Gold as a Hedge Against a Declining U.S. Dollar and Rising Inflation
The idea that gold preserves wealth is even more important in an economic environment where investors are faced with a declining U.S. dollar and rising inflation (due to rising commodity prices). Historically, gold has served as a hedge against both of these scenarios. With rising inflation, gold typically appreciates. When investors realize that their money is losing value, they will start positioning their investments in a hard asset that has traditionally maintained its value. The 1970s present a prime example of rising gold prices in the midst of rising inflation.
The reason gold benefits from a declining U.S. dollar are because gold is priced in U.S. dollars globally. There are two reasons for this relationship. First, investors who are looking at buying gold (like central banks) must sell their U.S. dollars to make this transaction. This ultimately drives the U.S. dollar lower as global investors seek to diversify out of the dollar. The second reason has to do with the fact that a weakening dollar makes gold cheaper for investors who hold other currencies. This results in greater demand from investors who hold currencies that have appreciated relative to the U.S. dollar.
Gold as a Safe Haven
Whether it is the tensions in the Middle East, Africa or elsewhere, it is becoming increasingly obvious that political and economic uncertainty is another reality of our modern economic environment. For this reason, investors typically look at gold as a safe haven during times of political and economic uncertainty. Why is this? Well, history is full of collapsing empires, political coups, and the collapse of currencies. During such times, investors who held onto gold were able to successfully protect their wealth and, in some cases, even use gold to escape from all of the turmoil. Consequently, whenever there are news events that hint at some type of uncertainty, investors will often buy gold as a safe haven.
Gold as a Diversifying Investment
The sum of all the above reasons to own gold is that gold is a diversifying investment. Regardless of whether you are worried about inflation, a declining U.S. dollar, or even protecting your wealth, it is clear that gold has historically served as an investment that can add a diversifying component to your portfolio. At the end of the day, if your focus is simply diversification, gold is not correlated to stocks, bonds and real estate.
Different Ways of Owning Gold
One of the main differences between investing in gold several hundred years ago and investing in gold today is that there are many more options to participating in the intrinsic qualities that gold offers. Today, investors can invest in gold by buying:
• Gold Futures
• Gold Coins
• Gold Companies
• Gold ETFs
• Gold Mutual Funds
• Gold Bullion
• Gold jewelry
Conclusion
There are advantages to every investment. If you are more concerned with holding the physical gold, buying shares in a gold mining company might not be the answer. Instead, you might want to consider investing in gold coins, gold bullion, or jewelry. If your primary interest is in using leverage to profit from rising gold prices, the futures market might be your answer.
Saturday, March 15, 2008
Sunday, March 2, 2008
HOW TO EARN 9% TAX FREE RETURN
Ever since the bulls and bears began slugging it out over the past few months, equity fund managers are trying hard to make sense of the market and manage volatility. In the midst of all this humdrum, there has been one category of mutual funds that has quietly gone about its business without too much of a noise. Those are the arbitrage funds which are sometimes more lucidly referred to as equity-and-derivative funds. While these terms tend to convey a risky and aggressive investment, the reverse is actually true.
These funds are an ideal way to earn a reasonable income with a moderate amount of risk. In fact, this puts them at par with income funds on the risk-return profile. So the equity-and-derivatives funds are actually a good alternative to income funds.
The concept
All the arbitrage funds have an identical objective: to capitalise on the price difference between the spot market (cash segment) and the derivatives market (futures and options segment - F&O). So they generate income by taking advantage of the arbitrage opportunity emerging out of the mis-pricing between the spot and derivatives market.
Let’s say that the shares of company XYZ are trading at Rs 500 (cash segment). Simultaneously, they are also being traded in the derivatives market, where the stock futures is priced at Rs 510.
So what the arbitrage fund manager will do is sell a contract of XYZ stock futures at Rs 510 and buy an equivalent number of shares at Rs 500. This number of shares will be equal to the number in one contract of a stock future. The result: a risk-less profit of Rs 10 (less transaction costs like brokerage). Just by buying in the spot market and selling in the futures market, the fund manager has made a profit, irrespective of the overall market movement.
All these transactions in futures get settled on the settlement day. On this day, the price of the stocks in the spot and futures market tends to coincide. Since he already bought shares at Rs 500 and sold stock futures at Rs 510, he will just have to reverse the transaction, i.e., buy back a contract in the futures market and sell off the holding of equity shares in the spot Markets.
In this way, irrespective of which direction the market moves, the fund earns its share of profit (i.e., the spread between the initial purchase price of equity shares and sale price of futures contract).
