Thursday 31 July 2008

Alternative Investment Performance Update: Macquarie Equinox

A couple of years ago I borrowed $50,000 to invest in an "alternative" investment - ie. not the usual cash, stocks, bonds or real estate. I invested in the Macquarie Equinox Select Opportunities Trust, a portfolio of absolute return managers (hedge funds) initially the following proportions:

Component Fund .................................. Initial Weight .... Fund Inception Date .. Compound Annual Return
------------------------------------------------- ------------------- ---------------------- ----------------------
Convivo Absolute Sovereign High Yield Fund ...... 10% ............... Jul 1999 ............. 18.08%p.a. (USD)
Ashmore Asian Recovery Fund ..................... 10% ............... Jun 1998 ............. 16.34%p.a. (USD)
Japan Macro Fund ................................ 10% ............... Mar 2000 ............. 19.62%p.a. (Yen)
SPARX Korea Long-Short Fund Limited ............. 10% ............... Dec 2003 ............. 32.25%p.a. (USD)
Campbell & Company - FME Large Program .......... 10% ............... Apr 1983 ............. 14.72%P.a. (USD)
Denali Offshore Parners - Global Macro Traing ... 10% ............... Jun 2000 ............. 26.43%p.a. (USD)
Aspect Diversified Programme .................... 10% ............... Dec 1998 ............. 11.46%p.a. (USD)
Irongate Global Strategy Fund ................... 30% ............... Jul 2004 ............. 15.24%p.a. (USD)

Weighted average "expected" return ......................................................... 18.46%p.a. (USD)
Actual Annual return to date ............................................................... 10.03%p.a. (AUD)

The usual provisos applied regarding "historic returns are not an indication of future performance", so when I decided to invest in this product I ignored the splendorous compound annual return figures and instead assumed that returns on this investment had a reasonable chance of achieving around 10%p.a. over the 7-year investment period - so far, despite the turmoil in the global stock markets the fund has yielded 10.03%p.a. I expect that the returns so far have also been negatively affected by the appreciation in the AUD over this period, so there is some prospect for a boost in returns in coming years if the Australian dollar has peaked against the USD and starts to drop back to it's long term average exchange rate (around 75c-80c).

I borrowing the entire amount from Macquarie Financing at a fixed rate of 7.75%pa until the maturity date (30 May 2014), at which time the loan can either be repaid with the proceeds of liquidating the investment, or paid out and the investment retained. Borrowing to invest in an income-producing asset such as this is quite tax effective. The annual interest payments are 100% tax deductible, so I get a tax refund of, say, 40% of the interest cost each year. When the investment is eventually sold, any capital gains will benefit from the long-term CGT concession, and so will be taxed at around 20%. The effect of this tax benefit can be seen in the "Loan" and "Net Tax Loan" lines:

The unrealised Net Profit from this investment (Investment Valuation - Total (after tax) cost of Loan) is currently around 9c per $1 invested - or a total of approximately $4,500.

This plot also shows how the Macquarie Equinox returns have low correlation with the Australian Stock market returns. It can also be seen that the Trust has had lower volatility than the stock market over this period. The Trust underperformed an investment in the stock market for the first year, but in the second year has continued to produce positive returns will the market has suffered considerably. I'm not betting on the Trust producing superior returns to the stock market or real estate over the long term, but by including it in my overall portfolio of investments it should help reduce risk (volatility) without adversely impacting on overall performance.

When the investment is due to mature in 2014 I'll need to investigate possible refinancing of the investment loan, as it may be tax-efficient to retain the investment until I am retired and (hopefully) living off my tax-exempt SMSF pension income. If the Seniors Tax Offset is still available by the time I reach 65, it may be possible to realise up to $50,000 of capital gains each year during retirement will a lower effective capital gains tax rate.

