In This Chapter
Understanding the mysteries of hedge funds
Getting to grips with guaranteed income bonds
Engaging with Exchange-Traded Funds
I was never noted for my prowess at science. In fact, I was thrown out of the lab at school for fighting with my best friend in class, because it seemed more fun than learning my atomic numbers. I'm reliably informed, however, that atomic scientists have spent a lot of their time scratching their heads over a strange type of atomic particle known as a Higgs boson, which is now the subject of a $9 billion experiment at the CERN laboratories in Lucerne. All of which is an act of faith, really, considering that the only way the scientists know these invisible atomic particles exist at all is that they can observe the effect they have on the things around them. Other particles dodge and swerve and do unexpected things whenever the Higgs bosons are in town. And, in a strange way, hedge funds bear a certain resemblance to these mysterious particles. Bear with me, it'll all become clear.
Investors might think they know what hedge funds are up to, most of the time, but they can never be completely sure. That's because hedge funds are secretive organisations that don't reveal what they're doing – and indeed, they often go to enormous lengths to cover their tracks. What I can say for certain, though, is that the role hedge funds play in the financial markets is simply enormous, and becoming more so with every passing year. I have to give hedge funds at least some sort of mention, because without them the daily behaviour of today's markets just doesn't make sense.
What you'll certainly have noticed, though, is that everyone seems to have heaped a lot of blame for the 2007/2008 global stock market crisis on the hedge fund managers. At a time when the stock markets were in desperate need of clarity and visibility, the hedge funds went about their business as usual in their own sweet way. They wouldn't tell anybody how many bonds or how much gold they'd bought, or how many shares they were short-selling (that's to say, how many shares they were gambling on to lose money rather than make it). And the result was that, when it all went wrong and the hedge funds' investors started to withdraw their cash, the funds found themselves locked into a devils' dance of more and more selling, which just heightened the general uncertainty and made everybody more panicky than ever, because you could only guess at what the hedge fund managers were selling – or what they'd be selling next. The result was chaos.
But I'm getting ahead of myself. This chapter covers the intricacies of three types of managed fund: hedge funds, guaranteed income bonds, and Exchange-Traded Funds, which are a whole lot less mysterious, and a bit less risky.
Let's go back to basics here. Every time you read in the morning papers that the gold price has been boosted by hedge funds making speculative bullion buys in the Hong Kong market, you need to take the news with a big pinch of salt. What the reporter means is that the City's full of gossip that such-and-such a fund has been doing such-and-such a thing today. And although he may be able to name one or two funds, he's nothing much more than hearsay and apocryphal evidence to go on.
The reason this lack of information is a problem is that hedge funds are a $2.5 trillion industry (2007 estimate) that's attracting nearly $300 billion of new money every year. Now, $2.5 trillion is pretty close to the total gross domestic product of the United Kingdom. And, as I've said in my introduction, hedge funds leave no audit trails and no easy way of knowing exactly what they're doing. This elusiveness is a problem!
Hedge funds differ from ordinary managed funds in many ways, but to start with the basics:
They're allowed to invest in anything they choose. A normal trust has statutes that define what sort of securities it can buy. But a hedge fund manager has no limits. If he thinks the time's come to swap diamonds for wheat, or biotechnology for property management, or bank certificates of deposit for carbon emission permits, he's free to do so.
They're not required to post their results or their trading records. Indeed, since the majority of hedge funds are domiciled in tax hideaways like Bermuda or the British Virgin Islands, making them come clean's really quite hard, even if anybody wanted to. (Some movement's now occurring on this issue, however, as 'Considering if hedge funds are becoming respectable at last', later in this chapter, considers.)
They adopt what's called an 'absolute return' policy. This means that they're committed to making a profit regardless of whether the market's moving up or down. Some of the time, this means using so-called long–short policies, under which the manager buys shares (or whatever) while simultaneously taking up complicated contrary positions through the derivatives markets (see Chapter 12 for more on these), to produce a win–win result. (This policy goes to the heart of why they're called hedge funds: the idea is that, by 'sitting on the fence', they ought to be able to make money out of any situation.)
