Alternative Equity Investment
by
Jeremy Hetherington-Gore, April 2006
IMPORTANT
WARNING:
The contents of this report have been compiled in good
faith by Investorsoffshore.com to provide assistance
to investors, but do not constitute investment advice
or recommendations. Investors should not rely upon the
information given in order to choose types or routes
of investment but should make their own independent
enquiries before making choices. Investorsoffshore.com
has taken reasonable care in researching and presenting
the information herein but makes no representations
as to its accuracy and accepts no liability for actions
taken or not taken as a result.
Once upon a time, before the Internet and before globalization
of the financial sector, investment for most people
meant buying stocks, shares or collective investment
units through a broker, using the mail and the telephone.
You can still do it that way, but more and more people,
especially globe-trotting expatriates, do it on-line,
and do it for themselves using a whole zoo of techniques
in which direct ownership of underlying shares is just
one solution, and no longer the best in many situations.
Trading
methods now encompass Contracts For Differences (CFDs),
Spread Betting, Equity and Financial Derivatives (Futures
and Options), and Exchange Traded Funds. Even in plain
vanilla equity investment, the one-time focus on national
bourses has given way to a wide variety of tradeable
markets, on or off the Internet, including so-called
'offshore' stock exchanges.
In
this feature, we will review the progress and uses of
some of the newer ways of trading and investing, paying
attention as well to tax, which is a major issue for
many investors and underlies the development of many
of the newer techniques, particularly in jurisdictions
which cling to stamp duty, such as Ireland and the UK.
Contracts
For Differences (CFDs)
Share
CFDs (they are also used to trade other instruments
such as currencies) are an agreement to exchange the
difference in value of a particular share between the
time at which a contract is opened and the time at which
it is closed. CFDs mirror the performance of a share
or an index; they are traded on margin, and profit or
loss is determined by the difference between the buy
and the sell price.
Because
contracts for difference trade on margin, investors
only need a small proportion of the total value of a
position to trade. CFDs mirror rights in the underlying
shares; thus the owner of a share CFD will receive cash
dividends and participate in stock splits, rights issues
or takeover action.
CFDs have grown enormously in popularity over the past
five years, particularly with hedge funds, and are thought
to underlie 30% of the LSE's trading. The majority of
major brokerages now offer these products to individual
traders via internet trading platforms, giving instant
access to quotes and other information pertaining to
the market. However, individual investors often use
spread betting (see below) rather then CFDs.
CFDs,
which were launched on the marketplace in 1998, have
a number of advantages. Firstly, they allow individual
traders the opportunity to take larger positions in
equities than might otherwise be the case through the
use of leveraged margin accounts. In many cases, the
margin requirement may be as low as 10% of the full
transaction value. So, for example, if an individual
wanted to buy 10,000 of ‘Company A’s’
shares and their broker was quoting a price of $1.00,
they would put up an initial margin deposit of just
$1,000, instead of having to fork out $10,000 to buy
the shares outright. If Company A’s share price
subsequently increased and the shares were sold at a
price of $1.20, a profit of 0.20 per share, or $2,000
would be the result. Not a bad return considering an
initial outlay of only $1,000 was needed! The other
major advantage CFDs have over standard share dealing
is that they allow the investor to sell ‘short’
a company’s share, so that profits can be made
on the falling value of stock prices.
However,
where leverage has the potential to deliver handsome
returns, it can also hit one with nightmarish losses,
and the reverse of the above coin is that you could
equally have lost $2,000 for just a $1,000 stake if
the share price had fallen by 20 cents per share. Traders
can protect their downside risk to a degree by placing
a stop loss order. This is an order placed above or
below the entry price (depending on whether one is long
or short) at a point of the maximum loss the trader
is prepared to take, and is usually automatically triggered
when the security reaches that price.
Because
of the risks, CFD trading is highly regulated in a bid
to protect the smaller investor from any unscrupulous
broker. Therefore only traders deemed knowledgeable
enough about the markets in which they are trading and
the risks involved in trading via a margin account are
permitted to open CFD accounts, making them an unsuitable
investment instrument for novice traders.
CFD
providers fall into two main categories, those that
act simply as agents, hedging all CFD orders in the
underlying cash market, and those who make markets in
CFDs, living off their own spreads. Obviously, there
are hybrid types as well; but an investor may get the
best prices through the first, 'agent' type of intermediary.
