UNIT 2021 Investing and Trading Guide

UNIT 2021.

GNIDART DNA GNITSEVNI ROF KROWTEN YTISREVINU

ACKNOWLEDGEMENTS EDITOR IN CHIEF: Angela Gao EXECUTIVE CONTENT EDITORS: Dominic Marino, Ryan Chan EXECUTIVE DESIGN EDITORS: Anna Ly, Melissa Qiu

AUTHORS: Anthea Trang, Chrissa Stephen, Daniel Lum, Derek Zhou, Elissa Lieu, Ethan Proutt, John Xie, Lexie McKinnon, Neve Glowacki, Omar Khan, Serena Hu, Sophie Barclay, Tara Mintoff, Will Arnott DESIGNERS: Anthea Trang, Cassandra Chang, Chrissa Stephen, Elissa Lieu, Moniq Wever, Omar Khan, Tara Mintoff

DISCLAIMER 1. The information in this free guide is provided for the purpose of education and intended to be of a factual and objective nature only. The University Network for Investing and Trading (“UNIT”) makes no recommendations or opinions about any particular financial product or class thereof.

2. UNIT has monitored the quality of the information provided in this guide. However, UNIT does not make any representations or warranty about the accuracy, reliability, currency or completeness of any material contained in this guide.

3. Whilst UNIT has made the effort to ensure the information in this guide was accurate and up-to-date at the time of the publication of this guide, you should exercise your own independent skill, judgement and research before relying on it. This guide is not a substitute for independent professional advice and you should obtain any appropriate professional advice relevant to your particular circumstances.

4. References to other organisations are provided for your convenience. UNIT makes no endorsements of those organisations or any other associated organisation, product or service.

5. In some cases, the information in this guide may incorporate or summarise views, standards or recommendations of third parties or comprise material contributed by third parties (“third party material”). Such third party material is assembled in good faith, but does not necessarily reflect the views of UNIT, or indicate a commitment to a particular course of action. UNIT makes no representations or warranties about the accuracy, reliability, currency or completeness of any third party material.

6. UNIT takes no responsibility for any loss resulting from any action taken or reliance made by you on any information in this guide (including, without limitation, third party material).

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Equi ti es

ETF s

F i xe d I nco m e S e c ur i t i e s

Co m m o di ti es

Cur rency

Cr y pto cur r ency

D e r i v a ti v es

P ro perty

A l t e r na ti v e I nv e s t m e nt s

CONT E N T S

I nt ro ducti o n

TABLE OF

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INTRODUCTION Welcome to UNIT’s 2021 Investing and Trading Guide!

This Guide provides a comprehensive overview of nine different categories of investment - equities, exchangetraded funds, fixed income, currency, cryptocurrency, property, derivatives and alternative investments.

For each investment type, the analysis will consist of an overview of the main methods of investment, the different categories within each investment and some core risks that are particular to the investment type. Each chapter will also shed light on some key trends which have affected the specific investment in recent years.

The aim of the publication is to enhance UNIT’s mission of educating motivated university students and bridging the gap between personal investing and university knowledge.

We hope you find this Guide useful in assisting with your studies, future careers and understanding of finance.

Happy reading!

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EQUITIES INTRODUCTION

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Equities, also known as stocks or shares, are the most well-known and talked about investment. Put simply, purchasing a share gives investors partial ownership of a publicly listed company.

This chapter will overview the different ways of categorising equities, the risks that should be considered when investing in equities and current trends in the equities market. There is also an overview of the major platforms on which equities can be bought and sold.

CATEGORIES

When beginning to invest in stocks, often investors will hear them discussed through separate modes of classification which aren’t necessarily mutually exclusive to each other.

This section will explore each of the qualities a stock might have.

COMMON STOCK & PREFERRED STOCK As per the name, the common stock is the one most people invest in. Holding a common stock represents partial ownership, with rights to vote and receive a proportion of returns through variable dividends.

Conversely, preferred stock usually provides a fixed dividend and preferential treatment in the case of bankruptcy. Furthermore, as they do not provide a right to vote, preferred stocks bear many similarities to bonds, presenting a lower yield but less volatile investment to common stock.

MARKET CAPITALISATION Another method of categorisation of stocks is through the total value of all shares, or market capitalisation. Generally, companies are divided into three groups: large cap (market capitalisation of $10bn or more), mid cap (between $10bn and $2bn) and small cap (below $2bn). Large cap companies are sometimes referred to as “blue chip” stocks.

GROWTH STOCKS & VALUE STOCKS Growth or value stocks are representative of the most prominent styles of investment.

Growth stocks are from companies that are seeing sales and profits rise quickly, presenting higher risk, but strong potential returns.

By contrast, value stocks are more conservative investments, with the focus on companies who have shares which are relatively inexpensive currently and are undervalued. Often they are more mature, well-known companies which have less opportunity for significant growth but present a safer investment.

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BY SECTOR Stocks can be divided by industry, otherwise known as sectors. These sectors contain firms which perform similar business activities such as technology, agriculture and energy. Stocks in the same sector often trend in the same direction following in response to significant economic or market changes. Investing in stocks from multiple sectors can be a method to diversify the overall portfolio and spread risk.

CYCLICAL & NON-CYCLICAL STOCKS

Most economies follow the business cycle, with periods of expansion and growth followed by periods of contraction and recession. Certain sectors with greater exposure to changes in the business cycle are cyclical stocks. Cyclical stocks include industries such as luxury goods and travel, which can have significant decline in demand in an economic downturn as consumers cut down on spending.

Conversely, non-cyclical stocks are stocks which are resistant to economic changes such as grocery stores or utilities firms as they provide necessities which are consumed regardless of an economic downturn. While non-cyclical stocks may perform better during a downturn, cyclical stocks often perform stronger during an upswing.

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RISKS CONCENTRATION RISK The most common mistake of beginner investors is putting all their eggs in one basket. A well crafted portfolio should be well diversified on both a country, industry, and individual level.

It is notoriously difficult to consistently pick winners in the share market.

Despite the influence of technology clearly on the rise during the early 2000s, 52% of tech companies in the 2000 Dot-com bubble failed by 2004. Only a comparatively small proportion of companies survived, an even smaller proportion were profitable, and a handful fulfilled initial expectations to become Big Tech.

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The rationale behind diversification is that since industries themselves can display different rates of growth, have peaks and troughs, and therefore a portfolio concentrated on a limited subset of industries may increase the exposure to industry related risks.

In addition, it might be said that the equities market is diluted by a multitude of options, making it hard for investors to discern between companies. MSFT and MSTR only differ by 2 letters, yet Microsoft’s stock price increased five-fold (excluding dividends) over 2 decades from 2000, whilst Microstrategy lost 80% of its value over the same period. Investors cannot be sure that one particular stock will dominate its industry 10, 20 years into the future.

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LIQUIDITY RISK A well constructed stock portfolio should consist of investments that are relatively liquid, and little bid/ask spread (difference between the highest bid and lowest selling price).

This is one reason why penny stocks (small cap) are generally not recommended for retail investors. Their low market capitalisation almost guarantees that they come with significant spreads that insidiously gnaw at your cost basis, especially if investors trade via market orders.

Further, holding a concentrated position in illiquid stocks may also prove costly. When it comes time to sell, there may not be sufficient bids to catch your sell orders, leaving you with less cash than expected.

REGULATORY RISK Does owning a stake in an established e-tuition company in China sound like a great investment opportunity? The fundamentals of the business were strong, growth prospects aplenty, and the Chinese population was hooked on extracurricular education. Surely nothing would go wrong, right?

Yet, between February and July of 2021, NYSE:EDU and NYSE:GOTU, two of the biggest Ed-Tech companies in China, bled 90% and 98% respectively. The reason? The Chinese government had introduced new regulations cracking down on overseas-listed companies, and rumours had circulated that it had further plans to turn the tutoring sector into a non-profit.

Let this be a cautionary tale to all investors. An attractive company in an unpredictable regulatory framework may not actually be that attractive in practicality. Indeed, the regulatory framework which surrounds a particular market or industry should be accounted for in any decision to invest.

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LOCKDOWN EFFECT Although most major economies’ markets have reopened with no signs of putting on further mobility restrictions (USA, UK), waning vaccine efficacy over time could threaten their rapid recovery.

Closer to home, lockdowns remain a key risk. At time of writing, Sydney remains in its longest and harshest lockdown since COVID landed on Australian shores, with no real end in sight. Both Victoria and South Australia have just emerged from harsh stage 4 lockdowns, with significant restrictions still at play. Although many investors have looked through 2020 and 2021 earnings, basing their valuations on 2+ year forward earnings multiples, these lockdowns continue to pose a threat to stock prices and earnings.

CURRENT TRENDS Equity markets have been on a rollercoaster ride for the ages over the past 18 months.

March 2020 saw one of the most violent crashes in the modern market, dropping over 30% in a single month, before rebounding 25% in the following three months. Government spending, record low rates, expansive money printing programmes and vaccine-driven recovery expectations then continued to pump oxygen into what can only be described as a rocket-fuelled rally, with the ASX200 closing at a record 7,431 points on 27 July 2021 (for comparison the pre-COVID record close was on 20 Feb 2020 at 7,286 points). American markets have seen an even more impressive rally - the Dow Jones is now over 20% above its pre-COVID peak, and the NASDAQ a whopping 55% above its previous record close.

Despite all sectors contributing to swiftly ending the shortest bear market on record, there have been some intra-rally bumps as investors continued to gain clarity on the COVID economy and outlook.