Let’s create two scenarios to understand. Say the fund manager bought the shares of company XYZ at Rs 500 and sold stock futures at Rs 510.
Now let’s look at two different price scenarios on settlement day. Remember, on this day, the price will be the same in the cash and derivatives segment.
Situation I: He bought the shares in the cash segment at Rs 500 and now sells them at Rs 600, earning a profit of Rs 100. Now he will purchase the stock future at a loss of Rs 90 (because he had sold it at Rs 510). Both the transactions net up to a profit of Rs 10.
Situation II: The stock price plummets to Rs 400. He makes a loss of Rs 100 in the cash segment (he bought the shares at Rs 500). But he sold the futures contract at Rs 510 and now buys it at Rs 400, making a profit of Rs 110. Once again, both transactions net up to a profit of Rs 10.
So whichever way the market moves, the arbitrage has worked. The investment strategy of arbitrage funds is such that they earn moderate returns by taking low to moderate risk.
Even though the underlying securities in which they invest in are risky, since the portfolio is always completely hedged it is market neutral, i.e., the returns do not get affected by the Markets moving up or down.
The performance
The concept presents a wonderful proposition on paper. But the test lies in whether these funds have been able to translate it into substantial gains. The returns certainly suggest so.
Arbitrage funds have outperformed the major categories of debt funds across time periods. The category average returns of 8.9% over the last one year are definitely appealing when compared with the income funds’ average of 6.10%. And what adds to the glitter is the fact that the returns of an arbitrage fund become tax-free after a holding period of one year, since they are treated as equity-oriented funds from taxation point of view.
Moreover, these returns have come at a low risk. Barring one fund, none of them have delivered negative returns over any one month period.
This means that if you invested in these funds for a month, you would not have incurred a loss. Ditto is the case over three-month and one-year periods. And remember, this includes the periods of market correction (May-June 2006 and July-August 2007) as well. The market neutrality factor that we talked about earlier has ensured that wherever the Markets go, these funds remain unscathed.
The concerns
Though not the case now, a bloating asset size can be a real drag on the performance of an arbitrage fund, which will face the challenge of identifying that many more mis-pricing opportunities to keep up the performance. ICICI Prudential Equity & Derivative Income Optimiser, the biggest of the lot, manages Rs 1,400 crore and also happens to be the best performer. However, it has to be kept in mind that this fund has the option to invest up to 5% in equities without taking an off-setting position in the derivatives market. This enhances its return potential while adding slightly to its risk profile as well.
Going forward, a concern does arise on the availability of adequate arbitrage opportunities to generate reasonable amount of returns.
This category of funds is managing a modest amount of assets. But going forward, should there be a surge in the assets of such funds, they might find it difficult to identify enough arbitrage opportunities to keep up their performance records achieved thus far. Moreover, arbitrage is a self-cannibalising activity. As more and more money chases the limited amount of mis-pricing opportunities, the occurrence of such situations tends to diminish. In such a scenario, the assets can remain parked in the money market instruments for want of arbitrage opportunities, turning such a fund into nothing more than a liquid fund.
However, we seem to be far from such a situation as of now. More and more stocks are being introduced in the derivatives Markets, broadening the investment universe for these funds. For example, 14 stocks were added to the derivative segment from September 6, 2007, taking the total number of stocks traded in the F&O segment to 207. Therefore, there is little to worry about the future potential of these funds as of now.
The decision
Should you decide to opt for such a fund, there are 10 such offerings in the market, up from just one at the start of 2005. Their ability to generate reasonable returns by taking moderate risk, coupled with their tax efficiency, makes them a strong contender to be part of income fund investors’ portfolios.
These funds generally thrive on volatility. The reason being that higher the volatility in the Markets, higher the potential of mis-pricing between the spot and futures Markets which leads to arbitrage opportunities. So don’t shirk them when you find the market volatile. That’s the time you should seriously look at them.
These funds are an ideal way to earn a reasonable income with a moderate amount of risk. In fact, this puts them at par with income funds on the risk-return profile. So the equity-and-derivatives funds are actually a good alternative to income funds.
The concept
All the arbitrage funds have an identical objective: to capitalise on the price difference between the spot market (cash segment) and the derivatives market (futures and options segment - F&O). So they generate income by taking advantage of the arbitrage opportunity emerging out of the mis-pricing between the spot and derivatives market.
Let’s say that the shares of company XYZ are trading at Rs 500 (cash segment). Simultaneously, they are also being traded in the derivatives market, where the stock futures is priced at Rs 510.