So far this investment strategy is working out quite nicely (better than my CFD Forex trading!), although there is always the risk that one (or more) of the component funds might implode (think Long Term Capital Management), which could easily wipe out the returns on this investment, and leave me out of pocket for the interest on the investment loan. In a worst case scenario, the Macquarie Equinox Trust itself could become worthless, leaving me with a $50,000 debt. While it is alluring to make a profit from "other people's money", it's never a free ride. It reminds me of the Lloyds Insurance "Names" who for many years received income without having to tie up any of their investible net worth. However, when things went pear-shaped they had massive personal liabilities, which drove many of them bankrupt.

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Monday 28 July 2008


More of an implosion, actually. After slowly trading my CFD account back up to $3,300 during this year (with some hope of recovering my initial $5,000 stake by year's end), I had a big loss a week ago when the Aussie suddenly dipped against the greenback. I managed to pick the wrong directional moves several times in a row, ending up with less than $2,000 in my account by the start of last week. Foolishly I then increased my contract size from $25K to $150K in an attempt to recover my losses if the Aussie resumed it's trend towards parity with the USD. For a while this high risk approach appeared to have paid off, with the AUD reaching close to 98c just prior to the release of the latest inflation numbers last week. My account balance had recovered to just under $3,000 and I started thinking about reducing my position from $150K to my usual position size of $25K or $50K. Unfortunately I decided to "hang in there" for just a little bit longer...

Of course the Aussie dollar then plummeted overnight, and continued dropping even when the inflation numbers came out slightly higher than expected (which theoretically should have increased the chance on another interest rate rise by the RBA, and hence boosted the AUD vs USD). Having rapidly lost $1,000 I decided to keep the position open in the hope that there would be a rapid rebound. But eventually I gave up and closed out the position when my account balance was down to only $700. I then bought the AUD again when it had dropped another half a cent and seemed to have bottomed out. This turned out to be a false bottom and the Aussie broke through the bottom of the long term up trend and my position got closed out with a residual $190 in the account, which I'll have to cash out. It's nice to imagine that if I just added a little bit more to my account and resumed trading I could eventually recoup my losses - but that's the siren song that lures gambling addicts to their doom. I'd rather just cut my losses and run.

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Monday 21 July 2008

Salary review time

Last week the annual salary reviews were distributed at my workplace - since I'm already at the top of the salary range for my position I just received the standard across-the-board "inflation" adjustment, which was 4% this year. The chart below shows how well the "inflation" rises have tracked the headline CPI rate over the past few years - the figures for 99/00, 01/02 and 03/4 can be ignored as I changed roles and received pay increments in those years. Overall, it appears that my company has been pretty good at increasing salary in line with inflation. Of course, the AWE (average weekly earnings) rate tends to increase by more than inflation, so the company policy of making the basic pay rise track the inflation rate isn't particularly generous. However, although I want my salary to keep pace with our living expenses and provide enough income to fund my savings plan, the annual "pay rise" is rather insignificant compared to other influences on our wealth and standard of living. Compared to the effect of RBA rate rises on the monthly payments for our home loan and margin loans, and the impact of real estate and stock market valuations on my net worth, it matters very little whether my pay rise is 2%, 4% or even 10%!

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Saturday 19 July 2008

Makes you wonder about all the mistakes they don't fix up

DS2 has a retirement (superannuation) account with ING that I opened on his behalf in November 2006. There haven't been any transactions on the account since the initial $1,200 deposit, and the value of the account had only increased slightly to $1,289.48 by 30 June 2008. It was therefore a bit of a surprise to get a letter from ING yesterday stating that a recent "review [of] our processes, controls and systems" had "identified an additional value" of $26.80 that will now be credited to the account as an adjustment. While I'm glad that they've apparently found a mistake and are rectifying it, it's a bit of a shock that the required "adjustment" is over 2% of the account balance! It makes you wonder how many mistakes by professional investment managers go undetected.