TECHNOLOGY The IT sector drove the initial COVID recovery with everyone becoming reliant on computers not just for day to day work, but for education, communication and social interaction. The Australian tech index (ASX:XTX) rallied close to 150% from the March 2020 low to February 2021, with the NASDAQ closely matching this rallying over 100%.

However, when significant inflationary expectations began to be priced into bond yields in February 2021, concerns about viability of tech companies’ growth and earnings profile saw a sharp sell off in tech stocks, with the main tech indexes dropping 10-20% in a month. Since this correction, tech has traded largely in line with the rest of the market, and remains one of the best performing sectors of the COVID market.

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INFLATION CONCERNS

Following the COVID market, inflationary worries have not completely dispersed. In short, the pace at which prices rise in the economy is called inflation. The US has seen annualised quarterly inflation of over 5% for the past two quarters. Australia is starting to mirror this trend, seeing 3.8% year-on-year headline CPI inflation last quarter. Central banks globally have become more bullish in posturing, matching the Federal Reserve in the USA. Keep in mind that this is all relative to the ultra-dovish, low-interest rate stance which these central banks were taking through COVID. Rates remain lower and quantitative easing (simply put, printing more money) larger than pre-COVID times. Additionally, a lot of this inflationary pressure is now priced in, and seems unlikely to cause another sharp correction. Many analysts now consider it transitory, and predict it dispersing quickly.

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BIGGEST WINNERS

The post-COVID market boom has resulted in some giant gains for companies. Focusing here at home, buy now pay later (BNPL) stocks have absolutely taken off. Afterpay (ASX:APT), after hitting a low of $8.01/sh in March 2020, hit over $150 per share in Feb 2021. Investors couldn’t seem to get enough of BNPL stocks, with rivals Zip Co (ASX:Z1P) seeing a price rally of over 125% in late 2020 to a record $14.50/share. Z1P commanded just over $1.00 per share in the March low.

Rotation to value benefitted a wide range of stocks, but it would be hard to look past Seven West Media’s (ASX:SWM) meteoric 500% jump from just $0.10 in October 2020 to hit $0.59 briefly in February 2021.

Other notable movers (among a huge basket of winners in a flourishing bull market) include Galaxy Resources (ASX:GXY) jumping nearly 500% in the past 12 months, Uniti Group (ASX:UWL) up 200% in the past 9 months, and online retailers such as Kogan (ASX:KGN) rallying close to 500% in the past 9 months. Kogan however has retreated ~60% since then as people return to shopping in person, and sales growth rates were unable to keep pace with record quarters in the height of national lockdown.

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MERGERS, ACQUISITIONS & IPOS One of the biggest trends that is starting to surface in 2021 is the boom in mergers and acquisitions activity in the market. Market crashes or crises often result in significant M&A activity, as many companies are unable to bear the impact of the crash, whilst the larger or better funded companies look to acquire assets and companies at attractive discounted valuations. In fact, the Australian market has seen US$64.3bn of M&A deals announced so far this calendar year, tracking ahead of the post-GFC ‘golden era’ of M&A in 2011, where US$56.9bn of deals were announced to the same date.

2021 has seen a A$4bn bid for Tabcorp’s (ASX:TAH) wagering and media division, proposed IPO demerger for Link Group’s (ASX:LNK) PEXA, Woolworths (ASX:WOW) demerger of Endeavour, AGL Energy’s (ASX:AGL) demerger of its power generation business, BHP’s plan to sell off its coal assets, and Orocobre (ASX:ORE) and Galaxy Resources (ASX:GXY) entering into a A$4bn merger of equals to form a top five global lithium miner. That’s just to name a few.

IPOs (where a company lists on the stock exchange for the first time) are coming online in record volumes, with a giant public listing pipeline across the globe. At home in Australia, Airtasker (ASX:ART) went public with a market cap of $450m in March 2021, joining other big names such as Liberty Financial (ASX:LFG) at a market cap of $2.3bn and Nuix (ASX:NXL) at a market cap of $1.7bn. In the US, some of the biggest tech IPOs of all time occurred in late 2020, with Snowflake, Airbnb and DoorDash all becoming public in a single week in December 2020, raising US$3.9bn, US$3.7bn and US$3.4bn respectively.

TRADING PLATFORMS Platform

CommSec Australia’s largest online stockbroking firm – a subsidiary of Commonwealth Bank of Australia

Investments

ASX shares International Shares (25+ markets) ETFs (exchange traded funds) Options Fixed Income securities Fee structure (online trading to CDIA): $10.00 (<$1,000) $19.95 ($1,000 to $10,000) $29.95 ($10,000 to $25,000) 0.12% (> $25,000)

IG Online trading platform specialising in CFD (contract for differences) trading across many markets, also provides share trading services

17000+ international markets including: ASX shares Out-of-hours US shares FX Indices Crypto Shares Commodities Other international markets

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Key Features Online platform + Mobile app Live market data Extensive research & analytics tools: advanced charting, CommSecIRESS Viewpoint for real-time data streaming Commentary, recommendations & daily updates from respected financial sources (GS, MorningStar) Place orders <$25000 without deposit

Online platform + Mobile app Live market data Extensive research & analytics tools: charts, news & analysis, in-house TV channel, real-time alerts & buy/sell signals CFD trading: allows you to speculate on financial markets without actually owning underlying assets Various trading options: short/long, leveraging, margin, hedging 24hr expert support: live chat, phone, email

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Platform

Investments

Key Features

Superhero One of the cheapest share trading brokers in Australia – focused on making investing accessible and jargon-free

7000+ securities on ASX, NASDAQ, NYSE Shares ETFs REITs (real estate investment trusts) LICs (listed investment companies)

Online + mobile app Clean & easy to navigate platform Live market data Real-time deposits & currency transfers with PayID into “Superhero Wallet” Comprehensive tax reporting Minimal trading features: market + limit orders Limited market research features Secure: funds kept in segregated account + regulated by ASIC

Stake Australian share trading platform providing commission-free, seamless access to ownership of US stocks

4500+ US stocks & ETFs Currently no ASX trading (platform being developed)

Online + mobile app Free stock when you fund your account within 24hrs of creating it Digital, automated US tax form completion Trading options: market & limit, stop loss, fractional shares Premium account Stake Black – US$9/month: instant buying power, analyst ratings, price targets, full company financials Non-premium account has limited research/analytics features

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Platform

eToro World’s leading social trading platform with various financial assets available to invest in

FEES

Investments

Key Features

2000+ different financial assets: Shares Crypto ETFs Indices Currencies Commodities

Online + mobile app Social trading platform: News feed: traders/investors can interact, share idea, insights & trading strategies Trading with crowd sentiment: CopyPortfolios allow users to replicate portfolios of topperforming, experienced, professional investors in real-time Research & analytics tools, professional analysis + recommendations Free demo account to test out features: $100K Secure: funds kept in segregated account

Platform

Brokerage (ASX)

Brokerage (US)

Minimum Investment

FX Fee

CommSec

$10.00*

US$29.95

$500 for initial purchase of share

0.60%/trade

IG

$8

$0

-

0.70%/trade

Superhero

$5

$0

$100/US$100

0.50%/transfer

Stake

-

$0

-

0.70%/transfer

eToro

$0

$0

$50

0.50%/transfer

*see page 14 for full fee details

ETFS INTRODUCTION

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The acronym ETF stands for Exchange Traded Funds. These are diversified investment vehicles that trade on a public exchange.

The popularity of ETFs has soared over the past 3 decades, since the inception of the original S&P500 SPY ETF on the New York Stock Exchange. Indeed, ETFs bring benefits of high liquidity, great diversification, low management costs and low entry barriers to retail investors, and have largely replaced clunky mutual funds.

This chapter will outline the different categories of ETFs, the risks associated and current trends affecting ETFs.

CATEGORIES AUSTRALIAN EQUITIES

ETFs in this category are composed of ASX listed equities, and aim to either match or beat respective benchmark indexes. Active ETFs in this category are managed closely and adjusted regularly to improve its return in an attempt to beat is respective benchmark. These ETFs generally come with higher management costs and sometimes cannot beat their respective benchmark due to poor management.

On the other hand, Australian equity ETFs that are constructed to match a benchmark index are composed of the top 100-200 biggest shares on the ASX and are weighted according to size to create a portfolio which replicates the index. These are called indexed or passive ETFs.

INTERNATIONAL EQUITIES

International equity ETFs are composed of shares from international markets such as the New York Stock Exchange (NYSE), Shanghai Stock Exchange (SSE), London Stock Exchange (LSE), NASDAQ, Tokyo Stock Exchange (TSE) and the Hong Kong Stock Exchange (HKEX).

International ETFs can come in many different shapes and sizes, varying by geographic regions, company sizes, company industries and currency hedged or unhedged. Currency hedged international ETFs use financial instruments to protect against foriegn currency fluctuations, therefore reducing the risk level.

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GEARED ETFS Geared ETFs combine funds received from investors with borrowed funds and invest the proceeds in a broadly diversified share portfolio. Geared ETFs have gearing ratios which indicate the percentage of borrowed funds to the value of invested funds. An example of this is BetaShares Geared Australian Equity fund (ASX:GEAR) which operates on a gearing ratio range of 5065%.

Gearing the investment means that as the base value of the asset rises, the return is magnified by the gearing ratio. For example, if the underlying value of the portfolio rises by 1% and the ETF is 50% geared, the net return will be 1.5%. However, magnified returns also mean that losses are magnified, resulting in a risker ETF.

TECHNOLOGY Technology ETFs are composed of companies that are involved in technology, biotech and software development activities.

