by WWM | Feb 14, 2018 | Mutual Funds
We detoured from our review of investment funds to look at a few strategies and analytical ratios often used by investors.
In our Mutual Fund Introduction, we saw that there are an overwhelming number of mutual funds on offer. And that these funds cover the entire spectrum of asset classes and sub-classes.
How can investors possibly make sense of these investments? Truthfully, it is hard.
Today we will look at a few available mutual fund types.
Money Market
Money market instruments are short-term debt instruments (i.e., less than 1 year to maturity). Investments are considered extremely safe due to the nature of the fund investments.
Interest income is paid to investors.
While the returns are not high, they are better than what one would receive from savings accounts. And as the fund aggregates money from many individual investors, it can obtain higher returns on treasury bills and other short-term debt than a small investor could achieve on his own.
Money market funds may be available in foreign currencies. This may create foreign exchange gains or losses as compared with the investor’s domestic currency. In some cases, this can greatly enhance investor returns or possibly create losses.
Always take care when investing in money market funds – or any asset – that are not in your own currency.
Fixed Income Funds
You may also see these termed “bond funds”.
These funds invest in government and corporate debt. Some include preferred shares as well.
Within the fixed income style, there are many sub-categories.
Quality of Issuer
Some funds focus only on high quality debt issuers.
Other funds specialize in high risk issuers in the expectation of receiving higher returns. This latter group of non-investment grade fixed income instruments is known as “high yield” or “junk bonds”.
The quality of the issuer is based on ratings assigned by one of the bond rating agencies. For example, bonds with ratings below BBB by Standards & Poors or Baa by Moody’s are considered non-investment grade bonds.
Terms to Maturity
Some funds concentrate on specific terms to maturity. Perhaps only investing in bonds with maturities between 5 and 10 years. Or maybe only in bonds with over 20 years life remaining.
Or you may see “bond ladders”. These funds spread out maturity dates like rungs of a ladder to smooth interest rate and reinvestment risks.
Regardless of Type
Fixed income funds attempt to generate a steady cash flow of interest (or dividend) income to investors. Although the objective is income, there may be capital gains or losses as well.
As interest rates fall, the market value of existing bonds will increase. This can create a capital gain if the bond is sold prior to maturity. Should interest rates rise, bond prices will fall, causing a capital loss if the bond is sold.
Due to the underlying investments and longer maturity dates, fixed income funds should generate greater interest income than money market funds. However, in times of rising interest rates, money market funds may outperform fixed income funds if the fixed income funds experience capital losses. Something to watch out for when investing in fixed income.
Balanced Funds
Balanced funds try to provide a balance between security, income, and capital appreciation.
The funds invest in a mix of money market, fixed income, and equity instruments to achieve this objective. As a result, the fund generates both dividend and interest income as well as capital gains (or losses).
The asset mixture is defined in the fund’s stated objectives. They do not need to be “balanced” equally.
Combination of asset classes may be fixed (e.g., 5% money market, 35% fixed income, 60% equities) or have a range of maximum and minimum investment levels for each of the three classes (e.g. 0-10% money market, 20-50% fixed income, 40-70% equities).
Investment percentages may further be broken down into asset sub-classes. For example, if 60% is allocated to equities, perhaps 30% is United States, 25% Other International, and 5% Canada.
The fund’s prospectus will lay out the investment strategy and restrictions.
Do not confuse balanced funds with asset allocation funds.
Asset Allocation Funds
Although similar in nature, there is usually greater flexibility in an asset allocation fund. This allows the portfolio manager to take advantage of changes in the business cycle to maximize investments in an asset class.
For example, as the economy heats up, stocks will begin to rise and fixed income assets should fall in value. An asset allocation portfolio manager has the flexibility to shift the bulk of the portfolio assets into equities and out of under-performing asset classes like bonds.
Balanced funds have less or no leeway in altering the asset mix.
Because of the extra work involved by the asset allocation managers, it is normal for asset allocation funds to charge higher fees than similar balanced funds.
Target-Date Funds
Like balanced or asset allocation funds, target-date funds invest in multiple asset classes.
However, target-date funds automatically reset the portfolio asset mix based on the stated investment time horizon.
With a long maturity, investments are skewed towards riskier assets. As the maturity date gets closer, assets shift into less risky investments.
This is much like Life-Cycle funds (also known as “Aged-Based” funds).
We will consider these funds further when we look at investor profiles and strategies.
Equity Funds
The largest class of funds are equity funds. They also have the most sub-categories.
In general, equity funds strive for long-term capital appreciation. Some may also generate income, but that is normally a secondary consideration. The exception being equity income funds that specifically seek dividends.
