Investing in Alternatives – Part 1

Over the last few weeks we have covered the major asset classes that investors include in their portfolio, namely cash, bonds, shares and property.

Over the last few weeks we have covered the major asset classes that investors include in their portfolio, namely cash, bonds, shares and property.  “Alternatives” is an all- encompassing term that includes anything else.  

This week we look at one of the most well known Alternatives, commodities.

Commodities

Some people like to include exposure to commodities within their portfolio, the most popular with non-professional investors tend to be gold and oil.

What:  Commodities are tradeable goods.  Commodities include metals (e.g. silver, gold), energy (e.g. oil), livestock (e.g. pork bellies) and agriculture (e.g. coffee, corn).

Why:     People invest in commodities due to a view they have on the market.  For example, if you believe that pork bellies are undervalued, then you need to get out more and stop researching the price of pork bellies!  Or you could try investing in them to benefit when the price rises. 

Other commodities, notably gold, are used to express a view about risk.  Generally when global risks increase, the value of gold increases because it is an absolute store of value.  That is, it has value in and of itself, and in times of crisis the price of gold rises.  During the period from 2007 until the end of 2010, the price of gold increased at an average annual rate of c.23%.

How:  Generally speaking, it is quite difficult to invest in commodities directly, because they trade in very large parcels that make it hard for retail investors to participate.  The easiest commodity to invest in directly is gold.  For example, if you want to go old school you can head to the Perth Mint and buy yourself some gold coins.  Other commodities, like oil, are a little harder to buy and store directly.

The easiest ways to invest in commodities are:

  • Share Purchases:  Although you cannot purchase all commodities directly, you can directly purchase shares in a company that trades in that commodity.  For example, to get exposure to gold you could invest in a gold mining company.

  • Passive Funds: There are exchange-traded funds available that will give you exposure to commodities, e.g. a Gold ETF or an Oil ETF.  The price of these ETFs will rise when the price of the underlying commodity rises, and vice versa. 

  • Managed Fund:  There is also the possibility of investing in a managed fund, where the manager specialises in a particular commodity. 

Risks:  Investing in commodities is purely a price play, you will only benefit if the price of the commodity increases.  Unlike shares, bonds or property, there is no income component of commodity investing (i.e. you do not receive a dividend, interest payment, or rent). 

Commodity investing can be complex and the prices are very volatile.  The people that trade and invest in commodities are highly specialised, for example the people that invest in gold do it day in and day out, for their whole career.  It is not an asset class that is recommended for novice investors.

If you want to invest in commodities, then ideally it should form only a small part of your portfolio (e.g. 5%) due to the risks, complexity and specialised knowledge required.

Next week we are going to look at another common Alternative, Private Equity.

 The information in this blog is of a general nature only and may contain advice that is not based on your personal objectives, financial situation or needs. Accordingly you should consider how appropriate the advice (if any) is to those objectives, financial situation and needs before acting on the advice.

Stepping on to the property ladder

Now that we’ve looked at some of the benefits, and risks, of investing in property, it’s time to consider how to invest.

Now that we’ve looked at some of the benefits, and risks, of investing in property, it’s time to consider how to invest.

How can I invest in Property?

There are a number of ways to invest in property, below we consider some of the most common.

Directly 

This is the road many people go down, purchasing a property for investment purposes.  Purchasing directly allows the owner to take advantage of negative gearing, it also allows you to choose and inspect the property yourself. 

The tax benefits need to be weighed against some of the downsides:

  • You need a lot of money to enter the property market, unlike the share market where you could start with a very small (e.g. $100) initial investment amount.
  • The purchase costs can be high (including the deposit, inspection costs, solicitors’ fees and stamp duty).
  • The ongoing management costs are high, including agent’s fees and maintenance costs.
  • By investing in one property in one location you are putting all your eggs in the one basket and concentrating your risk in that location
  • You can’t sell part of a property, it is either all or nothing.  Whereas with an investment in shares, you can sell part of your investment portfolio.

Indirectly via shares

Instead of buying directly into property, it is possible to get access to the property sector by buying the shares of companies that operate in the property sector.  This could include companies involved in property development, real estate management, or the supply of building materials.  Investing in the shares of property companies will not allow you to gain all the benefits we outlined above, but it is an option worth considering if you do not yet have the funds to purchase a property.

Exchange Traded Funds

There are a number of passive funds that provide access to property, including ETFs that focus on different classes of property (e.g. office, shopping centres, industrial).  The benefit is that you get access to a diversified portfolio, however the downside is that you do not get the benefit of negative gearing, or the security that comes with personally owning a tangible asset.