There are many other considerations, obviously, including
depth of research coverage, trading strategies and technical
analysis. The technical capabilities of the trading
platform are very important, especially for frequent
traders. The credit rating of the provider is also an
issue.
For
those suited to take the plunge, CFDs have certain tax
advantages, depending on the jurisdiction from which
they are being traded. For example, CFDs are exempt
from share stamp duty in the UK, as the underlying shares
are not physically owned by the investor. However, profits
may be liable for capital gains tax. Other costs to
take into consideration are broker commissions, which
are typically charged at a rate of around 0.2%. While
this sounds small, these costs can soon rack up if frequent
trades are placed.
CFDs are predominantly used for short-term trading and
a comparison must be made between the savings made from
not paying stamp duty and additional costs, including
financing. It's not easy to make comparisons, since
leakage from poor pricing can easily wipe out tax advantages.
However, for trades that are less than three months,
it is normally cheaper to trade with a CFD rather than
with the underlying stock.
In
the UK, CFDs also have their uses in position-building,
since they are not covered by FSA disclosure rules (the
Takeover Panel however does include them in its calculations).
In March, 2006, the FSA announced that it has no intention
of broadening disclosure rules to cover derivatives
such as CFDs.
However,
the tax advantages of CFDs in Ireland and the UK may
be short-term. In March, 2006, the Irish Revenue Commission,
which collects 1% stamp duty on stock exchange transactions,
said it was planning to extend the tax to CFDs.
Irish
Stock Exchange officials met the Revenue to try to persuade
them that Ireland's CFD business, which is said to underly
EUR3bn a month in trading on the Irish exchange, would
simply decamp to London if the tax was imposed.
In any case,
the financial sector thinks that stamp duty on shares
is an antiquated and anti-market tax which can only
damage the future of the UK and Irish stock exchanges,
and would like to see it abolished.
The
UK's HMRC watched its Irish brother's campaign with
the greatest interest. The UK Treasury is not good at
abolishing taxes, but is noted for its ability to invent
new ones.
Although
CFDs got their start in the UK because of stamp duty,
they have been taken up in other parts of the world
due to their convenience and flexibility, particularly
over the Internet.
Online
financial derivatives business Global Trader, active
in South Africa since 2000, has opened offices in Russia,
the Middle East and Australia. The group started operating
in Ireland in January 2002 and moved its trading desk
function there. Shortly thereafter it also expanded
to Canada as part of a joint venture. However, the Irish
regulators later said they were not interested in regulating
the CFD market in Ireland as it was not big enough.
So in 2004, Global Trader moved its trading desk back
to SA. The group later opened a London office.
In
Australia, Sydney Futures Exchange Limited, a wholly
owned subsidiary of SFE Corporation Limited, entered
into an agreement with CommSec Limited, a wholly owned
subsidiary of Commonwealth Bank, under which SFE committed
to establish an exchange traded contracts for difference
market covering a number of asset classes to complement
existing over-the-counter CFD offerings.
Spread
Betting
This
has also become a very popular way for smaller investors
to take a punt on the stock market, and the number of
firms now catering for this form of investing has grown
markedly in recent years. The internet has also made
spread-betting cheaper and more accessible to investors.
Put
simply, spread betting allows an individual to bet on
whether a company’s share price, or the value
of a stock index, will rise or fall above or below a
price quoted by the spread betting firm. In a typical
example, the firm will make a quote for the price of
a market or instrument at some point in the future.
So, for example, the firm may quote a bid/offer (selling/buying)
price for Company A’s shares of $1.00 - $1.05
at the end of a day’s trading. If the bettor thinks
Company A’s share price will finish the day higher
than this price, he would buy, or go long, at the offer
price of $1.10. If the trader is right, and the share
price ends the day at say, $1.20, he will have obviously
made a profit on the bet. The level of profit will depend
on how much money the trader has risked per one point
movement in the share price. If he bet $10 per point,
his profit would be $100 ($10 multiplied by 10 points).
Conversely, if Company A’s shares had dipped during
the day, and finished at $0.95, the trader would have
made a loss of $150.
Spread
betting gives the individual a lot of flexibility at
a relatively low cost in terms of commissions and tax.
It also allows small investors the opportunity to trade
a wide range of financial instruments ranging over stock
indices, currencies, interest rates, commodities, and
options. Most spread betting firms also offer an alternative
to conventional fixed-odds betting on sports and other
events. In fact, many brokers now offer the whole range
of the above services, from CFDs through to futures
and spread betting.
