By Greg Peel

It has been one year since FNArena launched its new section of the website dedicated more specifically to Self-Managed Super Fund (SMSF) trustees, or “smurfs” as we call them. FNArena introduced the service last year on the release of the first Russell/SPAA survey on the SMSF industry, and that survey revealed some interesting facts.

See "Welcome To SMSFundamentals".

The second annual Russell/SPAA survey left no doubt the SMSF cohort of the investment industry remains the fastest growing, indeed now exponentially so. Of total SMSFs established, 48.7% have now been established for over seven years. One in ten survey respondents will establish a SMSF in the next 2-5 years. (1406 Australian consumers were surveyed of which 337 were smurfs and 174 counted as high net worth individuals without SMSFs. Separately 513 financial advisers/accountants were surveyed).

It would be easy to assume that Baby Boomers would be the most keen to set up an SMSF with retirement looming but only 10.5% of Boomers surveyed indicated an intention to establish an SMSF compared to 13.7% of Gen-Xers and 10.0% of Gen-Yers. There is still plenty of growth to come in the smurf market.

Financial advisers would also do well to take note of the high correlation between people owning their own business and then similarly choosing to manage their own retirement funds. Some 38.8% of advisers surveyed noted more than half their client base were SME owners, up from 22.5% claiming so last year. According to the ABS there are over 2 million SMEs in Australia.

In the period since the GFC it is a well documented fact that investors now hold substantial, even record, levels of cash in their portfolios – a fact also borne out by the many periodic FNArena surveys. Initially the holding of cash was based mostly on the fear factor and there was a strong element of simply holding that cash “on the sidelines” temporarily until the dust settled. But with European issues prevalent more recently, smurfs are becoming more inclined simply to hold cash as a deliberate risk reduction strategy given extreme volatility in equities.

Australian equity investment still dominates the average smurf portfolio with 43.5% of value invested in 2011, up from 42.6% in 2010. Cash holdings have nevertheless increased to 25.6% in 2011 from 23.1% in 2010. That's true cash, such as a term deposit or cash management trust, and does not include fixed interest investments. It is interesting to note that the once typical allocation of a benchmark “balanced” portfolio included only 10% cash.

For probably three years now, many a global market analyst has cited large amounts of “cash on the sidelines” as a reason to be bullish the stock market, on the assumption that cash all had to pour back into equities sooner or later. We can perhaps, however, blame the Greeks in suggesting such view is losing its logical weight. After a strong bounce-back rally in 2009, 2010 started well until Greece hit the frame. When we finally thought Greece had been dealt with 2011 started well, only to see Europe fall apart once more. 

Now 2012 has also started well so far, and Greece has been dealt with yet again. But investors sitting with cash “on the sidelines” would have watched in horror as those investors prepared to join the stock market game once more – no doubt already battle scarred from 2008 – were chewed up and spat out, in both the first and second halves. Those sidelines, it seems, are quite a comfy place to be if not as exciting, with the promise of a warm jacket and a hot cup of cocoa to be had.

To that end, those citing equities as being too volatile as a reason to hold cash instead grew to a whopping 32.4% in 2011 from only 17.0% in 2010. Those holding cash but still looking for the right time to run onto the field fell to 44.3% compared to 52.0%. Those simply believing cash investment is a good means of reducing risk grew to 48.9% but only from 47.6%. (Note that survey respondents could tick more than one box.)

Now girls, what are you up to? You may not be able to read a road map or stack the dishwasher efficiently but you are meant to be the celebrated multi-taskers and dare I say possibly more intelligent on the whole than us neanderthals, yet it was with notable shame that SPAA CEO Andrea Slattery had to point out at the press conference that 43.2% of female smurfs believe they will fall short of their retirement income needs compared to 27.1% of males. Or is that pragmatism over bravado? And females suggest they only need $1200 per week on average compared to $1700 for males. I'm sorry, but you can drink a lot of beers for the price of a trip to the hairdresser.

“Women are the inevitable growth segment for the SMSF sector in future,” Slattery suggested, “The gap in both their perceived knowledge and understanding in achieving their desired retirement income compared to their male counterparts makes females an ideal target for the professional advice industry”.

I must note here that, anecdotally, FNArena seems very popular with female subscribers if correspondence is anything to go by.

Which brings us to what we might call the “nature” of smurfs. Russell/SPAA decided last year that smurfs could be divided into three general categories: the “controllers”, the “coach seekers” and the “outsourcers”.

In 2010 controllers made up about 40% of smurfs. These are investors who make all their own decisions without seeking outside help. This, of course, defines to some extent the concept of an SMSF in the first place. But over the past decade the growth in SMSFs has reflected not as much an “I can do better myself” attitude as an “I am sick of being ripped off by the big funds” attitude which has led investors towards a SMSF even if with a sense of trepidation. Of these, in 2010 some 14% were “outsourcers” who while managing an SMSF actually handed all investment decisions over to a professional. In a sense this contradicts the concept of an SMSF, but then the feeling of being ripped off previously has cut deep.

The balance of 25% of smurfs in 2010 were “coach seekers”. These are investors keen to make their own decisions but given limited experience are keen to seek “mentoring” rather than straight up allocation advice. One might say they don't want to be told what to do, but they do want to be informed so that the most suitable decisions can be made. In the 2011 survey, 17.3% of financial advisers noted increasing demand from controllers but 38.8% noted increasing demand from coach seekers. 