Equity funds may be aggregated in a variety of ways.
Market Capitalization
They may focus on stocks of companies that have certain levels of market capitalization. Large cap or small cap equity funds are common variations.
Type of Company
They may focus on characteristics and style fits of companies.
For example, value or growth equity funds.
Some funds focus on companies that pay high dividends. Others on companies that pay no dividends.
Geographics
You will also see funds based on the geographic location of the underlying companies. These equity funds may be designated domestic, international, and global.
Domestic equity funds are those that contain stocks listed on stock exchanges in the same country as the investor.
International equity funds are those whose companies are listed on stock exchanges outside the investor’s country of domicile. International funds may also be called “foreign” funds.
Global equity funds may contain shares of companies from anywhere in the world.
For example, consider the Credit Suisse (CH) Swiss Blue Chips Equity Fund UB. It invests mainly in large cap companies located in Switzerland. Nestle, Novartis, Roche, UBS, etc.
As a Swiss investor, this would be domestic fund. To an Canadian investor, it would be an international fund.
In contrast, the Credit Suisse (Lux) Global Value Equity Fund BH CHF invests in a wider range of equities. Its scope includes “undervalued companies which are listed worldwide on regulated and accessible markets.”
Because it has shares of companies from both within and outside Switzerland, it is a global fund to a Swiss investor. And to a Canadian investor as well.
Sector
Within the broader categories, you may see smaller fund compositions, such as by industry or business sector.
For example, Fidelity offers equity funds that cover: Consumer Staples, Consumer Discretionary, Energy, Industrials, Telecommunications, Financial Services, Health Care, Materials, Natural Resources, Precious Metals, Technology, Utilities.
Countries or Regions
Funds also exist that narrow the geographic segments into regions and countries.
T. Rowe Price has a Global Stock fund. But they also provide more geographically focussed equity funds including: Africa & Middle East, Emerging European & Mediterranean, Emerging Markets, European, Japan, Latin America, New Asia.
Or you may even see subsets of subsets. A BRIC fund is a good example. This is an emerging market segment that includes only Brazil, Russia, India, and China. The four largest emerging markets.
Speciality Funds
Speciality funds are those that do not fit into one of the above boxes. Hard to believe, I know.
That said, some people include sector and regional funds as specialty funds.
Real Estate
In this category, you usually find investments in real estate companies or assets.
Some funds invest in operating companies that manage hotels, develop properties, etc.
Precious Metals
You may also see funds that invest in precious metals.
This can be achieved by investing in companies involved in precious metals. Often this includes indirect involvement, such as service companies.
It may also include direct investments in the assets.
For example, Tocqueville Gold (TGLDX) invests about 80% of its capital into shares of mining and related companies. But up to “20% of the fund’s total assets may be invested directly in gold bullion and other precious metals.”
Collectibles
Some funds allow you to invest in other exotic assets such as collectibles.
There are many funds that specialize in tiny market segments, including fine art and vintage wine.
I would caution investors with these unique types of funds. Usually the management fees are extremely high, the ability to liquidate one’s investment may be limited, and the investment time frame required may be substantial.
While collectibles may be useful for diversification, I would not recommend their purchase for most investors.
Environment, Social, and Governance (ESG)
A very popular investment niche over the last decade or so.
These funds invest in specific areas or exclude specific investments from their options in an attempt to be socially responsible or ethical.
For example, the Pax Ellevate Global Women’s Index Fund (PXWIX) employs “a global, index-based investment strategy designed to capture investment returns associated with gender diversity and women’s leadership.”
Or consider The American Trust Allegiance Fund (ATAFX). Its investment strategy seeks positive returns, while “avoiding companies involved in the alcohol, gambling, tobacco and health care industries.”
That is an overview of common fund categories. Over time, I will discuss these in more detail as we look at constructing diversified portfolios.
by WWM | Dec 13, 2017 | Exchange Traded Funds, Investment Strategies, Mutual Funds
Investors often pursue investment strategies based on market capitalization.
Additionally, equities may be viewed through the prism of being either value or growth stocks.
Today we look at value investing.
What exactly is value investing? What are its advantages and potential pitfalls. Should you value invest?
Value Stocks
Stocks in this category are seen as value buys.
That is, the stock is considered undervalued based on quantitative and qualitative analysis.
The objective is to identify companies that trade below their intrinsic (i.e., “true”) value. Then purchase shares and wait patiently for the rest of the world to see what they have missed.
Companies in this category tend to be: established companies that have fallen out of favour and been beaten down in price due to poor performance, bad news, lawsuits, management changes, etc.; smaller companies that are not extensively followed by analysts and the investing public; mature companies that have minimal upside for internal growth, so they pay out their earnings in dividends rather than reinvest in the company’s operations.