However,
all of these forms of investment are fairly high risk
and not suitable for the inexperienced investor. Therefore,
they are also probably not the right choice for the
passive, more conservative longer-term investors.
In
January, 2006, the UK's Financial Services Authority
(FSA) announced that it had fined prominent spread-betting
firm Cantor Index Limited GBP70,000 for running a misleading
campaign promoting spread betting.
The financial
services regulator criticised a Cantor advertising campaign
entitled 'Free Xda' for Cantor Mobile, the firm's new
spread betting device.
According
to the FSA: "The promotional material, which included
flyers handed out at London stations, posters and advertisements
on television and in the popular press, did not contain
adequate warnings about the risks of spread betting
and consequently put a large number of potential customers
at risk."
One of the
key risks of spread betting is that if a spread bet
position moves against the customer they can lose far
more than their initial deposit, and although the firm's
terms and conditions contained risk warnings which the
customer had to agree to before they could spread bet,
the risk warnings were not deemed to be sufficiently
prominent by the FSA.
The regulator
also suggested that the structure of the offer of a
"free" combined handheld computer and mobile telephone
known as an "Xda" provided a strong incentive for consumers
to spread bet.
Added to
this, the service was promoted in a way that attracted
the attention of relatively less experienced investors,
and the firm did not consider the greater potential
risk posed or take appropriate additional steps to ensure
that those investors understood the risks associated
with spread betting.
Speaking
with regard to the advertising campaign, Anna Bradley,
director of the Retail Themes Division of the FSA announced
at the time that:
"Cantor
Index should have paid more attention to the greater
potential risk posed to less experienced investors and
the greater need to ensure that the risks associated
with spread betting were likely to be understood by
them. This should have been done through robust systems
and controls."
However,
the Financial Services Authority did acknowledge that
no Cantor Index customers suffered any unreasonable
losses as a result of the advertising campaign, and
praised the remedial action since taken by the spread
betting firm.
Equity Derivatives
Another
tool offering flexibility to individual and institutional
investors alike is the derivative. Trading in stock
futures, for instance, can be found through a number
of exchanges globally, and, increasingly, through the
Internet.
Although
futures are perhaps more readily associated with the
commodities or fixed income markets, where traders or
companies have traditionally tried to hedge against
adverse price swings, stock futures can perform the
same function as contracts for differences. They are
thus useful for individual investors who want to undertake
stock trading without actually having to physically
buy or sell the stocks. Basically, buying shares on
the futures market means that the buyer agrees to buy
or take delivery of the shares at a future date, but
paying the current price. Most futures trades are cashed
out before this delivery date, meaning that the underlying
share or instrument never actually changes hands. As
with CFDs, they are also traded on the principle of
margin, so, again, there is potential to take a large
position in an equity without having to put up the requisite
amount of cash.
There
is also the added flexibility that multiple trading
strategies can be employed (as with most other equity
derivative contracts), such as combining long and short
positions with a holding in the underlying shares, and
the use of options, which confers on the trader the
right, but not the obligation, to buy and sell share
futures when they reach a certain price (known as the
strike price). Options can be employed in many different
combinations, and themselves be bought and sold. However,
option strategies have defeated even Nobel-winning economists,
so inexperienced traders may want to start with the
simplest of options strategies where derivatives are
concerned!
Stock
Index Futures
Another
slightly more esoteric and less direct form of alternative
equity investment is buying and selling stock indices
in the futures market. While stock index futures have
been on the investment map since their introduction
in the early 1980s, they have only recently appeared
on the radar of the smaller investor thanks in large
part to the growth of internet trading and the rise
in popularity among private individuals of day trading.
Again, stock index futures were developed as a hedging
tool for institutional traders to provide protection
against a price reversal of the stocks in the manager’s
portfolio. However, stock index futures also provide
an opportunity to make smaller short term gains.
The
principle of trading in stock index futures is the same
as any other futures market, except that the trader
is effectively buying and selling a set of numbers,
and no physical delivery of an underlying asset is possible.
This means that positions are settled in cash at the
expiration of the contract at either a profit or loss,
although the vast majority of index futures contracts
are either settled prior to expiry, or ‘rolled
over’ to a later expiry date.
The
value of a stock index contracts is fixed by the exchange
upon which the index is traded. One of the more popular
(and most expensive) indices to trade is the S&P
500, where each point has a fixed value of $250, and
where quick profits (and losses) can be made.