Taking the opportunity here for a shameless plug, without having ever adopted the expression specifically, FNArena's mission has always been to be a “coach” to the “coach seekers” (while not being a licenced financial adviser). FNArena is fully independent of any broking house, fund manager or media giant and seeks to pull apart extensive market research collated every day and distill it down to an easy to understand assessment of the investment markets and where the most appropriate opportunities may lay.

As a last word I'll leave you with the following table which may help smurfs better appreciate how one's own experience as a self-manager stacks up against that of peers.

Technical limitations

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By Dimitri Vayanos and Paul Woolley
18 January 2012

According to classical economics, there are no gains to be made in an efficient market. Yet markets are often far from efficient and the gains are often far from insignificant. So should investors follow the herd or rely on best guesses of fair value? This column argues that the optimal strategy depends on whether you are in for the short or long term.

January finds many pondering the issue of what to do with their savings in the new year. There are two primary and distinct techniques of asset management: momentum and fair value.

- Momentum investors (‘the trend is your friend’) ignore fundamental value and follow the money, buying when prices are rising and selling when they reverse.
- Fair-value investors (‘a stock’s price is the present value of dividends’) disregard fund flows and trade securities based on their expected future cash flows.

A vast academic literature documents that both momentum and fair-value strategies are profitable; see, for example, Jegadeesh and Titman (1993) for momentum, and Fama and French (1992) for fair value. Investors use a mix of the two strategies to achieve their desired combination of risk and return.

Of course none of it makes sense from the perspective of canonical finance theory. As every trained economist learned at university, capital markets are efficient, so it is futile to pick stocks. The professionals have already priced in all the relevant information leaving no $100 bills lying on the sidewalk. Given this lack of guidance from traditional finance theory, investors have to rely on empirical observation of historic returns.

Delegation matters

Standard theory assumes that investors look after their own affairs and invest directly in financial markets. An alternative approach is to recognise the practice of most asset owners to delegate responsibility to fund managers.

In new research (Vayanos and Woolley 2011a; see also Vayanos and Woolley 2009) we take account of the impact of the resulting principal/agent relationships on asset price formation. The new framework can explain many features of capital market performance, such as momentum and value effects, that have so far proved problematic, while maintaining the assumption of rational agents. Moreover, it can be used to analyse the investment strategies that can be employed to exploit the inefficiencies. The model can be calibrated to show the risk-adjusted returns from the strategies used separately or in combination.

Significantly, it shows that the optimal mix of momentum and fair value depends on the investor’s horizon or term of his liabilities.

Shedding new light

In our model, delegation is the key. For example, asset owners have imperfect knowledge of the ability of the fund managers they invest with. They are uncertain whether underperformance against the benchmark arises from the manager’s prudent avoidance of overpriced stocks or is a sign of incompetence. As shortfalls grow, investors conclude incompetence and react by transferring funds to outperforming managers. The investors’ gradual flows amplify the price changes that led to the initial underperformance and generate momentum. In this way, Bayesian updating can explain how some prices are pushed below fair value, simultaneously creating the well-documented value effect as well as momentum-trading opportunities.

Calculating returns

The model incorporates multiple securities with each subjected to cash flow shocks and therefore changes in fair value, which are then amplified as investors move funds between managers according to accumulating evidence of their ability.1 The result is a theoretical model of a working market in which prices and returns on individual securities are observable over time. Into this marketplace we insert a new investor who, as price-taker, constructs portfolios with a variety of styles and execution. The Sharpe ratios (expected excess returns per unit of standard deviation) of these portfolios can then be compared over one period, and over multiple periods with continuous rebalancing, as in Vayanos and Woolley (2011b). The timing of the returns can also be observed.

Below are the main findings. Some are intuitive but useful to have validated; others are far less obvious with striking implications for policy.

Short horizon

The first step is to compare the Sharpe ratios for the two strategies over a one-period horizon.

- Based on optimal implementation of both strategies, and applying realistic calibrations, momentum dominates fair value.

This ties with intuition as well as the mechanism of the model. Amplification effects cause prices to continue trending down to the point where outflows dry up and prices begin to revert back to fair value; gradual inflows likewise explain amplified upward price movements. In this way, returns to the momentum style come quickly, whereas the fair-value investor has to be patient, often buying prematurely as he or she waits for reversal to occur.

Because it offers a higher Sharpe ratio over one period, momentum is the appropriate choice for investors seeking either short-term excess return or short-term risk reduction. But there are caveats.

Success for a momentum investor depends on getting the timing right, first with the buy signal and then selling before prices reverse. The model investigates combinations of ‘look backs’ – the length of time over which prices must rise for the security to be selected – and holding periods. Selecting the optimal lookback leads to strong, positive risk-adjusted returns. But as the investor moves away from this central peak, returns erode sharply to become negative for moving in too soon or selling out too late. (See Figure 1.)

Figure 1. Sharpe ratio of momentum as a function of the lookback period²

Note: The vertical axis is the excess return as measured by the Sharpe ratio; the horizontal axis is the lookback measured in years.

By contrast, success with fair-value investing is relatively insensitive to execution. The model shows that crude value models, such as those based on price to current earnings, deliver results only slightly below those using more refined estimates of future cash flows.

Long horizon

The second step is to compare the risk-adjusted returns in a dynamic framework over multiple periods with continuous rebalancing. Here the results are very different and the bottom line is that fair value dominates momentum for long horizons. This result hinges on the difference in risk characteristics.