Or perhaps entire industries or sectors are depressed. Look at real estate markets in the US and Canada over the last decade. At times, significant bear markets in some regions. Oil and gas is another industry that took a hit in the past few years. Nothing wrong with the companies per se, they just happened to be in a market with low oil prices.
In essence, you are attempting to buy assets that are “on-sale” due to specific circumstances. As the circumstances alleviate, the share price reverts back to its “true” price.
In theory, this is an excellent way to invest. In any other investment you make (house, art, coins, etc.) you always try to find acquisitions being sold at a discount to market value. Better to purchase your home in a down market than to buy the same property when demand is high.
Benjamin Graham and David Dodd are considered the fathers of this investment style. Warren Buffett uses this approach in a slightly modified form. Hard to argue with those investors.
I quite like value investing. But it is not an easy process.
Given the amount of publicly available data, the number of analytical tools one can use to screen stocks, and the sheer volume of investors searching for the next great value stock, it is not simple to find a hidden gem all on your own.
If you lack the time or expertise to do your own in-depth analysis, value equity funds are a good way to invest. Many are professionally managed, albeit often at a relatively high management fee. And by purchasing a number of companies that meet the value criteria, funds spread out the risk of the individual stocks.
Quantitative and Qualitative Analysis
In analyzing companies under a value approach, analysts examine an investment’s fundamentals.
Please refer to my post on Quantitative and Qualitative Analysis for details.
Quantitative analysis is not difficult. Find the data, plug it into the appropriate equation, and you have your result.
Common fundamentals include: price/earnings; price/book; dividend yields. Analysts usually arrive at similar numbers.
The difficulty lies in interpreting those results.
Qualitative Analysis
In value investing, the proper qualitative analysis is what separates value from junk. This is critical, because based on the quantitative data, terrible investments often look like value opportunities.
A low price/earnings ratio may suggest value. Or it may indicate a company heading for difficulties. The same is true for companies with high dividend yields. The exact same ratio in two different companies may indicate the complete opposite future potential.
When we cover the common fundamentals later, we will go through examples.
Qualitative analysis assesses an asset’s systematic and nonsystematic risk factors to make sense of the quantitative results. Risks involving: general economic conditions; management; operations; industry; competitors; customers and suppliers; credit and financial; tax and regulatory; legal.
Intrinsic Value
By conducting both quantitative and qualitative analysis, you attempt to determine a stock’s intrinsic value.
But what is this true value?
And that is the problem with value investing.
What exactly is a stock’s intrinsic value?
As I stated above, most analysts will arrive at similar quantitative results. Then they use quantitative analysis to adjust the data to reflect what they believe is the asset’s “correct” value.
Based on your analysis, you will arrive at one number. Other investors, using the same publicly available data, will arrive at different valuations. Some will be higher, some lower.
No matter how good the analysis, many investors will be incorrect.
And no matter how poor the analysis, some investors will get lucky.
Further, unforeseen events may render even the perfect analysis irrelevant.
Consider the September 11, 2001 terrorist attacks in the US.
On September 10, certain assumptions were made in respect of investments. Interest rates, government spending, oil prices, consumer demand, company revenues, to list a few variables.
On September 11, many factors changed completely. Share prices across the board fell. The US government launched a long and costly war. And so on.
In the space of 24 hours, many assumptions that investors relied on materially changed. And those changes impacted valuation calculations.
In November, 2016, it was widely expected that Hillary Clinton would win the US presidency. That win would usher in her world views and policies. When Donald Trump won, that required a significant shift in thinking. Forecasts and estimates based on assumptions made in late October required adjustments. Adjustments that impacted fundamental analysis.
Considering that just before the election, pollsters showed Clinton with a 95% probability of winning, it is hard to fault analysts for assuming she would win. But she lost and all analysis became erroneous to some degree.
Determining the “real” value for a company is difficult, if not impossible. As the world and company specific factors change, so too does its future value. Without a crystal ball, very hard to get it right.
As well, what you consider an asset’s true value will be different than others. Think of buying or selling a house or used car. Pretty much anything. The value you assign to something is likely different than other parties may believe.
Should You Value Invest?
While it may be impossible to accurately predict a company’s intrinsic value, should you ignore value investing?
Not at all.
Studies often show that value investing outperforms growth strategies.
I do not agree with this as a general statement as other data shows mixed results. But there are some who believe value investing is the only way to go.
I do believe that investors following any investment strategy (e.g., growth, balanced, Japanese equities) must follow the tenets of a value strategy. After all, when you get to the heart of value investing, it is simply common sense.