So,
say the index is valued at 1,000 points when it is bought,
one S&P futures contract will be worth $250,000.
If one contract is bought on a 10% margin, the trader
must put up $25,000 to initiate the position. If the
index swings by a relatively brisk twenty points during
the rest of the day, the trader has the potential to
gain, or to lose, $5,000 in one fell swoop ($250 multiplied
by 20 points).
Clearly,
such trading is not for the faint hearted or light of
pocket! However, recognising that there is considerable
demand for this type of trading among smaller investors,
‘e-mini’ contracts (‘e’ denoting
that trading is electronically driven) have been developed
on some exchanges where the index is otherwise prohibitively
expensive or too risky for small traders.
The
S&P 500 e-mini contract is worth $12.50 per quarter
of one index point, meaning that one contract is worth
$50,000 if the index is valued at 1,000 points, so a
20 point swing represents a loss or gain of $1,000.
It is worth mentioning that not all indices are as expensive
to trade as the S&P 500 or Nasdaq 100. For instance,
FTSE 100 index futures, traded on the London International
Financial Futures Exchange (LIFFE) are worth £10
($18) per index point.
ETFs
Exchange
Traded Funds are a relatively new addition to the equity
investment sphere. ETFs were first developed around
ten years ago as a means to give investors access to
a basket of stocks at a low cost. ETFs first began life
in the United States, but have slowly caught on in other
areas of the world, notably Europe, and they are also
making headway into the Asian markets. ETFs are usually
linked to a particular index, for example the Dow Jones
Industrial Average, the Standard & Poor’s
500, or London’s FTSE 100. They may track a certain
sector within these indices, like, for example, technology
companies, mining companies or pharmaceutical firms,
but they do so within a single share. ETFs have also
been developed that track company sectors across different
exchanges in a certain geographical region, for example,
Western European technology stocks.
This
gives investors the chance to diversify their portfolios
by taking exposure to international equities that may
have been off limits to smaller investors through complex
cross-border regulatory concerns. ETFs are also making
headway into territories where equities were previously
inaccessible to smaller investors, such as China.
On
the surface ETFs appear very similar to mutual funds,
but in actual fact, there are a couple of key differences.
One of the main differences is that ETFs can be traded
openly throughout the trading day, unlike mutual funds,
which can only be redeemed at the closing price of each
day. This means that ETFs may be equally suitable to
the more conservative buy-and-hold strategist, or the
more active trader looking for short-term speculative
gains. The other major advantage of ETFs over their
mutual fund cousins is that the former can be sold short,
whereas the latter cannot.
Furthermore,
costs are also much lower for ETFs, varying between
0.1% and 0.2%. This compares to average mutual fund
fees of around 1.4%, while unit trusts charges can be
as high as 1.75%. ETFs are also generally more tax efficient
than standard mutual funds. On the other hand, frequent
intra-day trading of ETFs means that costs will increase
the more an individual trades. As with direct stock
purchases, investors must also absorb the bid/offer
spread, meaning that an ETF may have to be bought or
sold at a higher or lower price than desired. So, as
with any other security, there are many considerations
for the investor to weigh up when choosing the construction
of a portfolio.
There
is an extensive and growing range of ETFs. In the United
States, most ETFs trade on the American Stock Exchange
(AMEX). The largest and most popular among them include
the S&P 500 Index Depository Receipts (known as
Spiders), the Nasdaq 100 Index Tracking Stock, otherwise
known as QQQ, and the Diamonds Trust, which tracks the
top 30 stocks on the Dow Jones Industrial Average. On
the London Stock Exchange there are 14 ETFs known as
ishares which are marketed by Barclays Global Investors,
tracking both the FTSE 100 and the broader FTSE250 indices,
the top 100 European firms, the Dow Jones Eurostoxx
index, the S&P 500 and Japanese shares.
Ethical Investing
Although
ethical investing does not strictly fall into the alternative
category, it can be nevertheless be viewed as an alternative
to the standard equity portfolio or mutual fund. Ethical
investments come in a variety of forms, and tend to
differ depending on the shade of ‘green’
that an individual wants with their investment.