They are often constructed to match a technology based index or an index with a large technology composition such as the NASDAQ. The NASDAQ includes the world’s foremost technology and biotech giants such as Apple, Google, Microsoft, Oracle, Amazon, and Intel. An example of a technology ETF is NDQ, a BetaShares ETF listed on the ASX which aims to track the performance of the top 100 companies listed on the NASDAQ.

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PROPERTY

Like technology ETFs, property ETFs attempt to give investors exposure to property assets through the form of an ASX listed security. These ETFs often attempt to match an index such as the MVIS Australia A-REITs Index which is designed to track the performance of the largest and most liquid ASX-listed Real Estate Investment Trusts (A-REITs). REITs provide an exposure to commercial, retail, office, specialised and industrial property in a single trade on the ASX.

INFRASTRUCTURE Infrastructure defined ETFs are characterised by their monopoly-like assets that face reliable demand and enjoy predictable cash flows. These include companies that are involved in communication, power production, utilities, toll roads, transportation and distribution.

FIXED INCOME/CASH

Fixed income/Cash ETFs are composed of fixed income securities and cash equivalents such as government bonds, treasury notes and corporate bonds. These ETFs deliver lower annual returns than equity composed ETFs and therefore they are far less risky. However, high returns can be earned by investing in ETFs composed of bonds and treasury notes of lower quality, which carry a greater risk of default.

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CURRENCY

Currency ETFs track the relative value of a currency or a basket of currencies. These ETFs allow investors to gain exposure to foreign currencies while avoiding the inconvenience and complexity of opening a foreign currency bank account, foriegn transaction fees, or dealing in FX markets.

DIVERSIFIED Diversified ETFs are composed of Australian, global developed and emerging markets equities and bonds. These ETFs can comprise over 8000+ equities and bonds listed on over 60 exchanges resulting in a security that gives investors exposure to a wide variety of assets in one trade.

ETHICAL/ SUSTAINABLE

Ethical/Sustainable ETFs are portfolios of large, sustainable, ethical companies from a range of global locations. This gives investors an opportunity to align their investments with their ethical standards. Different ETFs have different criteria for selecting equities for their baskets, such as shying away from tobacco or alcohol equities.

RISKS VOLATILITY RISKS - EQUITY ETFS ETFs create an opportunity for arbitrage, meaning that market participants can take advantage of inefficiencies. Authorised participants (APs) such as high-frequency traders or banks utilise a ‘creation mechanism’ when issuing new ETF securities, which has raised the level of volatility risk. This may result in increased market volatility and inefficiencies in the event of flash crashes.

How the arbitrage system works: APs are not legally obliged to intervene but are incentivised to do so as they can take advantage of mispricings in the market to turn a profit. An AP acts as an arbitrageur or liquidity buffer between investors and the ETF provider by buying the underlying assets (be it equities, currency, fixed income or other instruments) and delivering them to the ETF in exchange for new shares of the ETF (i.e. the creation mechanism). Whenever ETF prices rise above net asset value (NAV) it means demand is stronger than expected, and APs have an incentive to create extra ETF units. For example, an AP will buy $10 million of S&P 500 stocks, hand them to the ETF, and get back $10 million of ETF shares. On the flip side, when demand is weak people may want to sell ETF shares - therefore APs will do a redemption trade-in by handing ETF shares back to the ETF and receiving a basket of the underlying stocks, rather than cash.

Risk: Whilst the above discussion captures the safety net feature of equity ETFs, arbitrage is not always able to aid the market in bringing ETF prices back in line with underlying NAVs. A 2014 study published in the Journal of Finance concluded that ETFs can increase the daily volatility of its underlying assets by 3.4%. There are also questions on whether the arbitrage system is able to cause the NAV and market price to converge in the event of extreme market moves. An example of where ETF arbitrage may have temporarily increased volatility or had unintended consequences was during the flash crash of 2010. Many ETFs saw large price declines during the crash, whilst also experiencing temporary mispricing of greater than 10% from the underlying index.

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LIQUIDITY RISKS - BOND ETFS Unique characteristics: A contrasting characteristic of bond ETFs compared to equity ETFs is that bonds are inherently less liquid due to varying terms of the loan, trade in a market with fewer potential buyers and sellers, and have a maturity date whereas equities do not.

Risks: The ‘liquidity illusion’ of bond ETFs stems from the ability to trade bond ETFs easily on the exchange, which makes people think they are more liquid than they actually are. The illiquid nature of the ETF’s underlying bonds means that if everyone were to redeem out of their ETFs at once, they will sell shares to an AP, who will hand them back to the ETF sponsor. The ETF would hand the AP back a basket of its bonds - however, these will be the ‘worst’ and most illiquid bonds that it would have trouble selling. A tangible example of the liquidity risk of bond ETFs was in March 2020 - stress flooded the bond market and many bond ETFs traded at discounts to their net asset value (NAV). This has the flow-on effect of driving down its asset values and leading to more redemptions in a death spiral.

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MARKET RISKS GEOGRAPHICAL DIVERSITY Relying on the performance of an economy or index poses a risk when trading ETFs that don’t embrace geographical diversification. Australian domiciled funds are usually skewed towards stocks listed on the ASX - for example, the VAS (Vanguard Australian Shares Index ETF) is a basket of Australian companies and property trusts. ETFs with a certain geographical weighting may be prone to more fluctuations and hence underperform the global economy. The Nikkei 225 (Japan) and SSE Composite (China) are prime examples of country indexes that have gone through heavy swings for decades. Therefore trading ETFs that are geographically concentrated may be vulnerable to single economy fluctuations.

CURRENT TRENDS FEES - A RACE TO THE BOTTOM One key trend is the ever descending fee structures of ETFs. The average management fee of ETFs globally dropped from around 0.9% to just over 0.5% over the past 2 decades, with most of this coming from actively managed ETFs that have been pressured by the surge in popularity of passive ETFs. The descent of ETF management fees is only accelerating. There are now several well established funds with near-zero fees, for instance Vanguard’s US Total Market ETF (ASX:VTS) with fees of 0.03% p.a.

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OUTPERFORMANCE AGAINST ACTIVELY MANAGED FUNDS Warren Buffet, a long term proponent of the S&P500 index fund, famously issued a $1 million challenge to the hedge fund industry in 2008. The challenge was simple: any Wall Street fund manager may come forth and pick a basket of 5 Hedge Funds to beat a low cost S&P 500 index ETF over the next 10 years, after fees.

Ted Seides, the co-founder of the Protégé Partners hedge fund, accepted the wager. After 9 years, Seides conceded defeat and the results were published.

100%

75%

50%

25%

Fu nd A Fu nd B Fu nd C Fu nd D Fu H nd ed ge E Fu nd Av In de er ag x Fu e nd

0%

The results were clear. The low cost index ETF that tracks the U.S. S&P500 had outperformed the average hedge fund return by a whopping 63.4% over the 10 years, with no single hedge fund able to outperform the index over the 10 years.

Was this necessarily a surprise for Buffett?

No. His reasoning was simple. Imagine the market as a pie - half of the pie is taken by passive index investors, while the rest is taken by active stock pickers. Therefore, the aggregate performance of the stock pickers will be roughly equal to the market, making stock picking almost a zero sum game - one person or fund picking winners necessarily means that another fund held a losing position.

Of course, this does not dissuade actively managed funds, and their investors, from attempting to outperform the market.

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Given that very few hedge funds actually hold the insight to consistently outperform other hedge funds, a selection of hedge funds over a sufficiently long period of time would roughly underperform the market by its management fees - usually 2% on asset-under-management plus a further 20% index outperformance fee.

This is enormous when compared to the 0.04% management expense ratio of Buffett’s index fund.

This must be a U.S. only phenomenon, right?

Nope.

The largest Australian listed investment companies (LICs), traditionally the vehicle of choice for Aussie investors seeking diversification, underperformed the A200 index fund by 10-12% over the past 5 years. Over 60% of LICs which track broad global market indices also failed to beat their respective index ETFs over the past 5 years.

What was the reason?

Fees.

The average management fees of an Australian LIC is over 1% p.a. Compare that to Betashares’ passive A200 ETF at 0.07% p.a., and it’s no wonder why traditionally managed funds have a long term drag on performance - they are designed (mostly) to enrich the fund managers, not the average investor!

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IS THERE AN INDEX FUND BUBBLE? On the flipside is Michael Burry, the legendary investor who shorted the U.S. housing market in 2008 under Scion Capital, who has recently warned investors about the impending index fund bubble crash.

His reasoning? Passive investing is so commonplace now that stocks included in indices are automatically bought up by passive investors who buy shares at set intervals regardless of price. This artificially props up the price of stocks within an index and depresses those outside.

Burry argues that this is not sustainable, and eventually entire indices will come to a total collapse. There is some truth to his claim - stocks inside indices such as the S&P 500 or the ASX 200 generally trade at higher prices relative to their fundamental earnings. It is important to note, however, that Burry himself is a hedge fund manager who stands to benefit from increased numbers of active investors.

FIXED INCOME SECURITIES INTRODUCTION

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Fixed income broadly refers to the types of investment securities that pay investors fixed interest or dividend payments until its maturity date. Ever heard of a corporate bond? Or government bonds? These are examples of fixed income securities. Bonds make promises to make a series of interest payments in fixed amounts, and to repay the principal amount at maturity.

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WHAT ARE COUPONS? For example, take Kevin, a poor uni student who wants a steady cash flow for the rest of his life. When he becomes a grandparent, he wants to give his grandchildren something they can remember him by. He decides to buy a government bond. He pays $100 upfront now to the government. Every year, he will receive a small payment (called a coupon payment) from the government in turn for Kevin giving his hard earnt money to them. Soon enough, Kevin is a grandparent, and those interest payments have amounted to more than triple his initial investment of $100. Kevin gives the bond to his grandchild, and they will continue to receive those coupon payments. Then when the bond matures, Kevin's grandchild will get the principal amount back ($100) and the last interest payment/coupon payment back.

