James Ramsay | Stock Broker and Private Client Adviser

Two snapshot equity charts

1.  US share market volatility experienced a huge jump during the final months of 2008 but it has now dropped back to around 25%, which is approaching the long term average of 20%

2. US institutions/retail investors have been net sellers of US equities, especially the financials, during June.

The US “cash mountain”

In the USA, money market mutual funds and equity mutual funds are sitting on $3.7 trillion in cash, which is equivalent to 32% of the collective market capitalisation of the New York Stock Exchange and NASDAQ versus the 1992 to 2007 average of 13%.

This cash is earning a negligible return and, as the investment environment continues to improve, both institutions and private investors are expected to deploy some of this “cash mountain” into equities.

Trading and Investing In International Shares

A stronger then expected bounce in world equity markets may leave you looking for more investment opportunities and may even take you offshore. You may be forgiven for thinking investing offshore is exotic and only for the well informed although I think you will be surprised at how easy it is.

One of the easiest ways to gain exposure to offshore indices is to use Exchange Traded Funds (ETFs). These can be traded on the ASX and they manage all the currency conversions internally.

These ETFs give you access to most of the major world indices exactly the same way as you would buy and sell BHP. Think South Korea, Germany or the BRIC indices are over sold? Well now you can take that view and invest in them on the ASX. They pay dividends and handle the currency conversion all in one transaction.

If you would like to refine your view want exposure to one or more specific stocks you will need to set-up an offshore account. It gets a little more complex but still a simple process.

How does an international share trade work?

The mechanics of buying and selling are much the same as investing on the Australian market. You will need some extra paper work to get your account set-up but once that is done orders are much the same.

For this example we will buy 1000 Microsoft (MSFT) in the US when they are trading at US$25.00. The AUD/USD exchange rate is 0.80c.

The 1000 MSFT shares will cost you $25,000 USD or $31,250 AUD

If when you go to sell the MSFT stock the price is still US$25.00 but the AUD/USD exchange rate is 0.65c the net result will be $38,461 or a gain of $7,211.

The second scenario is when the AUD/USD rises above our initial entry price. If the AUD/USD rate was 0.95c and the MSFT price was still US$25.00, we would realise a loss of ($31,250 – $26,315) $4935

So what is the ideal scenario?

We want the stock move up and the currency to move down. Using the example above if MSFT moved to $35 and the currency went from 0.80c to 0.60c the net result would be:

Stock: $35 – $25 = $10 gain
Currency : Buy $25,000 USD at 0.80c = $31,250
Currency : Sell $35,000 USD at 0.60c = $58,333
Currency Gain = $58,333 – $31,250 = $27,083
Total profit = $27,083

If we did not have the benefit of the currency movement our gain would have only been $10,000

Pitfalls of investing offshore:

• Currency Movements – Good, Bad or Ugly? It all depends on which way they move while you have your position open. See the trade example above to see how it would play out.
• Keeping Track & Research - Most Australia based brokers will only offer stock research on Australian based companies. While it is possible to get offshore research it is not quite as easy find and compare multiple research reports.
• Time Zones – Depending on the stock exchange you are looking to trade, there may be a large time difference. While not unworkable it does make it harder to add and modify trades in real time.
• Dividends – Dividends will be paid in the currency of the underlying stock. So if you have a USD based stock the cash dividends will be paid in USD. These will be need to be transferred to back to your home currency at some point.
• No Franking Credits – Any dividends received will not have franking credits attached, as they do not pay tax in Australia.

Benefits of investing offshore:

• Currency Movements – When you pick the stock correctly and the currency moves in your favour you will receive the gain of two trades in one transaction.
• Greater choice of Stocks – You have almost every stock in the world to choose from.
• It has never been easier - With current technology and links to other stock exchanges the doors for international investing have opened wide.

Looking for above average Yield in a Low Yield Environment?

With interest rates at record lows and cash rates being decimated the question everyone is asking how do I get a decent yield in this environment?

Traditionally investors would use a Cash Management Trust (CMT) or use short dated Bank Bills to achieve a higher yield than cash in the bank.

One alternative you may not be aware of is Hybrids. Now before you go thinking about Hybrid cars and some special battery/fuel combination to power the car lets define what a financial Hybrid is.

As the name suggests a Hybrid is a combination of two or more different things, aimed at achieving a particular objective or goal. In our case it is normally equity and interest rate exposure combined together.

The Hybrid market is an often over looked sector of the ASX but with recent issues from AMP and WBC it’s worth revisiting. Hybrids can offer a combination of yield, capital growth and capital protection.

Although it is a hybrid you still need to access the underlying strength of the issuer / parent company.

Key operational developments for the issuing company will impact upon the level of risk attached to a hybrid’s income and capital.

In terms of industrial companies, two key measures we look at for each company are net interest cover (EBIT/net interest), and gearing (net debt/shareholders’ funds).