Find companies that are undervalued relative to what you believe is their true worth.
Then buy their shares.
At its basis, it is that simple.
And even if you follow a growth strategy you need to adhere to these principles.
Apple, Amazon, Facebook, and Google may be considered growth stocks. But even so, you want to buy the one(s) with the best potential. Not the ones that may be overpriced.
Implementing a value investing program requires investing skill. It also takes time and luck to do well picking individual value stocks. It is difficult, but not impossible. As the success of Warren Buffet and others can attest to.
Many investment companies offer value funds. I suggest initially using them if you wish to follow a value strategy.
As you develop experience and confidence in your analysis, then consider trading individual stocks.
by WWM | Nov 22, 2017 | Mutual Funds
Why are open end mutual funds worth reviewing?
First, mutual funds are extremely popular and there are many funds in existence. Whether you intend to or not, you will come across funds in your investment travels. In 2015, 43% of US households owned mutual funds.
Second, I believe mutual funds, along with exchange traded funds, should form the cornerstone in any investment portfolio. Hopefully, you will come to share that view.
Third, some things I read about mutual funds are not entirely accurate. I want to pass on a few caveats and considerations when assessing funds.
There are Many Funds to Choose From
The first thing you notice about mutual funds is the huge number that exist in the market.
Fortunately, whatever your investment strategy, you can find a fund that helps achieve your objectives.
Unfortunately, it also means that there are a lot of funds to wade through to find the good ones.
In 2015, per the Investment Company Institute’s 2016 Investment Company Fact Book, there were 100,494 regulated open end funds globally, valued at USD 37.2 trillion.
In Canada, there were 3283 regulated open end funds in 2015, valued at USD 890 billion.
If you use a common analytical tool like Morningstar, your universe will cover more than 18,000 funds in various classes.
Given the sheer volume, how do you pick a fund that is right for your specific needs?
There are three key ways to reduce your search and find an appropriate fund.
Investment Style
Mutual funds are grouped by investment style or category.
Fixed income or equities would be two very broad styles. Likely too general to be useful in practical fund comparisons.
Within a category, funds are often broken down into smaller sub-categories. These are the investment styles that make it easier to find funds that meet your specific strategy.
If you want a fund that invests solely in Japanese equities, you can find a grouping of funds that meet that objective. If you want to invest in high yield (“junk”) bonds from U.S. corporations, you can find a listing of these funds as well.
While there may be over 100,000 mutual funds out there, those that meet your search criteria will be significantly less. If not, you will need to refine your criteria to achieve a manageable number.
Comparing Performance By Style is Important
Besides reducing the number of funds to research, style is crucial in assessing funds.
As the old saying goes, always compare apples to apples, not apples to oranges. So too with mutual funds.
Like any asset, funds have their own risk-return profiles. One style may have lower risk than another. With a lower expected return. If you only compare actual returns, you may invest solely in higher risk funds and ignore more secure alternatives.
For example, emerging market equities are traditionally riskier than American “blue chip” shares. With higher risk, the expected return on emerging market shares should be higher than for “blue chips”.
In comparing two funds, Bluechip and EM, last year EM experienced a return of 12% versus 10% for Bluechip. That might cause you conclude EM is the better investment.
But what if the risk associated with EM is 20% versus 5% for Bluechip? If you recall our look at investment risk, an investment with a 20% standard deviation is significantly more volatile in price than one with 5%.
Comparing blue chip equities with emerging markets is apples to oranges. Instead, you want to compare emerging market funds to other emerging market funds. And blue chip to blue chip.
Sorting funds by style, funds within a specific category should have similar risk-return characteristics. That allows for better assessment of true performance by the fund managers.
Note that a potential problem with mutual funds is “style drift”. Where the actual investments (and risk-return profile) differ from the stated investment style. We will cover this shortly.
Rating Agencies
Ratings agencies rank funds on a variety of factors. One is performance on a risk-adjusted basis. This assists investors in narrowing choices for their own investment decisions.
Morningstar is the main rating agency, but there are others to consider using, including Lipper. Also, websites, such as TheStreet.com and Businessweek, review and grade funds.
For disclosure, I tend to use Morningstar raw data feeds in my analysis. Not to say it is the best, but it serves my needs.
Rating Mutual Funds
How do agencies rate mutual funds?
Morningstar, for example, plots each fund’s risk-adjusted return for a variety of time periods. These are then compared with other funds on a traditional bell curve. A fund that falls within the top 10% of all funds merits a 5 star rating. If the fund sits in the next 22.5%, it earns a 4 star rating. And so on until the bottom 10% receive only 1 star.
