Spread betting

This flexible technique for speculating on financial markets and sporting events has grown in popularity hugely in recent years. Unfortunately there aren't many specialist bookmakers offering spread betting at the moment, but the majority of those that do allow both online and telephone betting, and internationally the numbers are expected to increase commensurate with the activity's growing popularity.

Although the services, markets, and events that the client can access through each bookmaker may vary, all spread betting is based on the same principle. Basically, the bookmaker makes a prediction as to the result of a future event in the form of high and low estimates (the difference between these two figures is called the spread, or the difference between the price the bookmaker will sell to you, and the price he will buy from you), and if you think the result will be higher than their spread, you 'buy' at the top end, whereas if you predict that the result will be lower, you 'sell' at the low end. Having decided whether you are going to bet down or up from the spread, you must then decide how much money you are prepared to risk per point of the bet. For example, if the spread quoted was 6000-6012 on the FTSE 100 index, a GBP1 a point bet would make GBP1 in profit for every point that the FTSE exceeded the upper figure at the expiry of the bet (and sadly, it works in exactly the same way for losses.

Theoretically, spread bets can be placed on any event for which there can be an upper or lower limit, but in practice the majority of bookmakers providing spread betting services tend to limit themselves to sporting and political events and financial markets. This, however, is not much of a limitation, as there are a wide variety of options open to clients in these areas. For example, one leading spread betting enterprise allows bets on stock indices, share prices, currencies, interest rates, commodities, and options, while its sporting arm allows customers to place bets on such diverse events as soccer, horse racing, rugby, cricket, golf, tennis, American football, motor racing (deep breath…), greyhound racing, snooker, and boxing.

Most specialist bookmakers providing a spread betting service will offer both deposit and credit accounts, but in either case, you will need to be aware of the Notional Trading Requirement. (Yes, it is as dull as it sounds, but you need to know about it, so don't skip this bit. Here goes…) The NTR is the minimum amount of money required by the bookmaker to open a new position, and is a risk figure applied to each market that the bookmaker quotes, and it is what they see as a fair reflection of the potential daily volatility of that market. The figure varies from market to market, but if, for example, you wanted to bet GBP5 per point on the FTSE futures market, the NTR could be 300 times your stake, which would make the minimum deposit required to run that position GBP1,500.

Spread betting is appealing to ever greater numbers of investors for several reasons, not least of which is the absence of capital gains tax on profits (unlike conventional share trading, where CGT applies to trading gains in many countries), and the lack of stamp duty on transactions (most interesting in the UK; strictly speaking, the transaction is a bet, rather than an investment. Hence the name.)

However, by its very nature spread betting is more risky than traditional, fixed odds betting, or conventional domestic investment, where participants are usually a little more protected. If you judge wrong, you are likely to lose a great deal, and any losses made on a spread bet cannot be offset against capital gains on ordinary investments.

Spread betting, to conclude, is not suitable for long-term investment, or for placing your hopes, dreams, and life savings in, but can potentially be very profitable in the short term. The rules regarding residential restrictions do not seem to set in stone as yet, perhaps due to the removal of geographical restrictions facilitated by the Internet. However, every organisation offering spread betting recommends that their customers should examine the taxation laws of their country of residence before making any decision, so it may well be worth seeking professional advice.

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Contracts for Difference (CFDs)

On a more international note, some bookmakers also offer Contracts for Difference (sometimes known as Margined Equity Contracts), which are a type of equity derivative designed to give active traders extra leverage in their share trading. At the moment, most brokers do not offer a CFD service, but CFDs are rapidly becoming popular both in the UK and internationally as a mechanism for large but short term speculation, so this may well change.

Institutions and qualifying private investors can use a CFD to go 'long' or 'short' of a share (as with spread betting), and positions are taken on margin - typically, only 20% of the contract value has to be maintained in the CFD account. This allows users to establish much larger positions than would usually be possible, and in effect, the investor is able to speculate with much more money than he actually has by borrowing from his broker, and using the shares he has bought as collateral.