So what the arbitrage fund manager will do is sell a contract of XYZ stock futures at Rs 510 and buy an equivalent number of shares at Rs 500. This number of shares will be equal to the number in one contract of a stock future. The result: a risk-less profit of Rs 10 (less transaction costs like brokerage). Just by buying in the spot market and selling in the futures market, the fund manager has made a profit, irrespective of the overall market movement.
All these transactions in futures get settled on the settlement day. On this day, the price of the stocks in the spot and futures market tends to coincide. Since he already bought shares at Rs 500 and sold stock futures at Rs 510, he will just have to reverse the transaction, i.e., buy back a contract in the futures market and sell off the holding of equity shares in the spot Markets.
In this way, irrespective of which direction the market moves, the fund earns its share of profit (i.e., the spread between the initial purchase price of equity shares and sale price of futures contract).
Let’s create two scenarios to understand. Say the fund manager bought the shares of company XYZ at Rs 500 and sold stock futures at Rs 510.
Now let’s look at two different price scenarios on settlement day. Remember, on this day, the price will be the same in the cash and derivatives segment.
Situation I: He bought the shares in the cash segment at Rs 500 and now sells them at Rs 600, earning a profit of Rs 100. Now he will purchase the stock future at a loss of Rs 90 (because he had sold it at Rs 510). Both the transactions net up to a profit of Rs 10.
Situation II: The stock price plummets to Rs 400. He makes a loss of Rs 100 in the cash segment (he bought the shares at Rs 500). But he sold the futures contract at Rs 510 and now buys it at Rs 400, making a profit of Rs 110. Once again, both transactions net up to a profit of Rs 10.
So whichever way the market moves, the arbitrage has worked. The investment strategy of arbitrage funds is such that they earn moderate returns by taking low to moderate risk.
Even though the underlying securities in which they invest in are risky, since the portfolio is always completely hedged it is market neutral, i.e., the returns do not get affected by the Markets moving up or down.
The performance
The concept presents a wonderful proposition on paper. But the test lies in whether these funds have been able to translate it into substantial gains. The returns certainly suggest so.
Arbitrage funds have outperformed the major categories of debt funds across time periods. The category average returns of 8.9% over the last one year are definitely appealing when compared with the income funds’ average of 6.10%. And what adds to the glitter is the fact that the returns of an arbitrage fund become tax-free after a holding period of one year, since they are treated as equity-oriented funds from taxation point of view.
Moreover, these returns have come at a low risk. Barring one fund, none of them have delivered negative returns over any one month period.
This means that if you invested in these funds for a month, you would not have incurred a loss. Ditto is the case over three-month and one-year periods. And remember, this includes the periods of market correction (May-June 2006 and July-August 2007) as well. The market neutrality factor that we talked about earlier has ensured that wherever the Markets go, these funds remain unscathed.
The concerns
Though not the case now, a bloating asset size can be a real drag on the performance of an arbitrage fund, which will face the challenge of identifying that many more mis-pricing opportunities to keep up the performance. ICICI Prudential Equity & Derivative Income Optimiser, the biggest of the lot, manages Rs 1,400 crore and also happens to be the best performer. However, it has to be kept in mind that this fund has the option to invest up to 5% in equities without taking an off-setting position in the derivatives market. This enhances its return potential while adding slightly to its risk profile as well.
Going forward, a concern does arise on the availability of adequate arbitrage opportunities to generate reasonable amount of returns.
This category of funds is managing a modest amount of assets. But going forward, should there be a surge in the assets of such funds, they might find it difficult to identify enough arbitrage opportunities to keep up their performance records achieved thus far. Moreover, arbitrage is a self-cannibalising activity. As more and more money chases the limited amount of mis-pricing opportunities, the occurrence of such situations tends to diminish. In such a scenario, the assets can remain parked in the money market instruments for want of arbitrage opportunities, turning such a fund into nothing more than a liquid fund.
However, we seem to be far from such a situation as of now. More and more stocks are being introduced in the derivatives Markets, broadening the investment universe for these funds. For example, 14 stocks were added to the derivative segment from September 6, 2007, taking the total number of stocks traded in the F&O segment to 207. Therefore, there is little to worry about the future potential of these funds as of now.
The decision
Should you decide to opt for such a fund, there are 10 such offerings in the market, up from just one at the start of 2005. Their ability to generate reasonable returns by taking moderate risk, coupled with their tax efficiency, makes them a strong contender to be part of income fund investors’ portfolios.
These funds generally thrive on volatility. The reason being that higher the volatility in the Markets, higher the potential of mis-pricing between the spot and futures Markets which leads to arbitrage opportunities. So don’t shirk them when you find the market volatile. That’s the time you should seriously look at them.
Subscribe to:
Posts (Atom)