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CityIndex CFD Portfolio

I decided to create a portfolio of CFDs for the ASX20 stocks (top 20 Australian listed companies by market capitalisation), exlcuding the financials. This provided a list of ten stocks and I bought enough units of each stock CFD to give them equal weight in this portfolio. Overall the contracts have a value of approx. $3,000 worth of shares, and the required margin is around 10%. This used up approximately $300 out of the $400 account balance I had before making these trades. Combined with the $100 'credit' allowed on this account it means that these stocks could drop by around 8% before my account would be liquidated (and I'd end up owing CityIndex $100). On the upside, if the market recovers from here, a 10% gain would boost the value of these stocks by around $300, giving me a ROI of around 100%. It illustrates the extremely geared nature of using CFDs for "investing" - hence the reason they are mostly used for speculative day trading.

It will be interesting to see how the interest charges work out in practice. In theory interest is charged on the entire value of the CFD contract (not just the margin value), and the rate is a few percentage points above the RBA overnight cash rate. However, in practice interest charges are debited daily, and on the small amounts due each day on $3,000 worth of CFD contracts rounding to the nearest whole cent could have a significant effect. After one month I'll add up all the interest amounts and work out the effective interest rate being charged. I'm hoping to just hold on to these positions for a long period (rather than actively trading), so the interest charge will be important.

After the latest trades my CityIndex CFD portfolio is as follows:

Currency AUD
Cash Balance 411.56
Open Equity -14.72
Net Equity 396.84
Credit Allocation 100.00
Margin Requirement 286.89
Trading Resources 209.95
Account Summary
AUD 484.49
USD -85.05

CFD Trades
17 Jul 2008 BHP Billiton (AUD) CFD___ Buy Market _8 @ $38.03 $304.24
17 Jul 2008 Brambles Industries CFD__ Buy Market 44 @ _$7.90 $347.60
17 Jul 2008 CSL CFD__________________ Buy Market 10 @ $34.94 $349.40
17 Jul 2008 Foster's Group CFD_______ Buy Market 75 @ _$4.61 $345.75
17 Jul 2008 Rio Tinto (AUD) CFD______ Buy Market _3 @$117.16 $351.48
17 Jul 2008 Telstra Corp CFD_________ Buy Market 80 @ _$4.30 $344.00
17 Jul 2008 Woodside Petroleum CFD___ Buy Market _5 @ $59.24 $296.20
17 Jul 2008 Woolworths (AUD) CFD_____ Buy Market 14 @ $25.50 $357.00
17 Jul 2008 Wesfarmers CFD___________ Buy Market 10 @ $32.53 $325.30

Although the US and UK markets were up on Thursday night, the Australian market dropped on Friday - mainly due to the resource stocks which are a significant part of this portfolio. Therefore the portfolio had lost $14.72 the first day. If the Australia market doesn't bottom out soon this could be a very short-lived experiment.

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Thursday 17 July 2008

Playing with my CityIndex CFD account

It's gotten a bit boring watching the value of my geared stock accounts drop further and further each day. And in the past couple of days my Forex trading with CMC Markets has also given back the gains I'd made so far in July, and the latest monthly valuation figures for my real estate show an overall decrease.

So with all the doom and gloom around I decided to take my mind off the woeful state of my investments by dabbling a bit more with my CityIndex CFD account. I didn't like my earlier trades of commodities (gold and oil) on this account, as the minimum contract size was too large compared to the modest value of this account ($250 I initially deposited plus another $250 "bonus" money credited by CityIndex for opening the account). Today I thought I'd use the account to buy into the Australian stock market at it's current level, so I hunted around for a proxy for the overall market. The actual ASX200 futures contracts might suit, but I thought I'd start out by simply buying the minimum 1 unit of Australian Foundation Investments Co (AFI) CFD. AFI and ARG (Argo Investments) are listed investment companies that act a bit like a managed fund and perform very similar to the overall market (see the charts below), but with much lower fees than managed funds. The CityIndex stock list included AFI but didn't show ARG, so I decided to buy the minimum quantity if AFI. The stock was trading at $4.64 and the CFD for this stock has a margin requirement of 15%, so buying 1 unit cost $0.69 of my available funds (approx. $411 at the moment). Having confirmed the low amount of money required to buy a unit of this stock, I was intending to top up my holding to 100 or 200 units of AFI if it dropped a few more cents. However, the stocks CFD listing suddenly disappeared off CityIndex screen, and can now only traded by phone! Although CityIndex touts it's web-based trading platform as being much more dynamic that the java app provided by other CFD providers (such as CMC Markets), I'm finding the ability for stocks to be added (and removed) at will by CityIndex to be more of a nuisance than a benefit.