They also do a good deal of stock shorting (covered in Chapter 9) in an effort to make money out of even the most frighteningly bad markets. The general idea of shorting is that you aim to make money by borrowing shares from other people, then selling them – and hoping that the market will have fallen a long way by the time you need to buy the shares back again at a cheaper price, so that you can give them back to your lender. In the process, with a bit of luck, you'll have turned a profit on the difference between your sale price and your purchase price.your two transactions.
Short selling doesn't necessarily deserve the bad press that it sometimes gets. Short sellers claim that they perform a useful service by drawing the market's attention to weak companies. But that hasn't stopped the market authorities from trying to tighten up the regulation of aggressive shorting by hedge funds, which they have accused of making wobbly market situations much worse. The chances are that this debate will run and run....
Hedge funds make extensive use of leverage; that is, they borrow money heavily in order to invest it in the hope of securing better returns. This 'gears up' the returns they can get, sometimes twenty-fold, but it also increases the risks to their fundholders if things ever go wrong. Many of the root causes of the 2007/2008 banking crises lie in leveraged hedge fund positions that went wrong.
Hedge funds don't have fixed fees, or not large ones at any rate. Management fees are often pegged at 2 per cent of the funds under management. Instead, the vast bulk of the fee income derives from a hefty performance charge ('incentive fee') that the managers make on the profits they earn for their clients. Not untypically a manager charges 20 per cent of the amount by which he increases the net asset value of the funds under his control.
You don't ever find out what hedge funds are up to from reading the financial pages in your newspaper. Or at least, not in any 100 per cent reliable way. You certainly can't find any statistical material there. But you do find plenty of informed guesses on the Internet – both on dedicated discussion forums and in subscriber newsletters (go to Chapter 16 for more on these information sources).
You'll have noticed that I regard hedge funds with a certain amount of suspicion. Although I don't disagree that a well-placed 'short position' can put a very relevant question mark under a dodgy market situation, I do agree with those who say that the secrecy under which all this is going on is a problem for the financial markets at large. And that the more you can find out about a hedge fund in which you're considering investing, the better.
Oddly, for once I find myself in agreement with the US tax authorities, who've been clamping down on the whole offshore fund management industry in the aftermath of the 9/11 terrorist atrocities in New York and Washington. The Internal Revenue Service's claim that international terrorists are hiding behind the anonymity of these hedge funds may not have much substance, but if nothing else, the fear has forced Washington into seeking a sort of halfway house arrangement with the hedge fund managers.
Under a deal worked out a few years ago, the government of Bermuda has agreed to act as a kind of honest broker between the hedge funds and the US authorities. Basically, it inspects the affairs of the hedge funds in confidence, and then signals to Washington that all's well (or not), without giving details.
This deal marks progress. If it creates a greater atmosphere of trust between the cowboys and the lawmakers, and if it generates a less secretive atmosphere, then everyone should feel safer and the markets become more transparent. But, just in case I haven't said it loudly enough yet, the whole question of how to regulate hedge funds has been reopened in fine style by the credit crunch of 2007/2008, and it wouldn't surprise me at all if things started to get a lot more uncomfortable for the Higgs bosons of the investment world, some time very soon.
For many investors, a guaranteed income bond (GIB) sounds like the ideal way to cope with the uncertainties of a volatile stock market. You've probably seen these deals advertised in the Sunday newspapers, or in the windows of the banks and the building societies in the high street. For an unsophisticated investor who doesn't know much about the stock market but wants to have some of the benefits, they do have a certain appeal. Worse luck.
The usual deal with a guaranteed income bond (sometimes called a guaranteed equity bond) is that you commit your money to the provider for a fixed period of maybe five years. At the end of that time, if the stock market's fallen you get all your money back. But if it's risen you get a cash return on your money that's related to the growth in the market. Depending on the deal, you might get 100 per cent of the stock market's gains, although sometimes you only get 75 per cent. (The percentage terms are clearly set out in the offer document, so the provider can't change the ratio once you've signed up for it.)