In addition to 3, 5, and 10 year ratings, Morningstar also provides an Overall Morningstar Rating. This is a weighted average of all individual ratings for a fund.
In theory, by choosing funds that are rated as 4 and 5 stars, you are narrowing your options to funds that are in the top third of their style based on risk-adjusted performance.
That should help make better investment decisions.
Do Not Rely Only on Ratings
While ratings may help find above average performers, they are not foolproof.
Rankings are based on historic results and not the future. As circumstances change in the marketplace or in the fund itself, future performance may differ from the past. Always an issue with investments. The past is no guarantee of future results.
Agencies and reviewers do not cover all available funds. Some are more comprehensive than others.
Newer funds are often not rated due to limited history.
Different rating agencies, using different methodologies, may come to different conclusions.
Be aware of the limitations in the ratings. I would never rely solely on a fund rating to invest.
Simply because a mutual fund is not rated or is not in the highest bracket does not mean it is a poor investment. There are mutual and exchange traded funds in my top tiers that do not have “official” ratings from Morningstar. Or are ranked lower than I assess.
Screening Tools
In assessing funds, there are a variety of tools available to assist you.
These tools allow investors to screen funds by many different criteria.
Most brokers provide free screening tools, many with ties to rating agency or internal rankings.
As well, fund rating agencies like Morningstar have their own screeners. And many investment or finance websites (e.g., YahooFinance, Forbes, etc.) have screening tools available.
Some are free. Some offer limited services for free, with premium upgrades.
For the average, smaller investor, most of the completely free analytical tools will do the job.
Different screening tools may allow you to search by slightly different criteria. However, key criteria are usually the same. These include fund performance over varying periods, investment style, sales charges, annual expenses, etc.
I shall expand on some of the above items in future posts.
Next up, a look at a few common investment styles.
by WWM | Nov 15, 2017 | Exchange Traded Funds, Mutual Funds
To date, we have reviewed the major asset classes: cash and cash equivalent; fixed income; equity or common shares. There are a variety of lesser asset classes, as well as sub-classes within each class. We will cover some of these in time.
You can invest in assets of each class individually or via collective investment schemes. In the latter, many investors aggregate their money in a single investment vehicle. These collective schemes are generally called investment funds.
In theory, aggregation allows some or all of the following benefits for individual investors: a simple way to create and maintain an investment portfolio; better portfolio diversification through asset classes and time; access to investments that cannot be bought by small investors; improved liquidity; fund management by investment professionals; economies of scales on expenses that reduce costs allocated to any one investor; consolidation of tax information.
Because of these potential benefits, most investor portfolios should be comprised primarily of investment funds.
Today we will review four types of investment funds.
Closed-End Investment Fund (CEF)
This fund is established as a corporation with a limited number of shares initially issued to investors via an Initial Public Offering (IPO). The proceeds are then invested according to the objectives and fund policies as stated in the prospectus.
Occasionally CEFs have subsequent public offerings. But normally there are no other issues after the IPO.
The CEF is listed on a stock exchange. Share acquisitions or dispositions by investors takes place in this secondary market. Transactions occur during normal trading hours of the exchange.
Shares are not redeemed by the company. An exception would be if the CEF decides to either reorganize and redeems a portion of shares or liquidates the company itself.
Share value is determined in two ways.
Net Asset Value
Share price is based primarily on the net asset value (NAV) of the investment fund. The NAV is the value of the fund’s investment portfolio (its only assets) less any liabilities that exist. To calculate the NAV per share, divide the net assets of the fund by the number of outstanding shares.
For example, Omega Investment Fund has an investment portfolio with a market value of $100 million, short term liabilities of $1 million, and 9 million shares outstanding. The NAV of Omega’s shares is $11 per share.
The key to NAV is the market value of the investment portfolio. The portfolio is made up of common shares, bonds, money market instruments, etc. As these asset valuations fluctuate daily, a fund’s NAV will also change daily.
In our example, Omega’s NAV is $11 per share. If this was a real company and I checked the actual share price, I would expect to see it somewhere around $11 per share.
Somewhere, that is, but not exactly.
Premium or Discount
The second component of a CEF’s share price is based on investor supply and demand.
Investors who want the stock must buy it on the secondary market. The greater the number of investors who want the CEF, the more competition for available shares. Stronger demand than supply will increase the share price above the NAV.
The difference between the NAV and market price of the shares is known as the “premium”.
Other CEFs may trade below the NAV. This is because more shareholders wish to sell (supply) than there are new investors wanting to buy (demand). In this case, shares trade at a “discount” to NAV.
Why Trade at Premium or Discount?
Why are there premiums and discounts for mere investment portfolios?