Because momentum stocks are selected without reference to their value, the outcome of each momentum play is independent of the last. Momentum investing is a series of uncorrelated bets which means that the long-run risk of the strategy equates to the sum of risks for the intervening sub-periods. On the other hand, fair-value investors bide their time waiting to buy low and sell high. Purchases that disappoint will in many cases have become cheaper and are retained. The strategy benefits from the negative serial correlation of returns that causes the annualised long-run risk to decline over time.

All this means that the Sharpe ratio of momentum is approximately constant over time but the ratio for fair value rises with the lengthening term over which the strategy is employed (Figure 2).

Figure 2. Annualised Sharpe ratios of momentum and fair value as a function of the investment horizon²

Investment horizon

Our analysis offers a solution to one of investment's longstanding puzzles: Is the long-run equivalent to the succession of intervening short-runs? Operationally, the issue is whether investors should focus on getting the best return each year, or the best return over the long-run, or is there no difference? The answer is relevant to the current debate about short-termism and the so far unsubstantiated impression that long-run investing is privately, as well as socially, beneficial.

The answer lies in the choice and mix of strategies. It is well-known that returns to momentum and fair value display low or negative correlation (eg Asness et al 2009).

- This lack of positive correlation means that combining the two strategies improves a portfolio's risk-adjusted return.

Using relative returns from the model permits a definitive response. The model shows that the optimal mix depends on the term of the liabilities and therefore on the horizon of the individual fund.

- The longer the horizon, the more the investor should commit to fair value and the less to momentum.
- The shorter the horizon, the more the investor should commit to momentum and the less to fair value.

These findings are robust for all calibrations and it is the difference in risk over time that is the decisive factor. Figure 2 is based on optimal execution of both strategies and any departure from this will naturally shift the curves and crossover point.
Practice and policy

The analysis opens up a world of questions and challenges to conventional practice and policy.

Most large asset pools, sovereign-wealth, pension and charitable funds, have long-term liabilities or objectives. The model shows they are best served by majoring on fair value and limiting the use of momentum.
Yet several practices and conventions draw them in the opposite direction. These include the magnetism of the herd, tracking error constraints in relation to momentum-distorted indices, short-term performance assessment and reward, and regulatory or actuarial mark-to-market valuations.

Lack of awareness of the drawbacks of short-termism no doubt contributes to these costly mistakes.

Dimitri Vayanos is Professor of Finance and Director, Paul Woolley Centre for the Study of Capital Market Dysfunctionality, LSE
Paul Woolley is Senior Fellow at the London School of Economics, Hon. Professor of York University and Adjunct Professor at UTS

References

Asness, C, T Moskowitz, and L Pedersen (2009), “Value and Momentum Everywhere”, Working Paper, New York University.

Fama, E and K French (1992), "The Cross-Section of Expected Stock Returns", Journal of Finance, 47:427-465.

Jegadeesh, N and S Titman (1993), "Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency", Journal of Finance, 48:65-91.

Vayanos, D and P Woolley (2009), “An Institutional Theory of Momentum and Reversal”, CEPR DP 7068.

Vayanos D and P Woolley (2011a), "An Institutional Theory of Momentum and Reversal", Working paper, London School of Economics.

Vayanos D and P Woolley (2011b), “A Theoretical Analysis of Momentum and Value Strategies", Working paper, London School of Economics.

¹ For simplicity, the basic model has only one active manager and one investor. The investor responds to the performance of the manager by moving his funds between the active fund and an index fund.

² Figures 1 and 2 are based on data drawn from a conservative calibration in which only a subset of flows are considered. The actual flows will be augmented by investors external to the model piggybacking on momentum.

Copyright VoxEU.org - the above story was originally published on www.VoxEU.org  - readers reading this story through a third party channel may find that any graphs are not included (our apologies for this technical anomaly) - here's a link to the original story on the VoxEU website: click HERE

Technical limitations

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By Andrew Nelson

If you want something done right then do it yourself. That’s how the saying goes. However, in the world of financial management, that truism has never really been accepted as true. But as Bob Dylan sang: “The times, they are a changin’”. At least that’s how it now seems when it comes retirement investing.

Recent data from the Australian Tax Office have provided us with some very interesting results. It seems that over the past five years self-managed superannuation fund (SMSF) investors grew their assets by more than double the rate of the superannuation industry as a whole. In fact, in the five years to June 2010, SMSF investors booked a 122% rise in assets managed compared to just 60% from the professionals.

In the ATO report, Self Managed Super Funds: a Statistical Overview, the tax office says that the much of the growth is due to the increase in salary contributions and net rollovers into SMSFs over the past few years coupled with the deposit of investment earnings.

This trend is better explained by Self Managed Super Fund Professionals Association (SPAA) CEO, Andrea Slattery, who said that SMSF members tend to be the most engaged people in the superannuation industry. She notes that it’s these hands on investors that make sure their own funds operate and perform well.

As importantly, Slattery pointed out that it’s this positive relative performance that encourages SMSF operators to put a much higher proportion of their earnings and savings into super.

In fact, the ATO numbers show that, on average, member contributions to SMSFs were twice that of SMSF employer contributions. Tax office data shows that in the five years to June 2009, super contributions averaged $32.5bn a year, with $23.6bn from members and just $8.9bn from employers.

