gerald and Marvin Appel, it was found that funds with above-average performance during a three-month period have a better chance of returning aboveaverage profits during the subsequent three-month period.3 They showed with the help of ETFs how they were able to outperform the underlying benchmarks consistently with this momentum approach. This is a strategy we can carry out quite easily by simply switching into the top-performing funds within a category every three months. What this would entail for you for Asia ex-Japan funds, for example, is to access www.fundsingapore. com every three months to find out which funds outperformed and to switch into that fund, and to do this every three months. You should try this only if you are prepared to monitor your portfolio regularly. We have not back-tested this strategy on our regional markets although we believe it makes sense because 3

“Beating the Market, 3 Months at a Time,” by Gerald and Marvin Appel.

3. Redo your risk profile once a year Your risk profile is meant to be a long-term indicator of an appropriate asset allocation. If you are deemed an aggressive investor, then your asset allocation should reflect that view accordingly with larger amounts of stocks versus bonds in your retirement portfolio. You should still do your risk profile once a year, particularly when you are at the threshold of the next risk level. For example, if you are planning on retiring soon and your risk profile was done three years ago when you were deemed an aggressive investor, you should redo your risk profile right away and make any necessary adjustments to your asset allocation. Long-term indicators can change from year to year for short periods of time. For example, suppose: • You just won a huge lottery. • You and your spouse are expecting twins. • You contract a rare disease and the doctor says you need 12 months to recover. • Your apartment went en bloc. • Your daughter won a university scholarship. • Your retirement portfolio lost 50 per cent this year. These negative and positive situations are not remote at all. They happen all the time and they are unpredictable. Do hang on to your long-term asset allocation, but please do your short-term checks


when securities are on an uptrend, they tend to remain on that trend for some time.


also. Unexpected short-term events can permanently alter your long-term plans.

PROTECTING YOURSELF IN A DOWNTURN The market is falling. If you want to be more active about managing your portfolio, and not just buy-and-hold, here is a list of strategies you can consider: 1. Sell your holdings and move to cash This is not our favourite recommendation because it means incurring selling costs and moving your funds into cash that earns you less than the inflation rate. 2. Stay diversified You should do this without question. 3. Move into more favourable sectors in small steps This requires some monitoring. If the U.S. is faltering and China is hot, then reallocate five per cent to China or an Asian investment. If stocks are doing poorly, reallocate five per cent more to commodities or to bonds. We recommend that you do such active reallocation in small steps and such that your portfolio is not completely out of sync with your long-term plan. 4. Buy quality Buying quality such as blue chip stocks is a defensive move that works regardless of market conditions. So don’t wait for the market to be in a downturn before you invest in quality. 5. Buy absolute return investments Hedge funds are a good choice as they focus on absolute returns. If you are not an accredited investor, then there are quite a number of absolute return unit trusts available in Singapore. While hedge funds can short-sell stocks, use

6. Invest in commodities As stocks are falling, commodities have been rising. Not only is there a low correlation between stocks and commodities, commodities have provided good protection against inflation. 7. Sell derivatives If you want to protect your Singapore portfolio, for example, you could short sell STI futures. In the event of a market downturn, your losses from your actual portfolio can be compensated by the gains from your short futures position. 8. Invest in the market through ETFs This will save you expenses when you are in a tight spot although you will have to accept that ETFs are not expected to outperform their benchmarks. You see that many of the protective steps you can consider taking — whether the market is in a downturn or upturn — may be outside the expertise of your financial adviser, or outside the scope of products the financial institutions he belongs to offers. We’re not suggesting that you have four or five professional advisers to advise you on your portfolio. After a certain number, too many cooks will ruin your soup unless perhaps, you have at least a mega-million dollar portfolio, in which case you may not even need this book. The Asian financial crisis in 1996 changed a lot of perceptions as it showed how interlinked the world’s economies are. These days, we have a globalised financial system that allows billions of dollars to move from one jurisdiction to another in seconds, hedge fund


various derivatives and leverage, unit trusts cannot, but can use derivatives to generate income and hedge market exposure in order to generate absolute returns.


managers taking a bad situation such as the subprime crisis to make billions, and the invention of technically challenging products because of innovations made by financial engineering. We believe that as you move forward, you really need to pay attention more actively to the markets, monitor your portfolio actively and get the best financial advice you can. Yes, we believe in buy and hold, but please actively monitor your portfolio at the same time.

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