HOW DO BONDS OPERATE? In terms of technicals: when market interest rates (i.e., yields on bonds) increase, the value of bonds decrease.

This is because the present value of a bond’s promised cash flows (the value of the bond today) decreases when a higher discount rate/market rate is used.

Just like in high school maths, when a denominator becomes larger, the overall value of the fraction becomes smaller.

Here, the denominator is the ‘discount rate’ and the numerator is the face value of the bond.

Bonds are rated based on their relative probability of default (failure to make promised payments). Because investors prefer bonds with lower probability of default, bonds with lower credit quality must offer investors higher yields to compensate for the greater probability of default. Other things being equal, a decrease in a bond’s rating (an increased probability of default) will decrease the price of the bond, thus increasing its yield.

DEFINING ELEMENTS OF A BOND BASIC ELEMENTS OF FIXED INCOME SECURITIES

Issuer Maturity date, also known as a bond’s tenor Par value, also known as face value, maturity value, or redemption value Coupon rate Coupon frequency, also known as a bond’s periodicity Currency denomination in which interest and principal will be paid; a dual-currency bond pays interest in one currency and principal in another

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MAJOR TYPES OF ASSETS IN FIXED INCOME OVERVIEW

Securities can be classified as fixed-income or equity securities.

Corporations and governments are the most common issuers of individual securities. The initial sale of a security is called an issue when the security is sold to the public.

Fixed-income securities typically refer to debt securities that promise to repay borrowed money in the future. Short-term fixed-income securities generally have a maturity of less than one or two years, long-term term maturities are longer than 510 years, and intermediate term maturities fall in the middle of the maturity range.

Fixed-income securities can be traded via contracts (a type of financial derivative). Contracts are agreements between two parties that require some action in the future, such as exchanging an asset for cash. Financial contracts are often based on securities, currencies, commodities, or security indexes (portfolios). They include futures, forwards, options, swaps, and insurance contracts.

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FORWARD CONTRACTS

SWAPS CONTRACTS

A forward contract is an agreement to buy or sell an asset in the future at a price specified in the contract at its inception. An agreement to purchase 100 ounces of gold 90 days from now for $1,000 per ounce is a forward contract. Forward contracts are not traded on exchanges or in dealer markets.

In a swap contract, two parties make payments that are equivalent to one asset being traded (swapped) for another. In a simple interest rate swap, floating rate interest payments are exchanged for fixed-rate payments over multiple settlement dates. A currency swap involves a loan in one currency for the loan of another currency for a period of time. An equity swap involves the exchange of the return on an equity index or portfolio for the interest payment on a debt instrument.

An example of forward rate notation is “2y3y.” The “2y” refers to the number of years from today when a loan would begin, and the “3y” refers to the tenor (length) of the loan. Thus, 2y3y is the three-year rate two years from today.

Forward rates may also be expressed in months. “6m3m” is a three-month rate beginning six months from today.

FUTURES CONTRACTS

OPTIONS CONTRACTS

Futures contracts are similar to forward contracts except that they are standardized as to amount, asset characteristics, and delivery time and are traded on an exchange (in a secondary market) so that they are liquid investments.

An option contract gives its owner the right to buy or sell an asset at a specific exercise price at some specified time in the future. A call option gives the option buyer the right (but not the obligation) to buy an asset. A put option gives the option buyer the right (but not the obligation) to sell an asset.

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FIXED INCOME YIELD As mentioned before, a coupon rate is calculated by dividing the annual coupon payment by the bond face value. If a bond has a face value of $1000 and makes interest payments of $50 per year, then the coupon rate is 5%(50/1000).

Furthermore, the price of the bond and its yield has an inverse relationship. As the bond yields increase, the bond price decreases and vice versa. Once a bond is issued, it offers fixed interest payments to the bondholder over its term to maturity, which is constant.

However, interest rates in financial markets change all the time and, as a result, new bonds that are issued will offer different interest payments to investors than existing bonds.

For example, suppose interest rates fall. New bonds that are issued will now offer lower interest payments. This makes existing bonds that were issued before the fall in interest rates more valuable to investors, because they offer higher interest payments compared to new bonds. As a result, the price of purchasing the existing bonds will increase.

However, if a bond's price increases it is now more expensive for a potential new investor to buy. The bond's yield will then fall because the return an investor expects from purchasing this bond is now lower.

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RISKS OF FIXED INCOME CREDIT AND DEFAULT RISK

The credit risk linked to a corporation can have varying effects on the valuations of fixed income instruments leading up to its maturity. If a company is struggling, the prices of its bonds on the secondary market might decline in value. If an investor tries to sell a bond of a struggling corporation, they may find difficulty as there is simply no demand for an underperforming bond.

Default risk could occur when the bond’s issuer is unable to pay the contractual interest or principal on the bond in a timely manner or at all. Moody's, Standard & Poor's and Fitch are credit rating services that provide credit ratings on bonds. As such, investors have an idea of how likely a payment default will occur.

Additionally, the prices of bonds can increase and decrease over the life of the bond. If the investor holds the bond until its maturity, the price movements are immaterial since the investor will be paid the face value of the bond upon maturity. However, if the bondholder sells the bond before its maturity through a broker or financial institution, the investor will receive the current market price. The selling price could potentially result in a gain or loss on the investment depending on the coupon interest rate, and the current market interest rate.

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INFLATIONARY RISK Inflationary risk is also a danger that must be considered by investors. If prices rise or inflation increases, it eats into the gains of fixed income securities. For example, if an investor purchased a 2-year bond paying 2.5% per year and interest rates for 2-year bonds jumped to 5%, the investor is locked in at 2.5%. For better or worse, investors holding fixed-income products receive their fixed rate regardless of where interest rates move in the market.

INTEREST RISK Fixed-income investors might face interest rate risk. This risk happens in an environment where market interest rates are rising, and the rate paid by the bond falls behind. In this case, the bond would lose value in the secondary bond market. Also, the investor's capital is tied up in the investment, and they cannot put it to work earning higher income without taking an initial loss. For example, if an investor purchased a 2-year bond paying 2.5% per year and interest rates for 2-year bonds jumped to 5%, the investor is locked in at 2.5%. For better or worse, investors holding fixed-income products receive their fixed rate regardless of where interest rates move in the market.

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CALL/REPAYMENT RISK

EVENT RISK

This type of risk is prevalent when the issuer of the bond has the right to “call” the bond, which is established in their terms & conditions. This means the issuer can take back the bond before the maturity date. This is usually done when interest rates fall substantially since the issue date. Call provisions allow the issuer to retire the old, highrate bonds and sell low-rate bonds in a bid to lower debt costs.

This particular risk refers to an unexpected event that could decrease the value of a bond. The main two types of event risks are natural disasters or corporate restructuring. For example, during the COVID-19 global pandemic the yields of AUS government bonds declined to record lows (increasing in price). However, this typical response of a fall in yield (that is, increase in price) of government bonds in response to a deteriorating economic outlook soon gave way to an unexpected sharp rise in yields (fall in prices). The fall in risky asset prices, and the dramatic increase in economic uncertainty that drove it, led to a sharp increase in volatility as a range of investors needed to raise cash to reduce leverage, meet margin calls, and meet redemptions.

EXCHANGE RATE RISK Exchange rate risk is the risk that cash flows from securities lose value after exchanging them for a different currency. For example, if an investor has an international bond that pays in USD, the investor would only receive the cash flow in USD. As the exchange rate between currencies is constantly changing, if the AUD depreciates against the USD, then fewer AUD will be received. On the other hand, if the AUD appreciates against the dollar, then the investor will receive more AUD.

RETURNS

SOURCES OF RETURNS FROM INVESTING IN FIXED-INCOME INSTRUMENTS 1 2 3 Coupon and principal payments

Interest earned on reinvested coupon payments

Capital gain or loss if the bond is sold prior to maturity

The coupon rate, or the interest rate, is determined by the general level of interest rates at the time, the maturity of the bond, and the credit rating of the issuer. For example, if you buy a $1000 bond and the coupon rate is 7% p.a., you should collect $70 per year.

At the end of the bond period, your principal investment will be returned to you.

On the other hand, many bonds are not held until maturity. When this happens, you might earn a capital gain or experience capital loss depending upon what has happened to the credit quality of the issuer and the direction of interest rates. For example, if you buy a corporate bond yielding 7%, and suddenly, comparable bonds are yielding 10%, you're going to have to lower your price until your bond is yielding 10%, too. Investors aren't likely to buy it if they could just buy a newly issued bond for a higher yield.

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COMMODITIES INTRODUCTION

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At its core, commodities are raw primary materials used in day-to-day life, be it to power vehicles, construct buildings and even crops that produce the food found in supermarkets. Commodities, particularly metals and agriculture, form a significant portion of Australia’s economy and production.

This chapter will outline the different categories of commodities, risks specific to considering commodities as an investment and how the commodities market has fared recently.

INSTRUMENTS FUTURES

A futures contract is a legal agreement to buy or sell a commodity for a set price at a specific time in the future.

CONTRACTS FOR DIFFERENCES

A contract-For-Difference (CFDs) is a derivative investment which allows investors to purchase a position on the future price of a commodity. For example, buying a CFD when the investor predicts an increase in price as opposed to selling a CFD when predicting a decrease.