Anyhow, I then bought one unit of Westfarmers just before the market closed for the day. I'm not sure whether I'll buy a few units of various Australian stock CFDs and create a virtual diversified 'portfolio' in my CityIndex account, or if I'll have a go at trading the ASX200 futures CFD. Anyhow, this account only involves a few hundred dollars of 'play' money, and will give me something to fiddle with while ignoring the large changes in the value of my long-term stock and real estate investments.

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Thursday 10 July 2008

Sold some IPE and bought some IANG instead

I have a large block (for me) of the listed ING Private Equity company IPE, which I obtained last year when the $1.00 options were exercised. Since then the general market slump has seen them marked down severely, to around $0.70 at present. Although the book value of the IPE shares would still be much higher than this, they could continue trading at a discount to book value for a long time, so I decided to off load some of my holding - selling 22,000 of them at $0.70, realising $15,370.05 after Comsec brokerage fee of $29.95. That still leaves me holding 90,000 IPE shares, which I'll keep for the longer term.

I bought 200 IANG shares (IAG (NZ) Reset Exchangeable Securities) for $80.20 each - costing $16,269.95 incl. brokerage.

Overall, these trades will have increased my margin loan debt by $900, but will actually reduce the chance of getting a margin call. The IPE shares only have a margin value of 5%, whereas the IANG shares have a margin value of 80%, so the margin valuation of my portfolio will have increased by roughly $12,000 by making these trades. The IANG shares should also be a somewhat less risky investment than the IPE shares they're replacing - being an investment in a portfolio of high quality, short dated, fixed interest securities (Portfolio) managed by IAG Asset Management Limited (IAGAM). This Portfolio has an Australian Bond Fund Rating of ‘AAAf’ from S&P. It pays a fully franked dividend of 1.2% above the 90 day Bank Bill Rate, which should provide income roughly equivalent to the current margin loan interest cost (tax-deductible) of 10.50%. The IANG shares used to trade around the issue price ($100) plus accumulated dividend, as shown below. However, over the past year they have been deeply discounted by the market to currently trade around 20% below "face value". Since the IANG shares first "reset date" is in a couple of years time (15 March 2010), and the portfolio of bonds currently still has a valuation of $100.70 per share, this discount seems likely to be a temporary "panic" reaction and the shares should recover to around $100 by the reset date (barring any significant defaults in the bonds held within the portfolio). Combined with the fully franked dividend rate IANG seems a safer bet than holding on to the IPE shares they replace.

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Monday 7 July 2008

Why homeowners don't mind inflation, except when the central bank tries to fight it.

Around 35% of Australian "homeowners" actually own their homes outright, the rest have a mortgage to pay off. For those with a mortgage, such as myself, inflation has a positive impact in that house prices tend to be underpinned by the cost of new houses in the same area - which are in turn linked to inflation. On the other hand, the mortgage principal isn't affected by inflation. Whether you may be paying off the principal over 15, 20 or 25 years, or have an "interest only" loan, inflation won't change the amount of principal owed.

This means that if the value of your home just keeps up with inflation (no real increase in value), over ten or twenty years inflation will have reduced how much you owe the bank (in real terms). For example, our house is valued at around $840,000 and we have a mortgage balance of $490,000 which will remain constant (if we continue to use an interest only loan). If inflation kept running at the current 4% pa or so, our house price would increase to approx. $1.7 million by the time I'm due to retire eighteen years from now, but the amount owed would only be "worth" $242,000 in today's dollars by then. Therefore our equity would have increase from $350,000 to the equivalent of almost $600,000 simply due to inflation.