If the share price moves in the investor's favour, the CFD provider is obliged to pay margin each day to him/her, but conversely, if the share price moves against the investor, he/she will then have to pay 'variation margin' to the broker. For example: Say you were to decide to take a long position on 10,000 ICI shares at a quoted price of 500p (it must be firmly stated here that this is a fictitious example, as opposed to a recommendation). This is the equivalent to a GBP50,000 exposure, on which a GBP10,000 initial deposit is payable. If the shares rise to 550p in the next 3 days, you should receive GBP5,000 from your CFD provider, minus whatever interest charges are payable. If you then decide to close the CFD on the fourth day, when the price quoted is 555p, you should have made a total profit (before dealing commission and interest charges) of GBP5500. At the moment, there is no stamp duty payable on this type of transaction, as there is no physical stock transaction, but profits made on CFDs are liable for Capital Gains Tax.

Sounds good, doesn't it? But although it is possible to get rich quickly trading Contracts for Differences, because of the highly margined nature of this type of transaction, it is also possible to get poor quickly- if the share price goes against you, the margin payments (which have to be paid in cash) can prove crippling. CFD trading is not for novices, and regulatory authorities insist that investors only trade in this way if they have experience of both equity and margin trading. The high minimum deposit is also (deliberately) prohibitive, and most CFD providers will only do business with investors who can prove substantial liquid assets. Minimum transaction sizes can sometimes be as high as GBP25,000. In conclusion, then, CFDs may be the most economical option for large, short-term trades, executed by qualified investors, but should probably be avoided by the newer investor.

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Hedge Funds

Hedge funds, in the popularly accepted sense, are investment partnerships that invest in a variety of securities and seek above average returns through active portfolio management. Hedge funds are generally not regulated by any of the domestic securities regulatory bodies, and therefore do not raise funds via public offerings, and are not allowed to engage in general solicitation or advertising.

Although hedge funds have long been popular in the US, all-encompassing regulation in the European Union has meant that their marketing has been severely restricted in many EU member states, which have each had to repackage the funds in different ways, in order to make them palatable to regulators. However, recent agreements reached by the Council of Economics and Finance Ministers should eventually lead to a situation in which an investment product approved in one member state may be marketed anywhere in the EU, and where the range of approved products may be substantially extended to include hedge funds. This would give a tremendous boost to the funds' popularity in Europe.

Because they are not regulated in the same way as conventional mutual funds, hedge fund managers (who will usually have a substantial amount of their own money invested in the fund) are free to utilise more unconventional and potentially 'riskier' investment strategies in order to secure higher returns for the fund investors. Although there is no legal definition of a hedge fund, the term in fact derives from the fact that investments within this type of fund have tended to hold both long and short positions (just one of the aforementioned strategies), thus making them 'hedged' or protected to some degree against market volatility.

There are more hedge fund strategies available than it is possible to shake a substantially sized stick at, and the fact that that investment managers have the discretion (broadly speaking) to alter investments strategies without prior investor approval means that their management strategy can be flexible, and prone to alteration as market conditions dictate. However, here (just for information) are several of the more common strategies used:

• Sector investing: This is where the manager focuses on specific industry sectors with favourable growth prospects, such as health or technology
  
• Investment in emerging markets: Fairly self-explanatory really; this is when a hedge fund manager invests in debt and equity securities in countries with less well-developed financial markets which have strong prospects for rapid growth.
  
• Macro investing: When an investment manager adopts a wide variety of global instruments and strategies, sometimes assuming an aggressive risk posture
  
• Long/short equity investing: This strategy focuses on long and short investing in equities which a fund manager feels are under- or overvalued at a particular time. These investments may be focussed on one particular sector, or diversified across several industries.
  
• Market neutral investing: This strategy involves the simultaneous purchase and sale of similar securities in order to take advantage of pricing differentials.
  
• Distressed securities investing: This is when the hedge fund manager invests in debt and equity securities of companies experiencing financial difficulties, undergoing re-organisation, or bankruptcy procedures.
  
• Event driven investing: This is a strategy of investing in the securities of companies involved in mergers, acquisitions, liquidations, or any other events that might alter their financial structure or operating strategy.
  
• Short selling: This is when the fund manager seeks to benefit from declining securities prices by establishing short positions in companies with unfavourable profits.