Depending on the industry, we ideally require a minimum interest cover of 3.5x and gearing preferably below 50%. Adverse movements in these metrics will ultimately increase the perceived level of risk, reduce the equivalent credit rating on the hybrid, and result in a decline in security price to adjust for the increased risk margin.

Hybrids can be difficult to understand, so get to know some common terms and definitions:

• Cumulative: Describes a preference share for which unpaid dividends accrue.
• Gross margin to swap: gross running yield less the relevant swap rate.
• Gross running yield: forecast dividends (or distributions) over the next 12 months divided by the current security price. Where the dividend is fully franked, the yield includes the grossed up amount of the franking credits.
• Gross yield to maturity (including conversion discount): is the annualised internal rate of return on the hybrid’s cash flows, including purchase (current) price, forecast future dividends grossed up for franking credits, and the value of shares on conversion at maturity, which includes the conversion discount. While this assumes all issues are converted into shares on maturity / reset date, this may not occur on some issues where the issuer has the option to apply a step-up margin.
• Non-cumulative: Describes a preference share for which unpaid dividends do not accrue.
• Swap rates: Bank Bill Swap Rate (BBSW) is the primary benchmark interest rate for the Australian money markets. BBSW is also used a reference rate for floating rate hybrids. Dividend payment rates are set at a margin to the relevant BBSW for each dividend period. Quarterly dividends are based upon 90 day BBSW, while half yearly dividends are based upon 180 day BBSW. Fixed rate issues are typically priced at a margin to the Five Year Swap Rate at the time of a new issue or reset of terms.
• Floating or Fixed notes: Is how the interest is calculated. Floating notes normally use the BBSW plus a pre-determined margin. Fixed notes pay interest at a predetermined rate that does not move when the BBSW rate does.
• Credit Rating: Is the credit rating of the underlying issuer or parent company.
• Conversion date: The date at which a conversion event takes place. There are normally one of three events that happen at the conversion date as detailed below in the conversion type.
• Conversion Type: Normally one of three circumstances happens when conversion takes place. It is redeemed at face value, it is converted to stock in the underlying company or it is stepped up with a new margin.

When looking at Hybrids the devil is in the detail – a good understanding of each term and reading the Product Disclosure Statement (PDS) is a wise move. The PDS will detail any events that can create a change in the conversion method. To get the most from Hybrids you must know what happens at maturity.

Managed funds inside a SMSF. Is it worth it?

The other night I was at Big Kev’s house (my Father-in-law to be) going through his self managed super fund (SMSF) that his accountant and financial planner setup for him.

For the most part I have stayed away from giving advice about his super fund as I assumed his financial planner had it under control.

Anyway he said “James tell me what you think of what’s in the fund.”

So we got all the paper work out and tried to figure out exactly what was in his SMSF.  Turned out it was no easy task.

After about 2hrs we managed to get down to two pieces of paper that showed us exactly what they owned. I think we did anyway.

Now before I proceed I will explain my view on SMSFs and why you would/should use one.

A SMSF allows you to do exactly as the name suggests and manage the investments yourself. You decide when to buy and sell and what to buy and sell.

Plus there are tax benefits of doing it all inside of the fund:

• SMSFs are taxed only at 15% on contributions, and 15% on earnings.
• If your SMSF invests in shares that pay franked dividends, and get imputation credits of 30 cents in the dollar, you will get a refund of 15 cents in the dollar of tax paid by the company
• Assets purchased after 1999 and held for 12 months (such as shares or property) in a complying super fund are eligible for a one third discount on CGT (they’re taxed at 10% of the capital gain as opposed to 50% of your marginal rate outside of super).

If you are not taking advantage of the tax benefits and timing of investments inside your fund then you may want to just go back to a corporate fund and forget about all the administration that they create. Don’t forget just because you do it yourself does not mean you can’t consult advisors in property, shares and tax.

Now back to Big Kev’s SMSF. Upon finding what he holds, I found that he holds cash and five managed funds inside his fund.

The breakdown was three share funds and two property funds. What I could not figure out is why you would hold a managed fund inside a super fund.

The property funds I can see why – i.e. most people don’t have the cash available to go out and buy a commercial property or they don’t want the hassle of managing properties.

Although the share funds baffled me a bit. I don’t see why you would buy a managed fund inside a SMSF fund. You may lose out on the franking credits and tax benefits from the dividends you receive depending on the fund you choose and end up paying another layer of fees to another fund manager.

With direct share purchases you pay brokerage only when you buy or sell. From then on the shares are fee free. You could not do anything for 10 yrs and your only fees would be the SMSF administration fees.

Managed funds have their time and place, but I think anyone with a SMSF should be looking at direct shares and benefiting from the freedom and tax benefits.

If you have a SMSF and are concerned about what you currently own inside the fund, or would like to contact James, you can here