Investors look at securities within a CEF portfolio and believe these investments will increase or decrease. Based on perceptions about future returns on the portfolio, investors will be bullish (optimistic) or bearish (pessimistic). The more bullish, the greater the demand and the greater the premium. The more bearish, the opposite.
Secondly, investors look at fund management. If management is seen as strong, investors believe that management will find new investments that will bring superior returns versus other funds. This will also create a premium.
Consider Warren Buffett. If Mr. Buffett managed a CEF, I expect there would be a nice premium on the share price. And with Berkshire Hathaway (a conglomerate, not a CEF), there is usually a healthy premium to the share price.
Note that these are the same principles that drive the share price of operating companies.
Open-End Investment Fund (Mutual Fund)
Mutual funds, as the formal name indicates, are open-end funds.
Like closed-end funds, a new mutual fund issues shares (or units) to investors and invests the proceeds according to the fund’s stated objectives. However, a mutual fund continuously sells new shares to the public. The issue price of the shares is equal to the NAV of the fund.
There should be no premium or discount associated with the share/unit price.
Open-end funds are not traded on stock exchanges. Investors purchase shares directly from the fund. With no secondary market, the fund itself must buy back any shares investors wish to sell. This is known as “redemption of shares”.
For most funds, the NAV is calculated. Investors purchase or redeem shares at the close of day NAV.
A few funds do not allow purchases or redemptions on a daily basis. Investors may only have the option of buying or selling on a weekly, monthly, or quarterly basis. This can create liquidity problems for investors. Be certain you know the frequency of possible transactions before investing in any funds.
Over time, an open-end fund may become a “closed fund”. Do not confuse a “closed-end fund” with a “closed fund”.
A closed fund is an open-end fund that has been shut to new investors. Closure may be permanent or for a temporary period. While the fund may not accept new investors, often existing investors can still acquire additional shares.
The most common reason for a fund to close is that its assets under management has become too large for the fund to properly invest under its stated objectives and strategies.
Exchange Traded Fund (ETF)
An ETF is like a closed-end fund in that it trades on a stock exchange and does not issue new shares to the public.
An ETF is a security that tracks, or performs against, a specific index or benchmark. There are many different ETFs that cover a wide variety of areas. Many ETFs simply passively follow their benchmarks as closely as possible.
An ETF may track a: country (iShares MSCI Brazil Index); region (Vanguard Emerging Markets Stock ETF); stock exchange (SPDR for the Standard & Poors 500 Index); industry sector (United States Oil); commodity (SPDR Gold Shares).
Some ETFs are actively managed as they attempt to outperform their benchmarks. For example, the PowerShares Actively Managed Low Duration ETF.
ETFs trade like shares and there is no NAV calculation.
In attempting to replicate an index or benchmark, there are a few different methods employed. ETFs may hold the index fully in its proper proportion. This may be accomplished for smaller indices such as the Dow Jones 30.
ETFs may use representative sampling techniques to replicate performance with less than 100% of the index components.
ETFs may also utilize derivatives such as options, futures, and swaps, to try and mirror an index’s performance or synthetically create portfolios.
With passive index ETFs, how the fund replicates its benchmark and its tracking error are important considerations.
Hedge Fund
A hedge fund can be a variety of investment creatures. Some more scary than others.
In general, a hedge fund is a pooled structure of investments that uses a wide variety of strategies to achieve its stated investment objectives.
Sounds much like a CEF or mutual fund.
The main difference between hedge funds and other funds is the level of regulation.
Hedge funds are intended for (supposedly) sophisticated investors who understand the world of investments. Especially the concept of investment risk.
In many jurisdictions, there are rules governing who is and is not a sophisticated investor. Usually this is linked to the investor’s net worth, annual earnings, investment experience, etc.
As hedge fund investors are supposed to be experienced and knowledgeable, hedge funds invest in a wide variety of investments and utilize strategies and tactics not usually found in mutual funds. For example, hedge funds may take short positions, invest in derivatives, and utilize leverage.
A common perception of hedge funds is that they are out of control investment vehicles, engaging in high risk (hopefully high reward) activities.
Some hedge funds are indeed very risky. But other hedge funds use derivatives, short sales, etc. to reduce portfolio risk. In fact, the term “hedge” is used for activities that attempt to decrease investment risk in an asset or portfolio.
If you ever get to the point where you want to invest in a hedge fund, make sure you read the prospectus or offering documents very carefully. Know the level of risk that the fund will accept in their investment plans.
Another consideration with hedge funds is the cost.
Hedge funds tend to be extremely actively managed, so the management expense ratio is usually high relative to other funds types. Not always, some open and closed-ended funds also require extensive management, but usually.