EXCHANGE TRADED FUNDS

Exchange Traded Funds (ETFs) can comprise exclusively of commodities financial instruments, be it in equities or derivatives.

EQUITIES

Equities involve investing in specific companies which have business related to commodities. This is particularly relevant in Australia, where mining of metals is a significant industry, and companies such as Rio Tinto (ASX:RIO) and BHP Billiton (ASX:BHP) are major players in the equities market.

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CATEGORIES While there are a multitude of different commodities which can be traded, the majority can be classified under three categories: energy, metal and agricultural.

ENERGY As a fundamental requirement for all economies worldwide, energy is the most traded commodity category. To put in perspective how much energy is required globally, according to the US Energy Information Agency (EIA), the annual global energy consumption is an estimated 580 million terajoules, equivalent to 1.6 million trillion joules per day.

Around 85% of the total global energy consumption will come from three major fossil fuel groups: 1. Crude oil and derivatives – Unrefined petroleum which can then be transformed into other products such as gasoline, diesel and petrochemicals (a major component in plastic) 2. Natural gas – Naturally occurring fossil fuel that has a lower carbon footprint when compared with alternatives such as oil and coal 3. Coal – Sedimentary rock that can be burned for fuel However, investing in most energy sources can often be a difficult task, as it is near impossible to just buy a barrel of crude oil or an industrial wind turbine. As such, an indirect alternative is to purchase shares of companies involved with the commodity.

A more direct method of investing is via an exchange traded fund (ETFs). ETFs are sold and purchased on a stock exchange similar to traditional stock. For example, one share of the US Oil Fund would provide roughly the same value of one barrel of oil, based on the spot price of crude oil that day.

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METALS Under the metals, category are the precious metals; gold, silver, platinum, and the lesser-known palladium. Viewed as a ‘safe haven’ during times of market uncertainty, these metals maintain value for their applications in jewellery, electrical components and car parts as they do not naturally oxidise, corrode or tarnish. The metals also protect against inflation; as the value of the precious metal is derived intrinsically as a physical object.

To invest in precious metals, once again an investor should look at ETFs as a convenient means to begin purchasing these metals.

However, to gain ownership over a tangible piece of metal, investors can purchase bullion, officially recognised gold or silver in the form of bars and ingots. Investors can purchase bullion through dealers found on one of several global bullion markets.

AGRICULTURE Agricultural commodities include staple crops such as corn, soybeans, wheat, rice, cocoa, coffee, cotton and sugar; as well as livestock and produce such as cattle, dairy, swine and eggs.

Holistically, agricultural commodities present a sound investment decision as regardless of economic conditions, nations still require food for the population. However, on an individual commodity basis, they are subject to significant volatility due to factors such as weather, season and population.

As the average investor is unable to directly participate by purchasing a farm due to the capital requirement, other methods of investment include agricultural ETFs where investors can gain exposure to either a specific commodity or a basket of commodities.

Alternatively, an individual can invest in stocks directly involved in crop or livestock production, or supporting industries such as fertilizer, seeds, equipment or processing.

RISKS

To generate handsome returns, investors must carefully analyse the risks of such investment. Most people who are not involved in the commodity industry believe that the prices of commodities move extremely randomly, and they are often correct. The following illustrates the risks that an investor must be aware of before considering commodities as a vehicle for investment success.

GEOPOLITICAL RISK

One of the inherent risks of commodities is that the world’s natural resources are located in various continents and the jurisdiction over these commodities lies with sovereign governments, international companies and many other potential entities. For example, to access the valuable deposits of oil located in the Persian Gulf region, international companies must deal with the sovereign countries of the Middle East that have jurisdiction over this oil. Indeed, a large majority of oil price changes in the past can be attributed to OPEC (Organisation of Petroleum Exporting Countries), which is a cartel of 13 oil-producing countries.

International disagreements over the control of natural resources are far beyond abnormality. Sometimes a host country will simply kick out foreign companies involved in the production and distribution of the country’s natural resources. Referring to the USChina trade war, former President Trump imposed tariffs on more than $360bn of Chinese goods, and China has retaliated with tariffs on more than $110bn of US products, inclusive of essential commodities. As a result, the price of the commodities will be severely affected due to the uncertainty between diplomatic relationships.

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SPECULATIVE RISK/FUTURES RISK

The commodities markets are populated by traders whose primary interest is in making short-term profits by speculating on whether the price of a commodity will go up or go down. Additionally, commodities are frequently traded on futures markets that offer a high degree of leverage. A commodity trader normally only has to deposit 5% to 15% of the contract value in futures margin value to control 100% of the investment contract value.

For example, if the price of coal is trading at $133US dollars a ton (July 2021), and the coal futures contract is for 1,000 tons, the total value of the futures contract is $133,000 USD. A trader might only have to enter $6,650USD (5%) to control 100% of the futures contract.

As such, for every $1 that coal moves in price, the change in value is magnified to $1,000 per contract held.

Coal can move more than $60USD in less than 6 months.

This upwards or downwards movement equates to a 900% move when compared to the margin necessary to trade the coal futures contract. Therefore, the risk of commodities futures is what entices experienced investors and keeps junior traders far away.

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MACROECONOMIC RISK

Since commodities are defined as “real assets,” they tend to react to changing economic fundamentals in different ways than stocks and bonds. For example, commodities are one of the few asset classes that tend to benefit from rising inflation. As demand for goods and services increases, the price of those goods and services usually rises as well, as do the prices of the commodities used to produce those goods and services.

Furthermore, commodity prices usually rise when inflation is accelerating. In contrast, stocks and bonds tend to perform better when the rate of inflation is stable or slowing.

Faster inflation lowers the value of future cash flows paid by stocks and bonds because that future cash will be able to buy fewer goods and services than they would today.

With this in mind, commodities may not perform well during cyclical downturns in the U.S or global economy, where consumer and industrial demands are lacking. This has been magnified in the recent COVID-19 pandemic as oil(BRENT) fell from $70USD per barrel to $20USD in less than three months.

ENVIRONMENTAL RISK

Seasonal and other weather fluctuations have a substantial impact on certain commodity prices, in particular agriculture. The end of Summer normally brings plentiful harvests, hence commodity prices tend to fall in October. Droughts and floods can also lead to temporary increases in the prices of certain commodities.

RETURNS Despite the risks and the high volatility of commodities, many investors are still exposed to commodities within their portfolios. Why? Diversification.

The low correlation of commodity price movements to equities and bonds illustrates what may be the most significant benefit of broad exposure to commodities. In a diversified portfolio, asset classes tend not to move in sync with each other, which reduces the volatility of the overall portfolio. Lower volatility reduces portfolio risk and potentially improves the consistency of returns over time.

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OIL TRENDS AUSTRALIA

Australia’s crude oil production was rising from 2017 up until 2020. The COVID-19 pandemic had a significant impact on Australia's oil market, particularly with travel and broader economic restrictions severely dampening demand/consumption of oil. This saw a subsequent decline in production. This considerable reduction in demand exerted downward pressure on global oil prices, starting 2020 at USD$68 per barrel, decreasing to USD$60 in February, then drastically falling to USD$23 per barrel by the end of March 2020, representing a 66% plummet since the start of Q1.

Although the oil market has recovered considerably with price forecasts over the medium term projected to be roughly US$60 per barrel (real terms) and nearing pre-pandemic levels, there are still several factors that constrain this market in the short-medium term. Oil consumption used in the manufacturing of plastics and other petrochemicals, as well as road travel, has seen improvements; sluggish growth in aviation travel threatens to hold back the recovery of Australia’s oil market. Additionally, the Mediterranean Oil Spill at the end of February 2021 also generated further uncertainty in oil prices.

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GLOBAL COVID-19 impacted not only Australia but global consumption of oil. Between 2012 and 2019, OECD oil consumption was steady at 48 million barrels per day, which fell 12.5% to 42 million barrels per day in 2020. In the US, consumption declined by 11%, to 18 million barrels per day, and EU consumption fell by 13%, to 12 million barrels a day throughout this period. After a slight increase in 2019, oil consumption in other non-OECD nations also declined to 49 million barrels a day.

However, despite the pandemic-induced economic shock, China saw oil consumption rise by 0.6% in 2020, significantly contrasting other nations. Despite the slow recovery in other nations' consumption, China’s demand is forecasted to increase in 2021 to reach 52 million barrels/day. Although global consumption is expected to recover, reaching 2019 levels in 2022, beyond this period it is projected to marginally decrease, driven by the shifts in global climate policies towards ‘cleaner’ sources of energy.

IRON TRENDS AUSTRALIA Western Australia accounts for 98% of the production of Australian iron ore, representing approximately 28 billion tons of iron ore. Australia is the world’s largest producer of iron ore, with exports worth over $100 billion annually.

In December 2020 and January 2021, the iron ore price sharply increased reaching a record high since 2011. This price surge has been driven by high demand from China, as well as Brazil, due to fears of disrupted supply related to COVID-19 logistical problems. As a result, Australia accounts for 60% of China’s iron ore imports. The iron ore price is predicted to remain above US$100 per ton until late 2021, and then gradually decreasing in the following years. It is predicted to reach US$72 (in real terms) by the end of 2026.

Export volumes sat at 900 million tons in 2020-21, and are expected to increase to 1.1 billion by 2025-26.

GLOBAL Global iron ore is expected to increase by 5.1% in 2021 as output is expected to return to normal following the impacts of COVID-19. Reduced output of iron ore in 2020 is predominantly attributed to declines from Brazil’s iron ore giant, Vale, and declines in the auctioning of India’s Odisha mines.

Australia’s iron ore industry emerged out of the pandemic unscathed, still accounting for more than half of the world’s iron ore exports.