There
are two basic routes into ethical investing: pick the
stocks yourself based upon your own beliefs and ethical
principles; or put your money (and faith) into a managed
fund which only buys stocks in certain companies depending
on the pre-defined rules the fund has set itself. Naturally,
if one chooses not to invest in certain firms because
of the products they make, or because of the negative
side effects they have on the environment or health,
then this excludes a large number of potentially high
growth stocks from a portfolio - for example, firms
in the alcohol, tobacco, armaments, oil and gambling
industries will be off limits, leaving a limited choice
of companies in which to invest. As a consequence, many
feel that ethical funds will never match the returns
of conventional equity investment funds over the long-term.
Nonetheless,
in spite of these self-imposed restrictions, ethical
funds have performed comparatively well in recent years.
One example is the Stewardship Growth Fund, the UK’s
first ethical fund, which was launched in the mid 1980s
amid much scepticism over its prospects. Twenty years
on, the fund manages GBP600 million ($1 billion) and
was ranked in the top fifty of the 276 funds in its
sector over the last three years. Detractors argue that
ethical funds have performed well because they are weighted
towards small and mid-cap stocks, which have generated
good returns over the short term. However, there is
clear and growing demand for ethical funds and investment
products, as indicated by a recent Mori poll, which
showed that two-thirds of clients wanted independent
financial advisors to offer ethical investment options,
so there appears to be enough belief in ethical investments
to make them a viable alternative.
If
one wants to make an ethical investment, it pays to
do a bit of due diligence beforehand, as some funds,
and some companies, may not be as green as they seem
on first inspection. Advocates of ethical investment
recommend that prospective investors study a fund or
company prospectus carefully before deciding whether
it will be a suitable investment that matches their
own ethical principles. To be doubly sure, some advise
investors to obtain a written statement from the fund
or company clearly stating its investment policy or
business activities.
Islamic Investment
Another
route into the ethical investment universe is through
the rapidly-growing Islamic investment industry. Investments
constructed along the principles of Shariah law automatically
screen out companies deemed to have a harmful effect
on society or that are anathema to the Islamic religion,
for instance those connected with alcohol, gambling,
pornography, armaments, and pork.
Importantly,
Shariah law also precludes the charging of interest,
which is deemed to be profit made without effort and
with no beneficial effects on the community at large.
This puts a large swathe of conventional investment
off limits to Islamic investors, although a number of
specially constructed investment products continue to
be approved which circumvent the need to charge interest,
and which are proving ever popular.
Islamic
equity funds are widely available in the traditional
Muslim territories of the Middle East and the Far East
where many major banks and investment firms offer the
products to retail investors. Islamic finance is also
gaining a foothold in the west, with many specialist
institutions appearing in countries such as the UK and
the United States dedicated solely to selling Islamic
investment products. Moreover, some major western banks,
including the likes of HSBC and Deutsche Bank, are getting
in on the act, with more sure to follow.
In
some respects, the Islamic banking and finance industries
are still in their infancy. However, the sector has
grown sharply in the last decade or so, and with the
global Muslim population currently around 2 billion,
growth potential is clearly in place, so expect to see
Islamic investment become an established feature of
the investment landscape in years to come.
Offshore Equity Investment
Investment
in equities listed on offshore stock exchanges is another
avenue worth considering in the alternative sphere,
which can bring significant tax and cost benefits if
the right investment path is taken. Just what the right
investment path is, however, can vary enormously
depending on the jurisdiction of residence (including
whether offshore or onshore), the offshore jurisdiction
in which the investment is taking place, and the tax,
regulatory and legal considerations in both locations.
This subject alone could easily stretch to several pages!
Therefore,
offshore equity investing is an area that needs to be
thoroughly researched, and it is essential that a potential
offshore investor employs the services of a suitably
knowledgeable and impartial financial advisor who specialises
in this area. 'Offshore' jurisdictions which have stock
exchanges include: Bahamas, Bermuda, Costa Rica, Cyprus,
Dubai, Guernsey, Hong Kong, Luxembourg, Mauritius, Panama
and Switzerland.
By
and large, these offshore markets are suitable only
for experienced investors, and with obvious exceptions
such as Hong Kong and Switzerland have attracted mostly
professional investors. Most of them have done little
to encourage international retail investment.
The
perils of investing in smaller, offshore markets are
well illustrated by Cyprus and Dubai, both of which
have seen boom and bust scenarios based on localized
'irrational exuberance'. However, if you are cautious,
and do the due diligence, there are sometimes outstanding
opportunities in smaller market places. Anyone who was
brave and clever enough to go back into the Russian
market after 1998 will have been able to retire by now!
At least if they didn't buy Yukos...
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