Unfortunately, higher inflation levels are generally bad for the economy, so the central bank attempts to control it using the fairly blunt instrument of official interest rates, which in turn pushes up the interest charged on variable rate home loans. Although we fixed the interest rate on our investment property, our home loan is at the standard variable rate, so our repayments have almost doubled with the rise of inflation from 2% to 4%. For that reason a temporary spike in inflation would be better for us than a permanent shift to higher inflation rates. If inflation drops back into the RBA's target range of 2%-3%, repayments on our mortgage will trend back down towards the previous rates (although probably not quite as low as before, given the effects of the global credit squeeze), while the real value of our mortgage debt would have taken a permanent hit. Also, our salaries tend to keep pace with inflation, so a temporary spike in inflation would end up making the interest-only repayments a smaller proportion of our pay packet (although it's a bit of a struggle in the interim).

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Saturday 5 July 2008

Rents to rise 10%?

While browsing through an investment magazine at the local library I came across an interesting chart of seasonally adjusted vacancy rates vs. the real (above CPI) rent change. As one would expect, rents tend to rise most when vacancy rates are low, but the relationship was quite precise. As shown in the table below, real rents increase by an additional 2%pa for every 1% drop in rental property vacancy rates:

Real Rent Change......Vacancy Rate

Rents tend to just keep pace with inflation if there is an adequate supply of available rental properties (3% vacancy rate), and rents outpace inflation if there is a shortage of properties to rent.

With inflation in Australia currently running above 4% pa and the vacancy rate for rental properties in Sydney dropping below 1% this year, rents should (according to this relationship) rise by around 8% pa.

At some point housing affordability will limit the growth in house prices in Australia - some estimates suggest that Australian houses are currently 30%-50% overpriced. But, with new dwelling construction rates currently well below the rate of increased demand caused by immigration, and the potential for rapid rises in rental yields over the next couple of years, there could be at least one more 'boom' left in the Sydney property market before I retire. When the fixed rate mortgage on our rental property is due for renegotiation in about three years time we may think about selling it and investing the proceeds in our SMSF.

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Thursday 3 July 2008

Forex CFD Trading Update: Jun 2008

My AUDUSD CFD trading on my CMCMarkets account went well during the month of June - about the only thing (financially) that was positive about June 2008. My account balance finished at $2938.81 - a gain of $650.29. I traded less frequently than the previous couple of months, keeping winning positions open a bit longer while the trend continued, and only doing short-term trades while I was watching TV in the evening and could keep an eye on the price action.

I did a bit better using stop and limit OCO orders for positions kept open overnight or while I was at work this month - one useful tidbit of information provided at the CityIndex seminar was to set stops based on the recent market volatility, rather than stick to a set stop of say 13 pips from my order price. The limits were generally set based on recent resistance levels. A couple of times the trends reversed just short of my limit, and I had to take a smaller profit later on (when I was back at my PC), but at other times the limit closed out my order just before the trend reversed, which was very satisfying.

Overall my CFD trading with CMCMarket had produced a net loss of just over $2,000 (~40%) since I started trading in April '07, but this calendar year I've made $1,738.56 net profit, and my net loss for the financial year ending 30 June was only -$290.26. If my forex trading continues to be mostly profitable from now on, I might break even sometime this financial year.

It's interesting to note that excluding the cost of the 2 pip buy-sell spread incurred on each trade I would already be in positive territory. That's one reason that I'll stick to my CMCMarkets account for forex trading and only use my new CityIndex account for trading Stock indices or commodities - CityIndex spread is 3 pips for trading the Aussie. So far I've dabbled in crude oil and gold CFD trades with my new CityIndex account, and managed to lose around $100 of the "free" $250 provided by CityIndex in just three trades! The minimum gold CFD is a bit too costly relative to the meagre $500 "seed" money in that account, so I'll probably stick to trading the ASX index in the evening - trying to pick the rebound in the ASX that often occurs if the Australian market has been sold down during the day, and the DOW opens positively overnight. We'll see how that theory works out.