And it is not uncommon to find “performance fees” (also called “incentive fees”) paid to fund managers for returns in excess of agreed upon hurdle rates (e.g., benchmark or minimum return). These can be extremely generous, so know in advance what you might be paying to the fund managers for their efforts.
Strangely, while I have seen many performance fees in hedge funds for superior returns, I have yet to come across any funds that offer refunds for underperformance. Funny how it always works that way.
I believe management expense ratios and other fund costs should be the key consideration when selecting any type of fund. As a result, we will spend some time a little later on this topic.
That should give you a quick sense for investment funds. What they are and how they differ from one another.
I am a big proponent of mutual funds and ETFs. Especially for smaller investors, the potential benefits are often very worthwhile. We will consider these two investment funds in greater detail over time.
by WWM | Nov 8, 2017 | Equities
Most readers have traded common shares of individual companies.
The main method is to buy and sell shares on the open market through a brokerage account.
However, you can invest in public companies using other means. Many investors acquire common shares through public offerings, direct stock purchase plans, dividend reinvestment plans, employee stock purchase plans, and warrants. Often, these methods can be excellent ways to save costs, while building your investment portfolio.
Public Offerings
Investors may acquire shares through a “Direct Public Offering” or “public offering”.
Companies that go public for the first time have an “Initial Public Offering” (IPO) for its shares.
Existing public companies may have “Subsequent Public Offerings” or “Follow-On Public Offerings” when issuing additional shares to the public. You may also see other derivations of these terms.
In my experience, public offerings have mixed results for small investors.
Stock offerings have a maximum number of shares issued. If the offering is popular, there is a good chance that it will be fully or over-subscribed (more investors want shares than are being offered).
In the investing realm, large investors (mutual funds, pensions, wealthy individuals, etc.) are usually accommodated to a greater extent than small. For popular offerings, you may not be able to get any or all of the shares you desire.
If there is greater demand than supply, investors that cannot purchase all their shares in an IPO may do so on the open market once the shares begin trading.
Use caution if you follow this strategy. As with everything, when there is excess demand, prices rise. The greater the excess, the higher the price shoots until equilibrium is reached.
For very popular issues, the share price may rise simply on the excess demand and not on the company’s fundamentals. When this occurs, it is common to see the share price increase rapidly above the issue price in the initial few days of trading. It is also typical in these circumstances to look at the share price a year later and see that it has fallen significantly to reflect reality, rather than hysteria.
For example, The Blackstone Group (symbol: BX) issued an IPO in June of 2007 at $31 per share. Shares traded between $34.25 and $38.00 and closed at $35.06 on June 22, the initial day of trading. If you had been part of the IPO at $31, you could have earned between 10.5% and 22.5% (before transaction costs) in one day. A very nice return.
However, if you were one of the investors who had scrambled to buy this stock in the open market on June 22, your returns might have been a little different. One week later, at the end of June, your shares were only worth $29.27. At the end of July 2007, $24.01. The end of August 2007, $23.13. And so on.
After an initial frenzy, the shares settled back to where the fundamentals indicated they should trade. As for fundamentals, we shall look at this topic when reviewing how to analyze stock.
Over time, Blackstone shares have had ups and downs. As low as $4.51 in January 2009. As high as $43.80 in April 2015. In December 2016, Blackstone traded just under $30.00. Had you bought in the IPO or on the initial trading date, you would hold an unrealized capital loss after all this time. Not as nice as flipping the IPO immediately.
Yes, there are many examples where the IPO kept going up in price. This further complicates the issue of small investors buying IPOs once they begin to trade.
When investors bought Blackstone on the initial trading day, every one of them believed they were buying the next Alphabet Inc. Better known as Google (symbol: GOOGL). Google issued its IPO in 2004 at $85 and closed its opening day at $100. Over the next 52 weeks, Google never traded below $100. It traded at $280 a year later, and sat in December 2016 at $808. That also does not factor in the 2014 stock split which brought shareholders substantially more value.
But it does not work out this way very often.
When buying an IPO or shares in the open market, do not pay for the excess demand. Always buy based on facts, not hype. You may miss out on a few Googles, but you will also avoid purchasing the many Blackstones.
As an aside, Blackstone is a decent company. A reason I chose it here. Easy to take a fly by night company selling vapour-ware and see why it fell from favour. But plenty of real and profitable companies whose shares still suffer from IPO over-enthusiasm. Every stock looks very promising at IPO time. Be careful.
Open Market Purchases
Most investors buy and sell shares on the “open market”. Also known as the “secondary market” or “aftermarket”.