The trend is moderating, however, with the ATO indicating that the growth rate in member superannuation contributions has started to trend downwards over the past year.

So while Mrs. Slattery remains upbeat about the level of SMSF member voluntary contributions, and the confidence and commitment that drives it, she does note “the halving of the annual superannuation concessional caps from 2010 has already had a negative effect on savers' attempts to self-fund their retirement".

The report also confirmed what many believe, that SMSF members are generally older and have higher average taxable incomes and higher deposit levels than non-SMSF members. However, the age demographic of new SMSFs is getting younger and younger. The data show that 11% of new SMSF members were under the age of 35 in the June 2010 quarter compared to just over 5% for the whole SMSF member population.

Mrs. Slattery thinks that younger investors like the control and flexibility that running their own SMSF gives them. She believes SMSF will continue to appeal to “younger, highly educated professionals who are already confident about seeking service providers and skilled advisors".

Last but not least, while investment returns for almost everyone have showed some red over the 2007-08 and 2008-09 periods, the ATO data demonstrate that negative returns for SMSFs have been smaller than for APRA regulated funds.

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" - Warning this story contains unashamedly positive feedback on the service provided.

SMSFundamentals is an ongoing feature series dedicated to providing SMSFs (smurfs) with valuable news, investment ideas and services, in line with SMSF requirements and obligations.

For an introduction and story archive please visit FNArena's SMSFundamentals website.

Energy company and coal seam LNG developer Origin Energy ((ORG)) recently announced it was raising funds not by issuing new equity, or by issuing debt, but by issuing what's known as a "hybrid security". Origin's underwriters were flooded with applications from both institutional and retail investors who are hiding from the volatile stock market but are looking for opportunities to generate a decent yield without the risks inherent in a dividend paying stock, but with greater reward than the conservative term deposit or cash management trust their money is currently sitting in.

Recently supermarket leader Woolworths ((WOW)) issued a hybrid of its own which was also well oversubscribed and is now listed on the ASX  (ticker: WOWHC). Currently there are dozens of hybrid security listed on the ASX, representing everything from banks to media companies and hospital managers. In this world of investment uncertainty, Australian hybrid securities -- which were once eschewed by investors for being too complicated and too illiquid --  are flavour of the month.

What are hybrid securities and why might they suit a smurf's investment portfolio?

To discuss these questions FNArena has enlisted the assistance of Australian hybrid specialist Gamma Wealth Management.

Prologue

By Greg Peel

A hybrid engine, such as the one in Toyota's famous Prius, combines both petrol and electric power. Despite the combination, however, only one power source is driving the car at any one time. The fact that there are two power sources available in one car nevertheless provides for a combination of fuel efficiency and “greenness” on the one hand, and range and requisite oomph when needed on the other, and the vehicle's price represents that flexibility.

A hybrid security is a combination of debt and equity. Like the hybrid engine, a hybrid security is never debt and equity at the same time, but because both are available to the investor given certain circumstances, a hybrid security is priced based on that flexibility of style of investment.

If we take standard debt to be a bond and standard equity to be a stock, we can compare the various characteristics.

A common or garden bond is issued at a specified “face value” which is usually $100 and typically offers a predetermined coupon payment, let's say for the sake of argument 10%. When you buy a company's bond you are effectively lending that company money which you expect to get back at the maturity date. In between, the company regularly pays you the interest on the loan (coupon). So for a five-year bond, for example, you'd get your $100 back in five years plus five payments of 10% in the interim or $50 in total.

You are never going to make any more than $50 net profit, but you know for sure you will make $50 net profit provided (a) the company doesn't go broke before maturity and (b) it is always able to pay its coupons. If you're confident a company can do both, which you probably would be for a Big Four bank say, then a bond is a low risk-low reward investment instrument. If you're not completely confident but the coupon payment is much higher to compensate for that risk, then the risk-reward equation simply needs weighing up. At the very least, if the company is wound up you will be in line for some recourse head of any shareholder in the company.

Which brings us to equity. You can buy shares in a company on issue at whatever price the company deems to issue them at and you might receive dividends at some time or you might not. Unlike a coupon, the company is not obliged to pay a dividend even if it can, and payments can rise and fall over time. A share never reaches a maturity date like a bond does. Either it carries on for decades or the company buys back the shares and de-lists or another company takes over those shares or the company simply goes broke. Otherwise, the only way to exit the shares is to sell them. You cannot, unlike a bond, have any specific idea of what your investment might be worth in five years time.

Shares are therefore a lot more risky than bonds, but unlike bonds they offer “blue sky” upside in value whereas bonds have a predetermined value at maturity. Shares thus offer a higher risk-reward balance because you are an investor in the company rather than a lender of money to the company. Shareholders are thus last in line if a company is wound up.

While a diversified investment portfolio may contain both debt and equity instruments, an investor is usually more inclined to lean towards debt in a riskier and more volatile trading environment and towards equity in a more stable and promising investment environment. Episodes like the GFC saw, for example, Australian bank shares slammed but no one really assumed one of the Big Four would go out of business. Hence while the value of Big Four bonds also fell to reflect increased risk (for which you would otherwise expect a higher coupon), they did not fall by as much as the value of the same bank's shares because final payment at maturity was still assumed. What bonds lose on the swings of limited value upside they gain on the roundabout of limited value downside. On the other hand, back in 2004-07 when share market returns were averaging 20% per year a bond investor would have been missing out on the spoils. It would be great if an investor knew ahead of time whether markets were going to be stable and strong or weak and volatile because then that investor would choose an appropriate balance of debt and equity investment at the outset. But of course, an investor never quite knows.