One or two of these GIB deals have indeed been very good. National Savings ran one GIB a few years back that offered 115 per cent of the stock market's growth! But for all too many people, venturing into GIBs ends in tears and disappointment. Some real sharks are lurking in these sunny blue waters, and you need to know what their fins look like before you commit your money.
The following sections guide you through the pitfalls, and explain what some of the convoluted language connected with GIBs means. Until you've looked at those issues, you really don't have a clue exactly what sort of return you're really being offered.
I might confuse you by saying that although a GIB promises you a return that's linked to the stock market's growth, the GIB provider isn't going to invest your money in stocks and shares at all!
Instead, it's going to put most of the money into an interest-bearing account, where the money carries on earning a nice, reliable rate of interest until the five-year term (or whatever) is up. A small part of the money is then put to work in the derivatives markets (Chapter 12 covers these) and that's the part that brings in nearly all the income.
The details are complicated, but basically the fund manager takes out a series of futures contracts that will pay him a disproportionately large return in relation to any rise in the stock market. (A futures contract is an elaborate kind of bet on future trends, that can used to compensate the investor for any loses, whichever way the market might move. I talk more about this in Chapter 12.) The rest of the money sits in the bank account, effectively acting as collateral for the futures contracts. But these 'structured products' are 'hedged' in such a way that the overall result really can't deviate from the result that you'd get from investing directly in the stock market.
Your returns, then, are not stock market profits as such. Instead, they're a cash payment that imitates a stock market profit.
Most GIBs are run from bases outside mainland Britain (often in Ireland or the Channel Islands), where managers find wheeling and dealing at low cost easier. But don't worry about that. Because an accredited UK provider's selling you the product, you have full investor protection under UK law.
One of the important points about a GIB is that, once you've entered into it, you really can't back out of the deal before the fixed term's up. A few providers let you off the terms of the contract prematurely, subject to a heavy cash penalty that probably wipes out all your gains and damages your capital as well (especially if the stock market's fallen since you started the bond). But with most GIBs you quite literally have to be dead to get your money back! And that seems a rather excessive solution to the problem.
Warning
Never invest any money in a GIB unless you're absolutely certain that you don't need to get at it before the time's up.
Newspapers don't like GIBs, and they tend not to be reticent about saying so. One reason they don't like them is that they think the providers are trying to hoodwink their customers! It's all very well getting 100 per cent of the capital return that you might have got from the stock market if you'd bought shares instead – but the fact is that you'd also have got a pile of dividends on your shares, which you won't be getting from your GIB. In other words, the GIB providers are hoping that you won't notice that you're being shrt-changed.
Note
If you'd put £5,000 into real stocks and shares for five years at an average dividend yield of 4 per cent, you'd have amassed a rather amazing gross of £1,083 in dividends by the end of those five years (assuming that you left the dividends in the account to compound.) Even if you assumed that they were being taxed at source at the 20 per cent standard rate, your winnings would still be £852.
That's a 17% dividend return on your investment that you won't be seeing from your guaranteed income bond, which doesn't pay you any dividends at all! Of course, the capital gains from the bond is something that you'd have been getting from a stock market portfolio anyway.
Another reason the financial press isn't too keen on GIBs is that the marketing blurb often contains 'oversimplifications' about the way the return on your bond is calculated. Consequently, a lot of investors end up getting less than they expect at the end of the term.
Strangely enough, this practice isn't actually illegal, although it certainly ought to be. The companies that provide these bonds always take good care to make sure that the awkward truth's in the small print. The problem arises because the average high street investor doesn't read the small print at all.
Warning
These products are aimed at unsophisticated investors.
Here's an example. The headline on the GIB's blurb might say something like: 'You get 100 per cent of all the growth on the FTSE-100 index that happens between the start and finish dates.' But it ain't necessarily so. Often, when you look closely, you find that the starting price level for the FTSE-100 is actually a 'smoothed' level, which turns out to be an average of the daily prices at each end of the first three months of the term (that is, the FTSE-100 prices on Day 1 and Day 91).