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GOLD TRENDS AUSTRALIA

Australian gold production in the 2019-20 financial year reached a two decade record level of production of 328 tonnes. Australia is estimated to have the world’s largest gold reserves, at around 17% of global reserves, and remains the second largest producer of gold in the world, following China. 60% of Australian gold reserves are predicted to be in Western Australia.

Australia is on track to become the world’s largest gold producing country by the end of 2021, due to a decline in Chinese output resulting from COVID-19. The production of gold is expected to be above 400 metric tonnes by 2022.

GLOBAL Gold was one of the best performing major assets in 2020. Global gold prices increased by 28% from January to August 2020. This rise can be attributed to supply shortages as a result of COVID-19 restrictions and reduced transportation. Further, gold demand in the fourth quarter of 2020 hit an 11-year low of 783 tonnes, driven by the widespread lockdowns, economic lows and high gold prices. Gold jewellery demand in 2020 fell 13% from 2019. Central bank consumption of gold decreased by 60% in 2020.

However, gold backed ETFs experienced large inflows at the end of 2020, growing by US$47.9bn throughout the year, as a result of the high economic uncertainty during the pandemic and low global interest rates. Investment demand for gold is predicted to remain well supported in the coming years.

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COPPER TRENDS AUSTRALIA

South Australia boasts 68% of Australia’s copper resources, and is the country’s main copper producer and exporter, attracting hundreds of companies (including global majors) in developing and mining copper. Higher global copper prices have increased the performance of the Australian industry in the past 5 years.

With global supply chains disrupted by the pandemic, manufacturing activity in China declined, while copper ore mining output also declined in Australia during 2020. However, a weaker AUD pushed copper prices higher in Australian dollar terms, benefitting the industry. Subsequently, China’s consumption of Australia’s copper is projected to increase 3% annually on average.

The Copper Ore Mining industry is expected to expand at a steady pace over the next five years, driven by forecast growth in output, export demand, higher copper prices in USD, and the effects of the COVID-19 pandemic subside. February 2021 was the first time copper had risen above $US9000 since 2011.Australia’s copper exports have increased from 924,000 in FY19-20 to approximately 992,000 in FY25-26. This increase has been driven by growing production from new and existing mines.

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GLOBAL Prior to 2020, copper consumption was increasing at a moderate pace, particularly across major markets (China ROW, Europe, US, Japan), however, COVID-19 drove a significant 10% decline in world consumption. However, unlike other commodities, copper saw improvements earlier, recovering throughout the last quarter of 2020, increasing by 2% and projected to increase by 5% in 2021.

In the medium term, this 'returning appetite' can be attributed to the slow improvements in global economic growth, copper's role as an input in electrification, and its role in China, Japan and Germany's industrial and manufacturing sectors. The US and China's government policies directly supporting copper's use in future infrastructure developments, such as telecommunications and electric vehicles, and a growing trend towards investment in low-emission technologies, are also expected to drive global copper consumption.

Consumption is expected to grow at around 2.5% a year, reaching 28 million tonnes in 2026, then aligning with trends in global industrial production, growing at a more moderate pace. Subsequently, this is expected to drive copper prices up considerably with a forecasted average of US$8260 per tonne by 2021, which is predicted to stabilise at US$7940 per tonne by 2026.

CURRENCY

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INTRODUCTION

Currency investment is undertaken on the foreign exchange market, or FOREX, which is a global marketplace that facilitates the exchange of national currencies. While theoretically investors can trade any currency pairing they wish, there are only a few truly valuable pairings for trading (some of which are highlighted in ‘Categories’). The FOREX market is the largest investment market in the world, with a daily turnover of $4 trillion, compared to $25 million on the New York Stock Exchange (the largest global stock market).

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Trading currencies operates a bit differently to simply trading stock, where the stock is either bought or sold in exchange for cash. With currency trading, the transactions are always two-sided; one currency (the quote currency) must be exchanged for another (the base currency). The exchange rate states how many units of the quote currency can buy one unit of the base currency. For example, an AUD/USD exchange rate of 0.75 would require 75 US cents to buy 1 Australian dollar.

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To make money with FOREX trading, investors must capitalise on fluctuations in the value of a currency relative to another. The FOREX market is a 24 hour market, as opposed to the ASX with set trading hours from 10am - 4pm. However, it is broken up into blocks, namely the European, Asian and United States trading sessions.

As the largest financial market in the world, the FOREX market undeniable has some advantageous characteristics for the investor, namely: Superior liquidity the sheer size of the market enables investors to confidently trade any some without seeing rapid changes. This high liquidity also allows highly lrverec trades in currency markets, allowing investors to trade smaller amounts, often a 0.5% margin (equating to 10,000 PIP’s) Lower trading costs currency trades typically do not incur commission fees, unlike other investments, so the primary cost is limited to the spread (difference between the selling and buying prices for a currency pair).

Transparency there is free full access to all trading information and market data necessary to perform successful transactions, giving traders more control over their investments.

Easier to follow a lot of research is required to trading stocks, including news related to that specific business or sector. In comparison, if you trade one pair of currencies, you need to check the most important economic and political news of the two countries, which is readily available, easily accessible, and usually released immediately, often before or after the market opens.

Strong market trends due to strong trending of the FOREX market, it can be easier to analyse and identify possible entry and exit positions during trading.

Variety of factors influencing exchange rates possibilities for speculations and strategies are practically infinite

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CATEGORIES As mentioned before, currencies need to be exchanged in pairs. Some of the most profitable and popular currency pairings are:

USD/JPY “The Gopher” is a combination of the US dollar and the Japanese yen. It is one of the most popular forex pairs in the world due to the prominence of the JPY throughout Asia and the USD worldwide. It boasts high liquidity, meaning that traders can buy and sell the currency pair in large volumes without the price fluctuating too much in its exchange rate. It also has one of the tightest spreads (difference between selling and buying price) in the forex market, reducing the overall costs of the trade.

EUR/GBP

“The Chunnel” is a combination of the Euro and the British pound sterling, a play on words for the Channel Tunnel that connects both continents. This currency pair is typically seen as very strong, given the proximity of regions and their solid history of trade. Given the situation of Brexit on the economy, the forex pair has become more volatile in recent years, which can be very attractive for skilled traders. The exchange rate also relies on changes to interest rates which are announced by central banks, therefore, one currency can suddenly strengthen against the other, making the pair much more volatile. Interest rate considerations also apply to the other currency pairs on this list.

EUR/USD

“The Fiber” is a combination of the Euro and the US dollar. This is generally considered the most traded currency pair as it stems from two of the world’s largest and most reputable economies. Similar to the USD/JPY, this currency pair is associated with very low spreads, high liquidity and the ability to place large volumes of trade. This combination can be seen as one of the best currency pairs for forex scalping​​, as the markets are mostly stable throughout the year, therefore, it is perhaps one of the most profitable currency pairs in terms of smaller and more frequent earnings.

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USD/CHF

“The Swissie” is a combination of the US dollar and the Swiss franc. For many years, the financial stability of Switzerland has been used as a ‘safe haven’ for investors of the forex market, who will rely on trading the CHF in times of market volatility. Therefore, this is a popular forex pair for traders when the economic or political situation of a region is uncertain. As the value of the CHF strengthens against the USD due to increasing investment, the price of this currency pair starts to drop. Although it is one of the most stable currency pairs to trade and therefore offers many benefits. However, when the markets are in a more stable position, the USD/CHF may be of less interest to traders who opt for other major currency pairs that are featured on this list.

GBP/USD

“The Cable” is a combination of the British pound sterling and the US dollar.

This is seen as a particularly volatile currency pair, due to its frequent fluctuations in price, exchange rate and pip movements. This can result in large profits if the trader is successful, however, it can result in equally great losses when market volatility is at a high.

The GBP/USD is particularly favoured by day traders​, who aim to take advantage of price fluctuations by dipping in and out of the market at a quick and precise pace. For this reason, it is also one of the best forex pairs for swing trading​, another short-term forex strategy. It is recommended that those who trade this volatile currency pair strengthen their knowledge of technical analysis of the market before opening any positions.

RISKS

INTEREST RATE RISK

Interest rate differentials can influence the value of foreign exchange, making them highly susceptible to external macroeconomic influences. This is particularly poignant given that central banks across the world usually have no intention to support currencies in their policy decisions, as economic growth, inflation and unemployment remain the dominant focus. Thus, through a process called ‘carry trade’ when a country’s interest rate increases, there is often an influx of foreign investment, placing upward pressure on demand for that specific country’s currency as it presents a more attractive investment opportunity. Conversely, when interest rates fall under expansionary macroeconomic policy, this currency investment attractiveness is eroded and investors will swap this currency for another, denominated in an economy where returns are stronger.

Interest rate differentials are topical given current dynamics in the 2021 post-COVID global economic recovery. The United States’ high vaccination rates and stimulus funding supporting strong consumer discretionary spending, paired with COVID induced supply chain bottlenecks and higher shipping costs have facilitated an increase in the value of the USD against the AUD. This effect has been compounded by continued Australian lockdowns and explicit central bank messaging that rates will remain low until the economy can stabilise inflation within the 2-3% target, across the medium term.

CREDIT RISK Currency based assets are subject to the risk that a counterparty defaults or fails to perform a transaction prior to asset settlement. The risk value is calculated as the “thencurrent mark-to-market value of the transaction plus any estimated changes in the market value of the currency pair."