So now you know. As previously mentioned, due to their unregulated and potentially risky nature, hedge funds are not allowed to advertise to individual investors (at least not onshore), and therefore, are usually offered to limited numbers of affluent investors and institutional clients, who are subject to lock-up period of at least a year before they can make withdrawals from the fund. It used to be the case that only those with very substantial net worth would be considered for hedge fund investment partnerships, and although the minimum deposit required for some funds is lower than it was (due to their rise in popularity in recent years), it is usually still quite steep, and consequently, direct hedge fund investment should really only be considered by those with substantial liquid assets that they can easily do without for a year or more.

That being said, there are ways for individuals with lower (but still sizeable) net worth to take advantage of the superior returns often offered by hedge funds. There are basically three main ways to get involved in hedge fund investing:

Whichever way you choose to approach hedge fund investing, however, you should do some due diligence of your own, both before you get involved, and through the duration of your involvement with the fund. Below are some of the basic issues you will need to look at before investing in a hedge fund, or fund of hedge funds (although this is by no means comprehensive, so if you are thinking of investing in this way, professional advice is a must):

The Fund

• Volatility: Look at the fund's monthly (or weekly) volatility, as well as its annual or quarterly returns, checking whether the annual return was generated fairly evenly through the entire year, or whether it was generated by large gains in one or two specific periods
  
• Breadth: Check whether the manager turned in an even result on all issues, or whether one lucky trade accounted for the majority of the gains made in a particular period.
  
• Repetition: Is the investment process easily repeatable, or was the fund's good performance caused by an isolated incident in the period under examination?
  
• Strategy specific risk: Examine which strategies are commonly used by the particular fund manager in question, and look at the risks inherent in these strategies. Look at the risk management philosophy within the fund, and examine the precautions taken against currency exposure, interest rate exposure, technical and other problems, and marauding elephants. (Just kidding with the last one, although a fund manager that does have a contingency plan in the event of elephant attack is probably one to whom you can entrust your money!)
  
• Leverage: Look at the fund's rationale for leverage, ascertaining the leverage caps, the average leverage used, and whether leverage has ever been revoked for any reason.

The People

• Background: Look at the general background of the fund, including the division of responsibility amongst the principals, its formation and structure, fund terms and relationships, and possible conflicts of interest.
  
• Manager profile: Look into the background, qualifications, and employment history of the fund manager, and obtain references and current investor testimonials.
  
• Reporting: Ascertain who the custodian of the fund's assets is, and who the prime broker is. (An important point to remember is that a cheque, or wire transfer of funds should never go directly to the fund itself, but should always be sent to the prime broker, or custodial bank.)
  
• Administration: Find out whether the manager uses a third party administrator to calculate monthly returns, and ask for background on the fund, their calculation and verification methods, where their data comes from, and what procedures they have in place for monitoring that the terms of the fund's offering are being upheld.
  
• Audits: Every fund should be audited annually, and if the fund is new, they should have an auditor under contract for the end of the first year. Check how experienced the auditors of your preferred hedge fund are at performing this type of audit, and contact them to obtain background knowledge of the fund and its manager.
  
• Other investors: Finally, ask for information about the profile of the other investors; are they mostly individual, or institutional investors? Onshore or offshore investors? Look at their average net worth, if you can, and also the extent of diversification in their portfolios.

By now, of course, you may be wondering if you can be bothered with all that, and contemplating making yourself a nice cup of tea. That, of course, is also an option. Although hedge fund due diligence seems like a lot of work, it is worth remembering that if you are planning to invest in a fund of funds, a lot of this work (although not all) will be done for you. And if you are going it alone, chances are that you will not see this background research as a chore, because you are likely to be investing substantial amounts of money. Conventional mutual funds require somewhat less effort, because their more regulated nature means that some of the issues pertinent to hedge funds do not apply to them. However, lack of regulation (one of the reasons why this research has to be so comprehensive) is one of the factors which makes hedge funds so potentially profitable…

Here we get to the bottom line - if you are a wealthy investor with a fair tolerance for risk, and a desire to see your investments hedged against market volatility, hedge fund investment may be the way to go. If you have all of the above, but a slightly smaller liquid net worth, then you may want to consider investing in a fund of hedge funds, or some other similar vehicle. And if you want to know what's on TV tonight, and whether you can have your cup of tea yet, you may have come to the wrong place…!

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