What does that mean in practice? If the FTSE-100 happens to rise by 6 per cent during those first three months, from 6000 to 6360, the starting price the fund works from is 6180 – the average of those two daily prices – not the starting price of 6000 at all. That's 3 per cent of your growth that the company's just swiped!
The same thing might happen at the end of the term, so that the final value's actually an average of the last day's value and the value from 90 days earlier. If the markets are still rising at the time, the chances are that you've lost another 45 days' worth of growth there.
The GIB provider will tell you that this is all for your own good. By 'flattening out the bumps' at the start and finish of the term, he claims that it's protecting you from any damaging volatility. In practice, however, it's giving you four-and-three-quarter years' stock market growth instead of the five you thought you were buying.
Warning
I really hate to add yet another concern to your growing list of worries, but you do need to keep a sharp lookout for so-called 'precipice bond' clauses whenever you buy a GIB. These nasty little booby-traps can lie slumbering in the small print for years on end – and they very often don't wake up at all, which is a good thing because they can turn all your sweet dreams into nightmares if the worst should ever comes to the worst. But if you should ever get a particular combination of falling stock markets and sheer bad luck with your timing, precipice bond clauses can blow quite a large hole in the capital that you thought was 100 per cent safe.
If that sounds rather alarming, maybe I can say that the worst kinds of precipice bonds were outlawed nearly a decade ago, when the 2000 stock market crisis cost some GIB savers nearly all their money! But it looks as though they're now coming back in a slightly milder form. I was recently offered a bond with rather similar characteristics, so take great care.
The worst of the precipice bond deals used to have a little clause somewhere in the small print that said, in effect, that it wasn't entirely true that you'd get your money back if the stock market fell during the period of the term. If the investors had only read the terms and conditions carefully they'd have seen a line that said something like:
| 'If the FTSE-100 index falls by more than 20 per cent at any time during the five-year term, the value of the bond will be reduced by 3 per cent for every 1 per cent by which the fall exceeds 20 per cent.' |
So if the stock market were to fall by 21 per cent at any time, you'd get only 97 per cent of your money back at the end of the five-year period. The other 3 per cent would have been snaffled by the penalty clause. If it fell by 30 per cent, you'd lose 30 per cent of your supposedly 'guaranteed' money.
Please note, incidentally, that the penalty still applies even if the stock market picks itself up and forges ahead strongly again after its 30 per cent setback. The clause says 'at any time', remember?
Things get even nastier with the new breed of GIBs that base their outcomes not on the FTSE-100 but on a hand-selected 'basket' of leading shares. I was offered a bond that promised to pay a big return on the strict condition that none of six UK banks in the portfolio saw its share price fall by more than 50 per cent during the five-year period. If it did, I'd suffer big penalties. I didn't touch that bond. Months later, a whole slew of British banks hit the skids, including Bradford & Bingley, whose shares lost nearly 80 per cent in two months, and eventually the bank was effectively nationalised by the British government. By the end of 2008 even giants such as Lloyds TSB, Barclays and Royal Bank of Scotland had their share prices trailing in the dust. And it was exactly the same story in America, France, Germany and even Switzerland. A bond based on their share prices would very probably have wiped me out completely.
Tip
Don't reject all GIBs on principle just because you're naturally risk averse. Many of them are worthwhile and trustworthy. The ones from National Savings & Investments have historically been clean and decent, although you have to make your own mind up about any future releases. And the regulator's cracking down much harder on transgressors these days.
However, don't sign up to any GIB contract without reading the small print in detail. Are you happy with the fixed term? Do you know how much tax you have to pay? Do you fully understand the date system by which the company calculates the amount it owes you?
Exchange-Traded Funds (ETFs) are just one of a range of new fund products shaking up the London investment markets in fine style. They've been around in the United States for many years now, but in Britain they've only really had a proper presence since about 2006. Almost anything I say right now is going to be out of date within two years, because the rate of expansion's so fast. But you can keep up to date with the changing situation by checking with the London Stock Exchange (www.lse.co.uk) or independently run Internet sources such as the grandly named ETF Stock Encyclopedia (etf.stock-encyclopedia.com).