The open market may be a formal stock exchange (e.g., New York Stock Exchange [NYSE]) or “over the counter” (OTC).
OTC shares trade via a dealer network and not on a formal exchange. OTC stocks may also be called “unlisted” shares.
To purchase shares on the open market, you require a brokerage account. Further, you need to ensure that the brokerage house where you have your account is entitled to trade shares on the markets you desire.
For example, I use one on-line broker that allows me access to all major Canadian and US stock exchanges. But they do not have access to exchanges outside North America. I must use another broker to trade equities in Europe and Asia.
I believe most investors should trade via low-cost, on-line accounts. I see little value, for most investors, in using premium, full-service brokers. Your bank likely offers relatively easy to use on-line brokerage accounts.
Online brokers tend to offer adequate products and services to meet most investors’ needs. It is not difficult to trade on your own via your own bank. Just be wary if they try to “help” you purchase their own in-house products.
Direct Stock Purchase Plan (DSPP)
DSPPs allow individuals to purchase shares directly from a company (or transfer agent).
The benefit of DSPPs is that investors can acquire shares without paying a commission on the transaction. In today’s low cost on-line broker world this is less important, but every penny saved is useful in compounding returns for future growth.
A potential downside of DSPPs is that usually there is a minimum purchase amount. This may be higher on the initial purchase and then lower for subsequent acquisitions.
Employee Stock Purchase Plan (ESPP)
If you work for a public company, you may encounter an ESPP.
ESPPs allow eligible employees to acquire company shares with no transaction costs. Even better, the shares are normally offered at a discounted price to market value. This can be a very nice perk for staff.
The discounted share price incentivizes employees to invest in their company versus other investment options.
In return, the company has shareholder employees with a vested interest in the firm’s performance. As such, staff will work harder to ensure that the company does well financially and that its share price increases. Well, that is the idea.
Some ESPPs have restrictions on selling shares (e.g., an initial period of time where shares cannot be sold), but often there are no restrictions on trading. Also, depending on the discount value, there may be tax implications at purchase.
Dividend Reinvestment Plan (DRIP)
DRIPs are also helpful in avoiding commissions. One of my favourite investing recommendations.
DRIPs allow investors to reinvest any cash dividends, they are eligible to receive, into additional shares of the company. Often this results in the purchase of fractional shares based on the dividend amount.
DRIPs are nice as they help investors (hopefully) compound investment returns by adding to their existing shares in the company. The additional shares, in turn, result in their own future stock dividends, and so on throughout the future.
DRIPs are an easy way to invest. Without thinking or acting, you automatically acquire additional shares of the company.
One problem with DRIPs is that, in most countries, you are taxed on the dividend as if you received the cash.
For example, you are entitled to receive a dividend of $1000 that is reinvested in additional shares of the company. You receive shares and not cash. However the tax man usually still wants his share of your earnings. If you have a 30% marginal tax rate, you must find $300 to pay for tax on income you did not actually receive.
Another thing to watch with DRIPs (and other investing methods that make automatic purchases) is the lack of thinking required. When using DRIPs you need to still assess the investment potential of the dividend.
Perhaps you are entitled to a $5000 dividend from Omega corporation. You have the option of a cash dividend or stock dividend. Omega shares are expected to return 10% over the next year and carry a risk of 5%.
If you take the DRIP, you may earn 10% on your shares (and the stock that you received in lieu of a cash dividend). But perhaps you analyzed other investments and found Alpha company with the same 5% risk, but an expected return of 20%. If you received a cash dividend from Omega, you could have bought Alpha shares instead.
DRIP programs can be useful, but do not fall into the trap of blindly reinvesting in underperforming shares. Always look at where your income is being invested. Ensure it is the best investment for you, not simply the most convenient.
Note that with Omega, you could sell shares equal to the stock dividend and then use the proceeds to buy Alpha shares. But then you will incur transaction costs and possibly capital gains tax payable.
Warrants
Warrants are issued by companies, usually as a sweetener to an offering.
Warrants give holders the right to purchase shares from the company at a certain price for a specified period of time.
Warrants are much like call options. Both can be traded separately in the secondary market.
Also, options and warrants fluctuate in price based on the value of the underlying shares relative to the exercise price of the warrant/option and the time remaining until expiration.
However, options are not issued by companies. They are exchange traded instruments created by other investors.
As well, most options expire in under one year, whereas warrants may not expire for years.
I include warrants in this section as warrants are often exercised and company shares received by the warrant holder.
I do not include options here as almost all common share option contracts are closed out for financial consideration (assuming they are “in the money”) prior to expiration. There is no actual exchange of shares between the counterparties.
We will look at options, in brief, in the future.