What would be really good is if there were one investment that could be a sort of “horses for courses”. The Toyota Prius offers a cheap little city runabout that's great in the traffic (electric motor) but when needed can provide longer distance range or a spurt of acceleration at appropriate times (petrol). Imagine if you could have an investment security that offered the safety of a bond when times are scary but the upside of a stock when times are bountiful.

Ah hah!

Welcome to the hybrid security. It is wrong to say “a typical hybrid security is...” because in this day and age there is no such thing. Once upon a time there were pretty much just two forms, known as the “convertible bond” and the “converting preference share” which had slightly different but otherwise similar characteristics. Despite the word “share” in “preference share”, this instrument still started life as a bond. Today, however, hybrid securities come in so many different shapes and sizes that there no longer is a “generic” form, and indeed it's difficult to find any two hybrid issues which offer exactly the same characteristics. They may be convertible or converting, redeemable or redeeming. They may reset or "step up", they might be perpetual, their coupon could be fixed or floating or at a fixed spread over floating. They may get converted/redeemed by the investor before maturity or perhaps by the issuer. They may pay back face value, or some other value, or a value determined by the company's share price at the time. They may have all sorts of bells and whistles.

But underneath all of that will be one straight forward characteristic. They will be a bond (debt) with a share option (equity) attached. In pretty much all cases, hybrids start life as a bond at whatever the corresponding share price is now and change into an equity only if the share price rallies by a certain amount. The point is that if the share price rallies strongly, you as the investor want shares, not bonds. If the share price doesn't rally and indeed scarily falls, you want bonds, not shares. This is what a hybrid security offers the investor. Although the rule of thumb is you only get one chance to switch (which may even be the company's choice, not yours) and you can't then go back again. Most (but not all) hybrids have a maturity date of some description anyway.

Companies can choose whether they prefer to raise the funds they need by borrowing money (issuing debt) or by bringing in investors (issuing shares). A diversified balance sheet will exploit both. Pure equity is cheaper but dilutes value directly while pure debt is more expensive but doesn't dilute value directly. It can even enhance value if it means the company now has the funds to make those widgets it knows it can sell, for example. Thus for the issuer, a hybrid security also offers a balance. At first the company is issuing debt so there's no dilution. If those bond holders later convert to equity at the higher share price there will be dilution, but if the share price is higher then who cares? And given the buyer of the hybrid is keen to pay for that imbedded share option, the coupon the company has to offer can be less than if the security were straight debt.

Everybody wins.

I will now hand the microphone over to Gamma Wealth Management to provide some more specific details about investing in hybrid securities.

1. What are hybrid securities?

Hybrid securities combine the elements of debt and equity – hence the name hybrids. Hybrid securities pay a predictable (fixed or floating) rate of return or dividend until a certain date, at which point the investor(holder) has several options at maturity. Such investments are popular with retirees and self managed superannuation funds seeking higher yields and taking advantage of franking credits (where applicable). They are often an attractive alternative to term deposits and cash accounts.

As with most investments, riskier hybrids pay a higher interest payment (otherwise called a coupon or preferred dividend) to compensate investors for the added risk.

2. Risks of hybrid securities

Risk of losing capital - if the issuer’s share price falls dramatically then the hybrid securities are likely to lose capital value. Even worse if the issuer goes broke, hybrid investors are unlikely to see a return in a liquidation of the company however under most circumstances the hybrid securities rank higher than ordinary shareholders in the case of a company liquidation.

Distributions suspended - the other main risk is that the issuer may suspend distributions on the security. Issuers may suspend distributions on their hybrids, usually at the behest of the company's banks looking to safeguard their position. Currently, the hybrid issued by Elders (ELDPA) is suspended although it is forecast to be reinstated in the last quarter of 2011.

Conversion issues – usually the conversion conditions are dictated by the issuer and on occasions these terms may be detrimental to the investor.
Interest Rate Movements – interest rate movements may affect the return on the hybrid security.

3. Why do companies issue hybrid securities?

When buying a hybrid security you are typically lending money to a corporation. They are commonly known as the issuer. In return for the loan, the issuer pays a given interest rate (called the coupon) for the life of the security, usually repaying the principal at maturity.

The major reason why companies issue them is because it can sometimes be a cheaper alternative for funding (raising capital) and also because companies may be able to utilize the franking credits on their balance sheet to pay out distributions to holders of the securities.

4. Characteristics of hybrid securities

The main components of a hybrid security are:

The Face Value (initial principal investment or capital amount) is usually the amount repayable to the investor at maturity. Usually, most securities are issued at a face value of $100. Once they are listed on the ASX then the secondary market price may vary from the face value during the term of the security. Just like an ordinary share an investor can trade these securities.

Interest on the face value, which accumulates at a predetermined rate referred to as the coupon. This can be fixed (for the term) or floating based upon a particular benchmark (e.g. 90 day Bank Bill Rate or 5 year government bond).

Maturity date is the date the security expires and principal is either repaid or, in the case of selected hybrid securities, converts to ordinary shares (which is known as the conversion date).

Conversion ratio is the ratio of shares offered for each converting security. This may be a fixed ratio (for example 1:1) or at a discount or premium to the market price. For example, converted at a 2% discount to the ordinary share price.