ETFs are probably unlike anything you've ever seen before. They're a kind of second cousin to the guaranteed equity bonds or guaranteed income bonds that your bank or building society tries to sell you in an attempt to ride on the back of the stock market 'without taking any risks'. (I look at GIBs in Chapter 14.)
Just like a GIB, an ETF is a 'structured product', which means that it isn't normally invested directly in the underlying shares. Instead, the ETF provider takes your money, sticks most of it safely in the bank (or in very secure bank securities), and then uses the rest to fund a convoluted system of betting on the derivatives markets (see Chapter 12 for more on these). The manager sets out to get a disproportionate return from this small part of your money, depending on which way the market moves – thus allowing it to give you a return that exactly matches the return you get from backing the underlying index directly. (At present, all ETFs in Britain are based on a public index of one sort or another.) Your gains on the ETF are paid for not by an increase in the market capitalisation of the underlying shares, but by a cash disbursement derived from the success of the 'bets'.
There are certain subtle differences in the way that ETFS and other 'structured products' are constructed in Europe and in America. I won't bore you with the fine details, but American funds are required to hold more shares and fewer derivative bets in their portfolios than their British and European counterparts. It isn't every day that the US version of an investment is less racy and risky than its European counterpart, but this is one of them.
Incidentally, why don't you pay stamp duty on ETFs? Because stamp duty only applies to shares and share-related products such as investment trusts. ETFs, however, are considered to be a different type of animal for stock market purposes: many of them belong to an exotic family of securities known as zero coupon bonds. But explaining that's going to take us rather a long way from the matter in hand, so let's keep it simple.
Things are moving on a little in America, where ETFs are now moving into new and exciting territory. Companies such as PowerShares are starting to ditch the underlying 'weighting' principle, whereby the biggest companies in an index automatically get the biggest cash weighting; instead, some of these ETFs give equal weighting to both the minnows and the whales. That produces some very interesting results in sectors such as biotechnology, where small biotech researchers are effectively driving growth in a market that big boys like Pfizer and Monsanto have always dominated.
Finally, I want to say a word about something called Exchange Traded Notes (ETNs), which are quite new on the scene in Britain but which are already becoming very popular in America. They're quite similar to ETFs in many ways, but instead of being structured as a share-type fund, they're actually a type of bond issued by a bank.
For technical reasons I won't go into, this makes ETNs slightly more exciting and rather more volatile than an ETF – meaning that if you get your guesses right you can make money faster. But there's a drawback with ETNs that you really ought to know about. Because ETNs are effectively bank bonds, their solidity and safety is effectively pinned to the stability of the issuing bank itself, and not to the stability of the underlying shares, as it would normally be with an ETF. This could mean, in theory, that if the bank itself should ever go bust, your investment might go with it. Take care!
This is probably more than you wish to know at this stage in the learning curve, and I apologise deeply for leading you so far up a very twisting path. But ETFs are the shape of tomorrow as far as UK fund investing is concerned, and I would have been failing in my duties if I hadn't shown you which way they're headed.
Tip
One very important point which I'll leave you with is that all London-listed ETFs are covered by the same investor protection regulations as normal stocks and shares. So there is no reason to suppose that the new kids on the block have brought any particularly dangerous risks with them.
You'll find more about ETFs in Chapter 13, but for the time being let me just say once again that the situation is changing fast.
You will not find ETFs listed in any of Britain's newspapers – or not, at least, as far as I am aware. But the prices are always available from the FT or the LSE web sites, and from your online broker too.
There are really no reasons why you shouldn't be able to buy a New York-listed ETF, or indeed any other of the many internationally traded funds. You may not be able to get all of them into your ISA – that will depend on who your account is with – but, on the whole, the much wider range of ETFs available in America makes it worth tackling a few little obstacles along the way.
Tip
ETFs are changing fast. They aren't listed in any UK newspapers, but you can find information on www.ft.com and the London Stock Exchange (www.lse.co.uk). Chapter 13 on commodities also briefly covers ETFs.