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LIQUIDITY RISK A concept often overlooked, liquidity risk refers to how easily an asset, like currency, can be purchased and sold in the market, or converted into cash. Positively, the spot Forex market is one of the most liquid financial markets in the world, allowing investors and traders to enter and exit positions at exact traded price levels instantaneously. However, liquidity risk becomes concerning during periods of heightened uncertainty, which in modern and connected financial markets, are of increasing regularity.

Liquidity is influenced by the depth and availability of transactions on the market, the spreads that are offered, and the relative market volatility. A notable example of liquidity risk materialising in the market was the 2015 Swiss Franc, where due to extreme currency volatility, the Swiss central bank announced they would no longer be defending the Swiss Franc peg against the Euro, without market warning. This led to retail FX brokerage firms completely withdrawing the liquidity offered for CHF pairings.

CURRENT TRENDS NEW MARKET PARTICIPANTS

Similar to other asset classes, the pandemic accelerated trends amongst society that will now remain well into the future. Decreased confidence in ‘job security’ and the confinement of people to their homes meant that a greater number of new traders entered the market, general levels of market research increased, trading strategies strengthened and transaction volume grew. Driven largely by stronger ‘retail’ participation, Forex trading volume grew 300% between March and June of 2020, whilst developing countries made stronger impressions on the market given that 60% of all new trading accounts created were concentrated in Africa and South East Asia. This is particularly poignant, given that Forex trading volumes have not grown by more than 40% in any given year, since 2010.

Another undeniable catalyst of such trends is greater levels of government stimulus, disposable income, savings reserves and general currency growth across the major advanced economies. 14 of the 15 largest OECD economies recorded currency growth during COVID-19. In the US alone, household savings rates reached 9% of US GDP, 2% higher than in 2019.

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THE FINTECH CONNECTION Linked to the liquidity for Forex, low market volatility and low margins impact market liquidity. If volatility is too excessive, the amount of traders active in a market often falls. However, this works in the opposite for retail traders, as increased volatility can suggest greater opportunity to earn stronger returns, with stronger associated risk.

A higher number of market participants across the last 5 years, but now even more so in 2020 onwards, means that brokers and market makers need to think more carefully before offering competitive pricing, because there is consistently less room for error.

Accordingly, this competition has driven a trend of brokers reducing margins in an effort to ensure sustainable financial operations moving forward into the future.

The market moving forward will thus be characterised by lower spreads and lower market volatility, particularly amongst the dominant currency pairs, but greater liquidity and improved market access.

Fintech’s emergence, promoting this trading accessibility and developing financial literacy provides a ‘counter intuitive’ proposition where lower activity and narrowing margins has encouraged higher market participation. Expect this unique trend to continue enduringly.

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CRYPTOCURRENCY COMPETITION Cryptocurrency and blockchain are popular among investors, who are no longer fazed by its rapid growth, but are still treading uncharted waters surrounding its seemingly endless financial applications and easy trading and ownership accessibility.

Forex has long been perceived as the day trader’s favourite asset, characterised by significant price fluctuations that encourages ‘big wins’ and inflicts ‘big losses’. Cryptocurrency has seemingly stolen that title, reflected in the 30 day price table for the AUD/USD pair against Bitcoin (BTCUSD) and Ripple XRP. Currency Pair

Change across last 30 days*

AUD/USD

1.81%

BTC/USD

48.03%

XRP/USD

103.67%

Whilst it is unclear if Forex markets will be significantly impacted by cryptocurrency ubiquity, significant volatility differences between traditional value creation strategies and new investment blockchain opportunities provide a strong argument that cryptocurrency is now the optimal asset utilised to profit from fluctuating markets. Strong momentum supported by amateur investors looking for quick money will impact Forex trading in one way for certain - “it will speed up success or demise”.

Despite promise, this trend is unlikely to materialise for the next 2-3 years. Forex is still advantageous in the ‘sub instruments’ and trading strategies it involves, alongside more market confidence surrounding the nature of its regulation. A significant driver of May’s cryptocurrency downturn was regulatory uncertainty of the asset class.

*30 days being 26 July - 26 August

CRYPTOCURRENCY

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INTRODUCTION

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Cryptocurrency is a fully digital currency that is not issued by any central authority, making it theoretically immune to government influence. A blockchain is a database that stores encrypted blocks of data, then chains them together to form a chronological singlesource-of-truth for the data. Many of the larger cryptocurrencies like Bitcoin and Ethereum use blockchain technology. The digital assets are distributed instead of copied or transferred, creating an immutable record of an asset, which preserves integrity of the document and creates trust in the asset. Blockchain’s inherent security measures and public ledger make it a prime technology for almost every single sector.

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WHAT MAKES CRYPTO SO SPECIAL? After hearing about this new digital currency, what makes this form of investment so special? First, unlike cash, there is only a set amount of coins or tokens available, thus a coin's value is ever changing. Another special aspect of cryptocurrency is that there are little to no transaction costs associated, unlike many of the transaction costs associated with withdrawing money from a bank. Another advantage of using cryptocurrency is the ease of transactions internationally - whereas wire transfers usually take about half a day to go end-to-end, a crypto transaction takes a matter of seconds.

HOW VALUE OF CRYPTO IS GENERATED? Like any currency, cryptocurrencies gain their value based on the scale of community involvement such as the user demand, scarcity or coin’s utility. Still, having in mind, most of the digital coins on the market are issued by private blockchain-related corporations, some factors of cryptocurrency value will stem from the image and efficiency of these companies, such as a given project’s viability and perceived value.

CATEGORIES

While cryptocurrency itself is its own asset class, as the name implies, it stands as a currency. Just like in the currencies regulated by central banks around the world, there is no real ‘category’ to squeeze these into.

Instead, we typically think of these currencies in terms of their size, buying power and average volume traded in a typical day. Think the USD, EUR, GBP, AUD etc. For cryptocurrency, coins can be split into a similar fashion, instead by overall market capitalisation i.e. the value of the coin in USD multiplied by the number of coins in circulation.

However, this isn’t the only way to split these coins up. One of the primary reasons cryptocurrency is such an attractive technology to some people is that it is decentralised. The supply is not controlled by some central bank in some country, run by a set of appointed officials. Instead, coin supply is typically reliant on people ‘mining’ these coins, with the difficulty of mining a coin increasing in line with supply, thus making a coin harder and harder to attain. Different coins use different algorithms to do this, with each having its own pros and cons.

Below are the top three cryptocurrencies by market capital, which have completely different mining algorithms and processes.

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BITCOIN : BTC (US$747.8 TN MKT CAP) Overview: The biggest and oldest crypto, based on the SHA-256 hash. Faces lengthy (~10 min) transaction time and significant price volatility. Currently trades at ~A$54k.

Bitcoin is by far the biggest and most well known of all cryptos. Often used as a synonym for cryptocurrency itself, Bitcoin was released in 2009 and remains one of the oldest crypto currencies on the market.

Bitcoin mining has been the most common form of crypto mining for some time, originally popular due to the accessibility.

In the early days of the currency, you could simply setup your old computer or laptop, and let it churn away at the mining algorithms.

Bitcoin is based upon a blockchain hashed with the SHA-256 algorithm, perhaps the most common cryptographic hash utilised in encryption. The accessibility of this algorithm can also be seen as a potential contributor to Bitocin’s success.

BiAs Bitcoin began to rapidly increase in value through 2016, more expensive technologies were deployed onto the network, as well as specialised ASIC miners, which resulted in a significant increase in difficulty of mining, largely forcing the average person out of the mining market.

The rise to fame really took off in 2017, when Bitcoin rocketed 2000% from ~A$1,250 to touch just under A$26,000.

After a crash due to concerns about the utility of Bitcoin, another surge was seen over 2020 and into early 2021, when Bitcoin hit a record high of just over A$85,000.

However, this massive demand for Bitcoin also resulted in a massive surge in miners and thus supply - and when supply increases, so too does the difficulty of mining. This has kept pace with advances in technology in recent times, but has meant that the average Bitcoin transaction takes around ten minutes to complete. This is one of the key drawbacks of Bitcoin being implemented as a formal currency (aside from price volatility), as it is a big step backwards compared to the instantaneous cash or card transactions we are used to.

As of 17 September 2021, Bitcoin currently trades for approximately A$65,000, and has seen a large rally over the past weeks, however remains extremely volatile, like most cryptos.

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ETHEREUM : ETH (US$267.7 TN MKT CAP) Overview: The second largest crypto, regarded as having greater potential utility than other coins. Huge demand spike from 2020 to now. Currently trades at ~A$3.25k.

Ethereum is the next largest and well known crypto currency in circulation. It was funded in 2014 and then launched in 2015.

Ethereum is actually the name of the blockchain platform, with Ether (ETH) being the cryptocurrency of the platform.

Unlike Bitcoin, Ethereum utilises the KECCAK-256 hash function.

One of the key attractions of Ethereum is that it is based on an open-sourced platform which allows developers to create and embed applications onto it.

These applications open on a decentralized basis utilising the blockchain technology to carry out authentication and other processes. In this way, brokerages, exchanges, lending institutions and the like have become embedded into the Ethereum platform itself.

Another advantage is the easy creation of non-fungible tokens (NFTs) on the Ethereum platform, which have rapidly risen in popularity through 2021. These tokens are typically connected to digital works of art or digital property, with the owner of the token having the ultimate ownership of the underlying digital asset.

Ethereum offers a transaction time of approximately 5 minutes, half that of Bitcoin, which is also typically flaunted as an advantage when compared to Bitcoin, yet still evidently has a significant drawback when compared to the cash and card system we know and use day to day.

However, there is a large effort to create and deploy what is called ‘Ethereum 2.0’, with a key goal to increase the current rate of ~15 transactions per second to thousands per second.