Unlisted Managed Funds

Another option is paying a fund manager to invest in property.  Property managers generally specialise in one particular area, whether it be residential, or commercial, or industrial property.  The downside is that this will cost you between 1-2% p.a, and you do  not get the benefit of negative gearing, or the security that comes with personally owning a tangible asset. 

REITs

A REIT is a real estate investment trust and provides a way for investors to access property investment, without having to purchase the entire property.  The real estate investment trust owns and manages the property, and the investor gains access to the assets of the trust through a purchase on the Australian stock exchange. 

Each REIT usually has a particular investment focus, e.g. shopping centres, office buildings.  The performance of the REIT is dependent on the skills of the manager who is picking the underlying assets and managing them, it also depends on the amount of debt the REIT has, higher debt leads to higher risk.  Before purchasing a REIT, make sure you do your due diligence on who manages the REIT and the financial position of the REIT.

Another point to note regarding REITS is that although they might feel more liquid because they trade on the stock exchange, REITs are still exposed to property and the underlying investments can be illiquid.  A number of REITs were frozen (i.e. you couldn’t get your money out) during the GFC.

According to the SPIVA report  over 75% of actively managed Australian REITs under performed the passive index over the last 10 years.

So there you have it, a number of options for you to consider if you feel that property is an area you would like to invest in.  Next week we’re moving on to the exciting, and all-encompassing world, of “alternatives”.

The information in this blog is of a general nature only and may contain advice that is not based on your personal objectives, financial situation or needs. Accordingly you should consider how appropriate the advice (if any) is to those objectives, financial situation and needs before acting on the advice.

Property Q&A

The property market has outperformed the share market over the last 10 years, so why not jump straight in?

The property market has outperformed the share market over the last 10 years, so why not jump straight in?  This week we look at the risks of investing in property.

What are the Risks of investing in property?

There are lots of benefits to investing in property, but make sure you understand the risks before making what is likely to be the largest investment decision of your life.  Below we take a look at the key risks.

Liquidity: We have spoken about liquidity previously, it refers to the ability to turn assets into cash.  Shares are very liquid because they can be sold on any business day.  However selling a property can take some time, if the market is falling it is very hard to get out quickly.  Once the market has fallen, it can take years to sell certain kinds of properties (e.g. rural / remote properties, bespoke properties, commercial buildings that no longer have tenants).

Also, when selling property it is all or nothing, you can’t just sell part of it.

Volatility:  Property is classed as a growth asset, not a defensive asset (which include cash and bonds) because property values are volatile.  The volatility of the share market is very apparent, because the prices move all day every day, and there is clear visibility of the share price movements.  The property market is also continually moving, there is just less transparency around pricing, and therefore less visibility of the movements.   A study found that the standard deviation (a measure of volatility) of direct property investing over the period from 1985 to 2012 was close to 10%, compared to 20% for the stock market.  This data suggests that property investing is less volatile than investing in the stock market, however volatility is still present.

Leverage: One of the benefits of investing in property is the ability to borrow money to do so, which allows you to leverage you initial investment to purchase a more expensive property than you could afford without borrowing.  The downside of leverage is that it introduces additional risk.  If you invest $50,000 in the stock market, the most you can lose is $50,000.  If you use $50,000 as a down payment and borrow $400,000, then you get an asset worth $450,000, however you now owe $400,000 to the bank and are personally liable for making sure the money gets repaid.

Lack of diversification:  Due to the large cost of purchasing property, it is difficult to create a diversified portfolio by investing directly.  If you own only one residential investment portfolio, you are heavily dependent on the performance of that geographic location, which means a very concentrated portfolio.  This issue can be overcome by investing via a fund, however then you do not have direct ownership or control over the asset, and are unable to benefit from negative gearing.

Management Costs: Investing in property comes with high management costs for the owner of the asset.  This includes agents fees, maintenance costs and other running costs (e.g. utilities, council rates, land tax).  These fees tend to result in much higher management costs for a property portfolio than a share portfolio.

What goes up must come down: There has been a lot of talk in the press about the Australian market being over-valued.  Whatever your view, it is worth remembering that market conditions change; house prices will eventually come down, and interest rates will eventually go up.  Here’s a good overview of the last housing crash, including interest rates of 17.5% – yikes!

 The information in this blog is of a general nature only and may contain advice that is not based on your personal objectives, financial situation or needs. Accordingly you should consider how appropriate the advice (if any) is to those objectives, financial situation and needs before acting on the advice.