Nominal yield is the pre determined interest income calculated as a percentage of the face value.

Yield to maturity is the interest income calculated as a percentage of the current market price of the security and the time value until maturity.

5. What are the factors to consider when choosing a hybrid security?

Future Interest Rate Movements

Potential movements in interest rates will affect whether the investor considers floating rate securities or fixed rate securities. Many investors like fixed rate securities because there is a fixed and certain amount of distribution paid at regular intervals however in a rising interest rate environment fixed rate hybrids may be less attractive because the rate of return is not increasing in line with interest rate movements. Fixed rate issues that have been well supported in the marketplace are Macquarie Convertible Preference Shares (ASX Code: MQCPA - 11.1% fixed) and Heritage Building Society Notes (ASX Code: HBSHA - 10.0% fixed)
.
Credit rating

Credit ratings can assist potential investors to form a view of the creditworthiness of the corporation and compare them with other similar assets across different corporations. In general a AAA rated hybrid security will offer a lower rate of return while a lower rated hybrid security will offer a higher rate of return.

Margin

Margin is the spread over a certain reference rate that a hybrid is trading. This is in effect the running yield expressed in terms of a margin over bank bills. If the hybrid security pays a floating rate, the reference rate is usually the 90 day or 180 day BBSW (Bank Bill Swap Rate). In general, the lower the credit rating of the company, the higher the margin over the reference rate the issuer has to pay to entice investor to hold their securities.

Running yield

This is the yield of the security based on its market value.

Duration to conversion, step up or redemption

Once issued there is a point where the hybrid is reset for conversion, redemption or a distribution step-up.

Liquidity

The liquidity of the hybrid securities is often directly correlated to the credit rating and size of the issuing company. Generally the larger the hybrid issue the closer it tends to trade to fair value and generally more securities are traded in volume than smaller issues.

Frequency of dividend payment

Most of the floating rate hybrids either pay income quarterly or semi-annually. There should be a slight preference for investors to seek those hybrids that pay quarterly distributions as the income can be compounded. As previously outlined in a rising interest rate environment having a floating rate hybrid security is more advantageous.

Balance sheet

One of the most important parameters with respect to a hybrid security is the amount of debt that a company is carrying. The lower the net debt to equity ratio, the higher probability the hybrid will not suffer from capital loss due to it trading as a debt-type security.

The reputation of the corporation

The well established corporations and household names are often better at providing regular distributions to investors and they generally provide lower risk to the investor.

6. Potential growth in the hybrid market and upcoming issues

The Federal Government introduced a government guarantee for deposits in Authorised Deposit-Taking Institutions (ADIs) up to $1 million. The Government is currently reviewing the $1 million cap to determine an appropriate level at which it should be set from October 12, 2011. Any potential changes to this level i.e. being reduced to $250,000 or $100,000 guarantee from $1million may encourage investors to pull their funds out of the term deposits and cash accounts and look at other investment alternatives to obtain income. The Hybrid securities may benefit from these changes.

Companies may also look to issue more hybrid securities because they want to be better capitalise their balance sheets in these uncertain times. The four major banks in Australia are also required to meet certain capital requirements so therefore they may need to issue more hybrid securities.

Epilogue

By Greg Peel

Given that no one can honestly tell you which way financial markets are going to move over the next week, or month, or year, there is no reason why hybrid securities can't be a valuable risk-reward instrument to be included in any investment portfolio at any time. Right now hybrids have found renewed popularity given the frustrating uncertainty of a post GFC world dominated by sovereign debt problems.

In bull markets, a so-called “balanced” portfolio might have 5% invested in cash. Today however, FNArena surveys find that investors are holding 25% or more in cash, often in the form of the boring old bank term deposit. Those that are game enough to venture into the stock market are trying to keep away from too much risk and looking for solid and reliable dividend payers such as banks, utilities or other service companies for example that may not offer much in the way of screaming share price upside potential but at least offer a decent income, which of course is very important for the self-managed retiree in particular.

Perhaps the best way to appreciate the potential value to the investor of a hybrid instrument is to compare a hybrid and the underlying share of the same company. The following chart does so for Macquarie Group ((MQG)) shares and a Macquarie listed hybrid. The share price is in black and the hybrid price in blue:

These are price graphs only and do not account for either dividends paid on the share or coupons on the hybrid but obviously markets factor the value of those distributions into prices. As a rule of thumb, companies will offer hybrid coupons at levels higher than corresponding dividends (in yield terms) given debt is more expensive than equity. Note however that subsequent share price movements can send prevailing stock yields to level higher than hybrid coupons but only after a fall in the value of the stock. Note also the above discussion of franking credit considerations.

Here is another example, this time ANZ Bank ((ANZ)), and this time with the share price in blue and the price of an ANZ hybrid issue in pink:

Both these charts demonstrate that while the price of a hybrid security will be impacted by the price of the underlying share, its downside is more limited.

Note, however, that were the circumstances reversed such that bank shares were suddenly flying to the moon once more, the share price lines would cross over the hybrid price lines and begin to outperform. It is here that a hybrid really shows its stripes because at some point those debt instruments will be convertible or converted into ordinary shares.

As further illustration, here are a couple of tables provided by Gamma Wealth Management outlining the characteristics of just a handful of hybrids currently listed on the ASX. Note please that the risk rating is the opinion of Gamma Wealth Management.