I'll start tracking my Index CFD trading results from next month.

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Tuesday 1 July 2008

Networth Update: June 2008

Oh, the pain! The pain!

The worst June stockmarket result since 1930.

The worst financial year stock market result since 1982.

Not a good time to have geared investment in the Australian stock market!

During June my net worth declined by $83,111 - that's about one year's gross salary gone in one month. Poof! To put it another way, if I'd shifted all my investments into cash this time last month, I could have quit my job and gone fishing for a year and still ended up better off!

I also ended the month with my net worth dropping below the magic "one million" mark yet again. This time it looks more permanent than the three day dip below $1m earlier this year. At the end of last month I was still hopeful that I might get back to my previous peak net worth by the end of 2008, or at least by the end of the 2008/9 financial year. Now I'll be relieved if my net worth is over $1m at the end of 2008, and I doubt that I'll be setting any personal net worth records before the end of this decade. Considering inflation in Australia is currently running at over 4% pa and that you can get more than 7% return on cash invested in online savings accounts, that is really a rather pathetic outlook. On the other hand, if the stock market continues to drop I could soon be forced to sell off some shares to avoid margin calls - just when everyone else is bailing out of the market and prices have tanked, so things could still get much, much worse. Such is life when things go pear-shaped using "other people's money" to invest in stocks...

The bad net worth result is even worse considering there were several positive factors at work during the month:
* $3,885.50 was contributed into my retirement account (employer SGL contribution and salary sacrifice)
* a $19,130 increase in the estimated values of my share of our house and investment property

My stock equity and retirement account value dropped by a combined total of more than $100,000 during June! I'm running out of exclamation marks!! A small part (around $10,000) of this decline was due to pre-payment of margin loan interest for 2008/9 on one of my margin loan accounts. I applied for interest pre-payment for two of the other margin loan accounts as well, but the pre-payment hasn't appeared in my on-line account details as yet. It's possible that the faxed application forms were not received and processed before 30 June. In that case I may sell off some stocks and reduce the margin loan balances - this would save on the 10%+ interest rate on the loan balances, but would also "lock in" the recent losses if the market rebounded during the remainder of 2008. On the other hand, if there's an extended bear market (for example if there's a global recession in 2008/9) I would be happy to have reduced my gearing even now - pity I didn't do it last month, or in 2007 as I once considered. Even more pity that I let my Index put options expire in Dec 2007 without making more than a token effort to find replacement "insurance" via index put options, warrants, or selling index CFDs.

Property valuations +$19,130 (+2.29%) to +$853,830
Mortgage loans..... -$...165 (-0.05%) to -$365,579
Retirement accounts -$20,404 (-6.66%) to +$285,985
Stocks & other..... -$82,002(-27.92%) to +$211,694
TOTAL NW........... -$83,111 (-7.77%) to +$985,931

My employer's monthly retirement contributions for the months of Feb, May and Jun (a total of approx $11,650) isn't showing in this month's figures as the employer contribution hasn't appeared in my SMSF bank account yet. The payments were only processed in the last few days, so this may create problems with next year's superannuation tax. My SGL and salary sacrifice total in close to the $50,000 annual concessional contribution limit, so the late 2007/8 FY employer contributions could push next year's total concessional contributions over the limit, and make be liable for an extra 30% tax of the surplus amount. I've applied for a private ruling on this matter from the ATO (Australian Tax Office), as I'd like to know exactly how my SMSF administrator should report these contributions in our SMSF tax returns for 2007/8 and 2008/9, and if I'll need to make an application for 'Special Consideration' regarding these employer contributions.

Hopefully this month and the rest of 2008 turn out to be more positive. They say that it's "darkest before the dawn" - I can remember how dire things appeared during the days of the '87 stock market crash, and yet that now appears as a mere blip on the stock market charts.

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