What are the risks of investing in property?

The property market has outperformed the share market over the last 10 years, so why not jump straight in?

The property market has outperformed the share market over the last 10 years, so why not jump straight in?

This week we look at the risks of investing in property.

What are the Risks of investing in property?

There are lots of benefits to investing in property, but make sure you understand the risks before making what is likely to be the largest investment decision of your life. Below we take a look at the key risks.

Liquidity

We have spoken about liquidity previously, it refers to the ability to turn assets into cash.  Shares are very liquid because they can be sold on any business day.  However selling a property can take some time, if the market is falling it is very hard to get out quickly.  Once the market has fallen, it can take years to sell certain kinds of properties (e.g. rural / remote properties, bespoke properties, commercial buildings that no longer have tenants).

Also, when selling property it is all or nothing, you can’t just sell part of it.

Volatility

Property is classed as a growth asset, not a defensive asset (which include cash and bonds) because property values are volatile.  The volatility of the share market is very apparent, because the prices move all day every day, and there is clear visibility of the share price movements.  The property market is also continually moving, there is just less transparency around pricing, and therefore less visibility of the movements.   A study found that the standard deviation (a measure of volatility) of direct property investing over the period from 1985 to 2012 was close to 10%, compared to 20% for the stock market.  This data suggests that property investing is less volatile than investing in the stock market, however volatility is still present.

Leverage

One of the benefits of investing in property is the ability to borrow money to do so, which allows you to leverage you initial investment to purchase a more expensive property than you could afford without borrowing.  The downside of leverage is that it introduces additional risk.  If you invest $50,000 in the stock market, the most you can lose is $50,000.  If you use $50,000 as a down payment and borrow $400,000, then you get an asset worth $450,000, however you now owe $400,000 to the bank and are personally liable for making sure the money gets repaid.

Lack of diversification

Due to the large cost of purchasing property, it is difficult to create a diversified portfolio by investing directly.  If you own only one residential investment portfolio, you are heavily dependent on the performance of that geographic location, which means a very concentrated portfolio.  This issue can be overcome by investing via a fund, however then you do not have direct ownership or control over the asset, and are unable to benefit from negative gearing.

Management Costs

Investing in property comes with high management costs for the owner of the asset.  This includes agents fees, maintenance costs and other running costs (e.g. utilities, council rates, land tax).  These fees tend to result in much higher management costs for a property portfolio than a share portfolio.

What goes up must come down

There has been a lot of talk in the press about the Australian market being over-valued.  Whatever your view, it is worth remembering that market conditions change; house prices will eventually come down, and interest rates will eventually go up.  Here’s a good overview of the last housing crash, including interest rates of 17.5% – yikes!

The information in this blog is of a general nature only and may contain advice that is not based on your personal objectives, financial situation or needs. Accordingly you should consider how appropriate the advice (if any) is to those objectives, financial situation and needs before acting on the advice.

What’s to love about property?

Property is one of the most loved asset classes in Australia, and the state of the property market is always in the press, whether it’s going up or down.

Property is one of the most loved asset classes in Australia, and the state of the property market is always in the press, whether it’s going up or down.

This week we look at the whys of investing in property.

Why invest in property?

Bricks and Mortar

Many people invest in property because they like the feeling of security that comes with having a tangible asset.  They also like the ability to see the asset for themselves.  It is a lot easier to conduct due diligence when you are purchasing an investment property, which you can visit and inspect, than it is to conduct due diligence on a company, where you are reliant on the information that the company provides, and your ability to ask the right questions to analyse the stock. 

Leverage

Most people borrow money to invest in property, meaning that they slowly build up ownership of an asset that they could never afford outright.  It is also possible to borrow to invest in shares, however property borrowing is less risky as you are generally not subject to  margin calls.

Income

Another benefit of investing in property is the income that it provides, in the form of rent.  Rental income is a common feature across all types of property investment, whether it be residential, office, warehouse or retail.

Capital Growth

In addition to rental income, property also offers capital growth, through appreciation of property prices.  Over the last 20 years, property has on average returned 10.5% p.a, this is the total return and includes both income and capital gains.

Tax Benefits

Certain kinds of property investing comes with tax benefits, namely negative gearing.  If you purchase a property for investment purposes, you are able to deduct the cost of managing the property and owning the property, including the interest on your mortgage.  This results in a reduced taxable income and can make property investing more affordable.

Next week we look at how you can invest in property, there are many more options that simply buying a house!