(Please note prices displayed are recent but not up to date at the time of publication. Note also that CBA Perls are issued with a face value of $200, not $100 as is the case with the other listings.)

It is very important for investors to note, nevertheless, that hybrid issues are not simply by their nature a win-win investment. All hybrid issues are usually different in structure and terms and conditions can run to hundreds of pages of required disclosure. Buried therein might just be the clause that renders a particular hybrid more of a case of equity risk with only bond returns, rather than bond risk with potential equity rewards. ASIC has felt it necessary to post an official warning to investors that it is paramount to understand and appreciate the vagaries of different hybrid issues and their risks before considering an investment.

FNArena strongly recommends that investors interested in hybrid securities first contact their broker or financial adviser before making an investment decision. Please be fully appreciative that hybrids are complex financial instruments with extensive and often unique characteristics that need to be fully understood by the investor and, indeed, by the investor's adviser.

Gamma Wealth Management is a specialist in hybrid and other interest rate instruments but there are other firms investors can turn to.

Readers can contact Gamma Wealth Management at info@gammawealth.com.au to register interest in hybrid securities and any future offerings. Otherwise visit their website at  www.gammawealth.com.au.

(This story was originally published on 13 October, 2011. It has now been re-published to make it available to non-paying members at FNArena and to readers elsewhere).

SMSFundamentals is an ongoing feature series dedicated to providing SMSFs (smurfs) with valuable news, investment ideas and services, in line with SMSF requirements and obligations.

For an introduction and story archive please visit FNArena's SMSFundamentals section on the website.

By Greg Peel

Property analysts and property fund managers always like to pull out a particular chart which they use as their argument for superior returns available to the longer term investor in the property market. In simple terms, it compares the past ten-year or more return on property, stocks, fixed interest and cash. The reason property people like this chart is because it usually shows property investment as the winner.

The team at ANZ Research has also prepared such a chart, setting its base at the beginning of 1987. The chart compares returns on commercial property, residential property, the ASX 200 (accumulated for dividends), government bonds and term deposits. The chart appears shortly in this article but I won't unveil it yet, because ANZ Research has only produced it as a means of comparison. Not comparison between asset classes in this case, but comparison between what is for the most part a misleading chart and the chart investors really should be looking at if they are going to arrive at a realistic conclusion about the past performance of different asset classes.

One of the problems with the first chart is that it lumps in both owner-occupied and investment property under the same “residential property” banner. Yet as we well know, there are significantly different investment implications for each from the perspective of loan cost, tax and tax deductions. Realistically, owner-occupied housing (OOH) and residential investment property should be treated as two different asset classes for comparison purposes.

Indeed, as soon as we open up the Pandora's Box of costs and taxes, we realise that every asset class is very different, thus rendering an “apples to apples” chart more of a fruit salad. On that basis, ANZ Research decided to undertake a far more comprehensive exercise and thus produce a far more “apples to apples” set of results.

The initial, simple chart ignores debt, transaction or maintenance costs or taxes. Nor does it assume cashflows from any asset are reinvested. The problem here is that you can't reinvest rent from an investment property by buying a little bit more of the same property, whereas you can reinvest dividends from stocks, for example, by buying a bit more of the stock. So instead, ANZ takes any cashflows and sticks them in an accruing term deposit. Hence “total return” comparisons can be more realistic.

For its more complex chart, ANZ maintains the same reinvestment model but now takes account of that which the simple chart does not. The analysts have accounted for maintenance costs, stamp duty and agent's fees as realistically as possible. They have included tax effects using a marginal income tax rate of 45%, and have included capital gains tax.

Whereas such changes render OOH and residential investment property now quite different, residential investment property and commercial investment property are otherwise equivalent with the exception of maintenance costs. Simple chart assessments of commercial property always assume a level of maintenance costs whereas assessments of residential do not.

ANZ has assumed a 50% level of gearing for all assets other than government bonds and term deposits. Interest costs are then taken into account and the deductability of interest costs likewise, thus to allow for negative gearing. Cashflows from property and equity investments are first used in the model to pay off debt before they are placed into the aforementioned term deposit. The analysts have not made any allowance for enhanced property value from any renovations or improvements. That's getting just too esoteric.

So thus I can now unveil two charts for easy comparison. The first is ANZ's equivalent of the simple chart many of you would have seen before in some form. The second is ANZ's more complex and thus more realistic chart, taken all noted above into consideration:

So what can we see?

Firstly, the first chart has five lines and the second has six. In the first chart, the winning brown line represents “residential property” as both OOH and investor. The same brown line in the second chart is OOH only. Given the second brown line reaches to 1700 (return index from common base) to the first brown line's 1200, we can see that OOH has proven a much better investment than residential investment property when we include all the costs and taxes.

Such a conclusion is hardly knock-me-down-with-a-feather stuff. Australian government fiscal policy has always supported home ownership as an investment. On that basis, we can separate OOH from all other investments and let's face it, the decision to buy a property to live in is a very different one from the decision as to where to invest super or other funds, even though we might include our house as part of our super portfolio. We would not, for example, decide stocks look more attractive as an investment and thus forsake a roof over our heads. We may, however, decide stocks look like a better place to invest super than investment property.

On that basis we note that the darker blue line on the second chart represents residential investment, and that even without the boost provided from OOH included in the first chart, this line still beats the orange ASX 200 line. But also note that in both graphs, the orange line arrives roughly at the same price of around 800. This is important when we consider the remaining three lines, or asset classes, of commercial property, government bonds and term deposits. In the first graph their returns all reach 400-600 but in the second graph they are clumped within 200-300 only.

