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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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Alternative Investment
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:
| 1)
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Invest
directly. This option is really only reserved for
High Net Worth Individuals (able to make a minimum
investment from between $1 million and $5 million
in most cases) who possess a high degree of investment
knowledge. Word of mouth is a powerful tool in the
upper echelons of the hedge fund world, so if you
haven't been told about it, you probably aren't
eligible for it…
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| 2)
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Use
a consultant. A consultant can act as a bridge between
individual investors and hedge fund managers, and
can usually provide information about managers'
strategy and performance. (Hedge fund managers are
not required to report performance data to any central
authority, so this information is usually very hard
to come by).
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| 3)
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Invest
through a third party firm. A number of financial
services providers are now offering access to what
are essentially funds of hedge funds. This is probably
the most realistic option for mass affluent investors,
as the minimum investment required is usually a
lot more affordable, sometimes as low (!) as $100,000.
There are many benefits to this style of investing,
which not only provides investors with access to
multi-manager expertise which might not previously
have been available to them, but means that the
firm may be able to tap long standing relationships
with prominent fund managers, and to add professional
due diligence and asset allocation expertise to
the proceedings. |
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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