The information in this blog is of a general nature only and may contain advice that is not based on your personal objectives, financial situation or needs. Accordingly you should consider how appropriate the advice (if any) is to those objectives, financial situation and needs before acting on the advice.

International Shares

Last week we covered Australian equities. This week we cover International shares, a worthwhile addition to a portfolio if you are looking to improve geographic diversity and access a wider range of industries.

Last week we covered Australian equities.  This week we cover International shares, a worthwhile addition to a portfolio if you are looking to improve geographic diversity and access a wider range of industries.

Why invest in international shares?

One of the main reasons to invest in international shares is diversification:

Sector Diversification: In Australia, approximately 60% (by market capitalisation) of the top 100 companies operate in a very narrow set of industries, namely financials, mining & materials, and energy.  If you invest only in the Australian market, your portfolio may lack sector diversification. 

By investing internationally, you get access to other sectors. For example, the top sector in the US is Information Technology, which accounts for over 20% of the 500 largest companies in the US.  In Australia, information technology accounts for only 0.85% of the 100 largest companies.

Geographic Diversification:   If you invest only in the Australian market, the performance of your portfolio will be tied to the performance of the Australian economy.  This can be problematic because your financial well being (i.e. your ability to find work, buy a house, meet interest repayments) is also tied to the performance of the Australian economy. 

Investing internationally helps to diversify your investment risk, by providing access to markets outside of Australia.

How can I invest in international shares?

There are a number of ways to invest in international shares:

Directly:  You could pick a handful of stocks and try to invest directly.  This is a little tricky, because foreign stocks are listed on foreign stock exchanges, which are not easily accessible.  Some brokers in Australia do allow you to purchase stocks listed on certain foreign exchanges. 

 However, before you do this it is important to consider the impact of foreign exchange on your investment.  If your international share portfolio rises by 10%, but the Australian dollar appreciates by 10%, then your net return will be 0.  It is hard to manage this foreign exchange rate risk when you purchase shares directly.

Exchange Traded Funds:  It is possible to invest in international equities via an exchange traded fund (“ETF”).  This means that you can purchase the international equity ETF on the Australian stock exchange (the same way you would a share) and get access to a number of international stock markets.  The upside is that you get access to a diversified international portfolio, through a purchase in Australia, and you can choose a hedged portfolio (more on that below) to minimise your foreign exchange rate risk.  The downside is that you will pay a fee for this management, usually around 0.3% to 0.5%p.a.

Managed Fund: Another option is to invest via a fund manager, this allows you to invest in a professionally managed portfolio of international stocks.  This is a simpler option that investing directly in a number of different stock exchanges, and you get access to professional investment expertise, including expertise in managing foreign exchange rate risk. 

 The downside is that this will cost you between 1-2% p.a.   According to the SPIVA report just over 10% of international managed funds in Australia outperformed the index over the last 10 years.

Too many international shares?

International shares are an important part of a portfolio, particularly for those who are able to take on a higher level of risk, however they should not form 100% of your portfolio.  This is because international shares have all the same risks as Australian shares, plus the additional risk of foreign exchange fluctuations. 

When you invest internationally, you are selling Australian dollars and buying the currency of the investment.  This means that the value of your investment will fall in Australian dollar terms when the Australian dollar rises, so you are exposed to the risk of the Australian dollar appreciating.

If you invest via a managed fund, or an ETF, you are likely to have the option to hedge your foreign exchange rate risk.  If you go with a hedged option, the fund manager will pay a fee to lock in a set foreign exchange rate.   This means that you are protected if the Australian dollar appreciates, but you will miss any upside if the dollar depreciates.

Hedging does not eliminate foreign exchange rate risk, instead you are paying a fee (via the cost of the hedge) to manage it.

The decision of whether or not to hedge is a very personal one and will depend on your ability and willingness to take on risk.  Foreign exchange can be very volatile, if you do not like volatility you should consider hedging any foreign exchange rate risk in your portfolio.  The chart below shows the Australian Dollar / US Dollar exchange rate over the last 10 years, as you can see the rate has been very volatile.

 

A further point to consider with international shares is diversification.  If you invest in a handful of international stocks in the US technology industry, then you have added only a small additional layer of diversification to your portfolio.  To get the largest diversification benefit from international stocks, try to avoid concentrating your stocks in a particular industry or country.

Next week we are going to cover another popular asset class in Australia, Property.

The information in this blog is of a general nature only and may contain advice that is not based on your personal objectives, financial situation or needs. Accordingly you should consider how appropriate the advice (if any) is to those objectives, financial situation and needs before acting on the advice.