This tells us that the “risk” asset classes of stocks and property have provided superior returns to the “safe haven” classes of bonds and cash.

Commercial property has been a disappointment. If you break commercial property down into its constituents of retail, industrial and office, retail has performed a lot better than the other two over the period, with office the dowdiest performer.

There are two obvious points we can bring up here. One is that we would surely expect “risk” assets to provide greater reward than “safe haven” assets over time, or otherwise what is the point of the risk? The other is that we are looking at a particular period of time. We know that the biggest victim of the 1990s recession, which is captured in these graphs, was commercial property. We know the period 2004-07 brought booms in both residential property and stocks providing annual returns that may not be seen again for a while.

Let's take the first point first. As an accompaniment to the above return graphs, ANZ Research has also compared the risk of each asset class over the period using what is known as a “value at risk” (VaR) measurement. It's a complicated statistical measurement, but let's just say it takes account of volatility over the period. The ultimate returns reached by each of the asset classes on these graphs obviously required the investor to hang in there no matter how rough the ride, whereas in reality we may have either panicked, or gone bankrupt, or been forced to dump risk assets for the sake of raising required cash at any time during the period.

No prizes for guessing which asset class has the highest VaR – we need only look for the wobbliest line. That's the ASX 200, and the second graph shows the ding-dong battle for superior returns stocks and investment property have had over the period, particularly this century.

The next graph compares VaRs, and bare in mind the nature of the stat is that the highest volatility is represented by the largest negative result.

The graph says a lot, doesn't it? First of all we expect bonds and cash to barely register, and we've already dismissed OOH as a different kind of investment decision altogether. Then we see that residential investment property has a much lower risk profile than stocks, yet referring back to the second of the two graphs above, investment property “beat” stocks on a return basis. Commercial property, by contrast, was high risk and low return.

Were history to be our guide, we'd take out whatever we had invested in stocks and put that into investment property instead, perhaps with some bonds and cash as a risk diversification measure. But is the last 25 years going to tell us anything about what's going to happen in the next 25 years?

For starters, we know that the GFC impacted on the ASX 200, to the point where 50% of value was lost by early 2009 on a price basis, whereas property prices only stumbled for about five minutes before resuming their upward trend. Yet when we add in dividends, investment property has not beaten stocks by all that much in the end. Knowing that returns on bonds and cash are going to be pretty consistent over time, we have to ask: which of the two risk assets has the most upside return potential for the next decade? There's a lot of talk that stocks are looking pretty undervalued at present, while house prices are quietly slipping after the long running boom.

Fortunately ANZ Research has applied the same sort of modelling to the future as it has to the past.

And the winner is...drum roll please...the ASX 200. With dividends. And a special nod goes to commercial property, which actually comes in ahead of investment residential property. Indeed, both beat even OOH. Note the following graph, in which all elements of costs and taxes etc are equivalent for forecasts as they are for historical measurements:

These are, of course, only forecasts. And the ANZ analysts are the first to admit they only need adjust one of the assumptions in their forecast models slightly and the outcomes become rather different. If it were all simple, nevertheless, there'd be no such thing as a risk asset.

Technical limitations

If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.

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SMSFundamentals is an ongoing feature series dedicated to providing SMSFs (smurfs) with valuable news, investment ideas and services, in line with SMSF requirements and obligations.

For an introduction and story archive please visit FNArena's SMSFundamentals website.

By Greg Peel

Earlier SMSFundamentals articles have sought to introduce smurfs to exchange-traded funds (ETF) for consideration in self-managed super funds. (Active, Passive And ETFs; Exchange-Traded Funds Part II).

BlackRock Australia's ETF business iShares has this week announced the launch of what it calls a multi-faceted education campaign to raise investor understanding of ETFs. iShares is the world leader in listed ETFs, accounting for more than 40% of the global ETF market.

“This education series,” suggests iShares Australia head Mark Oliver, “explains what ETFs are, the way they work and how they can be incorporated into investment portfolios”.

In launching the campaign, Oliver is attempting to counter what he suggests is recently published misleading information about ETFs that should be countered by facts. “We believe all investors should be appropriately informed about ETFs,” says Oliver, “particularly their safe structure and the benefits they provide”. With ETFs, investors are provided with an attractive way to access multiple markets, asset classes and sectors in a cost-effective manner, Oliver suggests.

As part of the campaign, iShares has added tools to its website providing a performance chart which examines how closely an iShares ETF follows its benchmark. There is also a portfolio allocation tool allowing investors to view the underlying countries and sectors in a portfolio, and a global pricing tool that shows investors when a fund’s underlying holdings trade on the local market.

The above tools are prefaced by an educational video, “Understanding ETFs”. FNArena recommends readers take a look at the iShares educational website and peruse its offerings.

There are currently over 50 ETFs listed on the ASX through BlackRock and other ETF sponsors, offering investment in local and global stocks indices, stock sectors, high-yield portfolios, fixed interest and commodities. Visit the ASX's ETF page for listing details.

Please be advised by FNArena, as is the case with investments of any sort, that it is imperative you seek independent advice from your stockbroker or financial adviser as to the most appropriate ETF selections for your portfolio, and please educate yourself on the workings of EFTs and the implications for risk, reward and tax management before formulating your investment decisions.