Ethereum's price has seen similar volatility to that of Bitcoin, with similarly timed spikes, however saw an even stronger rally than Bitcoin through 2020 and early 2021 due to many regarding its potential utility as greater than that of Bitcoin. Ethereum increased in price by close to 3000% from the start of 2020 to May 2021, hitting a peak of just over A$5,000.

Ethereum currently trades for around A$3,250.

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TETHER USD : USDT (US$68.29 BN MKT CAP) Overview: Linked to the price of US$1.00, theory of risk-free crypto transactions under fire from significant Bitcoin price manipulation and lack of financial backing.

Tether USD is one of the most controversial cryptocurrencies, despite being the third largest in circulation.

Tether is called as such due to its ‘tethering’ or link to an underlying currency, in this case the USD. The price of one Tether USD is, theoretically, linked exactly to US$1.00.

Unlike Bitcoin or Ether, Tether USD is not a mined crypto currency. Instead, in practice what occurs is when an investor purchases a Tether USD coin, that coin is purchased from the Tether Limited company. The investor get a coin, and Tether gets US$1.00. As such, the utility of this coin comes in the fact that, theoretically, each and every coin is backed with exactly US$1.00, eliminating transaction and exchange risk as with other crypto currencies. This should also mean that the coin is tied exactly to the price of US$1.00.

In theory this is very useful: it allows for a seamless and near risk-free exchange from a centralised currency to cryptocurrency, and allows for near riskfree holdings of crypto currency.

However, Tether has been the subject of multiple lawsuits and investigations. In 2017 and 2018 they were accused of manipulating the price of Bitcoin higher by up to half of its price gain. Tether pricing itself was found to have been manipulated on multiple exchanges, with small orders moving prices as much as large orders did.

Further to the price manipulation, Tether’s claim of every coin being backed with US$1.00 has also been proven as marketing puff. In 2019, Tether's coins were backed by just $0.74 in cash and cash equivalents. By May 2021, Tether revealed that just 2.9% of all Tether coins were backed by cash, with over 65% backed by commercial paper (an unsecured short term note - basically an “IOU”).

RISKS

One of the largest risks of cryptocurrencies is their price volatility. Due to their decentralised nature, an attraction for many investors, there is no figurehead which is able to manipulate and stabilise the currency. Whereas the Fed or RBA may intervene in the USD or AUD markets respectively, cryptocurrency prices are simply determined by the broader market. Being such a new and highly speculative asset class, this leads to significant price swings and jumps.

Additionally, although decreasing each day, exchange risk remains a large issue with some coins. Lack of liquidity on some exchanges, or generally large exchange fees, can inhibit conversion from crypto into real currency, and vice versa.

There's also no guarantee that a crypto project will succeed due to the volatile nature of any investment. Competition is fierce among thousands of blockchain projects, and projects that are no more than scams are also prevalent in the crypto industry. Only a small number of cryptocurrency projects will ultimately flourish.

Regulators may also crack down on the entire crypto industry. This comes especially as governments begin to strongly view cryptocurrencies as a threat rather than just an innovative technology. With cryptocurrencies being based on cutting-edge technology, that also increases the risks for investors. Much of the technology is still being developed and is not yet extensively proven in real-world scenarios.

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CURRENT TRENDS INSTITUTIONAL ADOPTION Cryptocurrency will continue to transition from an asset shrouded in concern to a valuable asset used by institutional investors to drive returns on capital. By the end of 2020, over $15 billion in institutional assets had been directed to cryptocurrency, including over $429 million by US asset managers in a single December week. This represents a 5x increase, compared to the $2 billion allocated by the same period, in 2019. This trend is further reinforced by the growth in the ‘Grayscale Bitcoin Trust’, a method through which institutions gain specific BTC exposure, which is up 900% in 2020.

Beyond the Investment Management industry, Square, the recent acquirer of AfterPay, has been vocal of their bullish outlook on cryptocurrency, allocating significant cash reserves toward Bitcoin.

Institutional adoption will continue to be a notable trend for as long as value resides in cryptocurrency, supported by transactional uptake, but also because of improved accessibility PayPal and Venmo integrated cryptocurrency trading into their payment platforms in 2020, and PayPal reported a 100% increase in app activity after this functionality was introduced. The Chicago Mercantile Exchange, a Futures & Options exchange, introduced ether based futures contracts in February 2021. The more that corporations take the plunge, the greater the ‘fear of missing out’ will drive uptake.

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EMERGING MARKET UPTAKE Across the past year, there has been a 23x increase in global cryptocurrency adoption, with a particular focus on Indian, Pakistan and Ukraine as the key emerging market epicentres.

Comparatively, US and China adoption rates have slowed following stronger regulatory ‘crackdowns’ on crypto trading and greater uncertainty surrounding major financial institutions, and their role in facilitating transactions.

Emerging markets are benefiting from two major outcomes, accounting for the current growth trend. First, that crypto adoption across 2020 has transformed from a trivial idea to a valuable asset with disruptive capabilities, and secondly, that economies previously at the forefront of crypto adoption have now stalled in determining what the regulatory and financial services landscape looks like. By moving slower than in the developed world, developing economies can, and have, used this as an opportunity to understand political mistakes and introduce stronger frameworks to deliver crypto functionality in a frictionless way.

Analysing blockchain activity can be done through the use of three key metrics - “on chain value received” (transactions that occur on blockchain), “on chain retail value received” (value below $10,000) and “P2P exchange trading volume”. Based on such metrics, Vietnam, India, Pakistan, Ukraine and Kenya ranked in the top 5 amongst 154 surveyed countries.

This trend is set to extend well into the future considering that beyond cryptocurrency being a natural extension of improved digital infrastructure, emerging markets see cryptocurrency as a savings tool in light of currency devaluation, and a way to conduct business transactions without government input.

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NFT Non-fungible tokens (NFTs) and search interest in them have grown more than 90x since 2015.

By representing a ‘claim’ to a unique asset object, whether it be digital or physical, it is a concept that will revolutionise collectables, redefine what has economic value, and deliver exciting functionality to the cryptocurrency sector.

The growth of Ethereum as a viable cryptocurrency ‘coin’ to be used in transactions will continue to support NFT popularity, as NFT’s have ‘smart contracts’, synonymous with ETH capabilities, that describe the product they represent. In terms of NFT market size, the fragmented market consisting of whole ownership and ‘divisible’ components means it’s difficult to accurately quantify. However, NFT trading volume reached an estimated $40 million across a month in 2020, and Ethereum’s NFT sector grew 1000% across January.

NFTs aren’t just reserved for meaningless tokens or pictures. They are, and will continue to, revolutionize the art world. SuperRare, an ‘authentic digital art marketplace’ has reported transaction values greater than $4 million per month by Q4 of 2020, whilst AsyncArt has created a platform where artists can collect royalties on the sales of their original artworks.

Thus, NFT’s are improving artistic outcomes by solving prevalent ownership and copyright issues.

DERIVATIVES

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INTRODUCTION

A derivative is a security that derives its value from another asset or security. A physical exchange exists for many options contracts and futures contracts. Exchange-traded derivatives are standardised and backed by a clearinghouse. Forwards and swaps are custom instruments traded/created by dealers in a market with no central location. A dealer market with no central location is referred to as an over-the-counter market.

These are largely unregulated markets, and each contract is with a counter-party, which exposes the owner of a derivative to default risk (when the counter-party does not honour their commitment).

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Some options trade in the over-the-counter (OTC) market, notably bond options.

A forward commitment is a legally binding promise to perform some action in the future. Forward commitments include forward contracts, futures contracts, and swaps. Forward contracts and futures contracts can be written on equities, indexes, bonds, foreign currencies, physical assets, or interest rates.

A contingent claim is a claim (to a payoff) that depends on a particular event.

Options are contingent claims that depend on a stock price at some future date.

Credit derivatives are contingent claims that depend on a credit event such as a default or ratings downgrade.

The criticism of derivatives is that they are “too risky,” especially to investors with limited knowledge of sometimes complex instruments. Because of the high leverage involved in derivatives payoffs, they are sometimes likened to gambling.

The benefits of derivatives markets are that they: Provide price information.

Allow risk to be managed and shifted among market participants.

Reduce transaction costs.

FORWARD CONTRACTS WHAT IS A FORWARD CONTRACT?

A forward contract is simply a contract agreement to buy or sell an asset at a specific price on a specified date in the future. This type of derivative can be used to lock in a specific price to avoid volatility in pricing. The party that purchases a forward contract is entering into a long position, while the party selling a forward contract enters into a short position. If the price of the underlying asset increases, the long position benefits and vice versa.

FOUR COMPONENTS 1 2 3 4

Asset Expiration Date Quantity Price

HOW ARE FORWARDS TRADED? Forwards are not traded on centralised exchanges. Instead, they are customised, over the counter contracts (OTC instrument) that are created between two parties. On the expiration date, the contract must be settled. One party will deliver the underlying asset, while the other party will pay the agreed-upon price and take possession of the asset. Forwards can also be cash-settled at the date of expiration rather than delivering the physical underlying asset.

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HOW DO FORWARD CONTRACTS WORK? For example, assume that an agricultural supplier is looking to sell 1000 barrels of white sugar in six months time that are valued at a total price of $20,000. The supplier is concerned that the declining weather conditions in the country of production will decrease the price of sugar, relating to supply and demand. As such, the supplier settles on a forward contract to sell the 1000 barrels to an international buyer for the spot market price of $20,000.

There are three possible outcomes from the forward contract: The value of the sugar remains the same at $20,000 for 1000 barrels. In this case, no party owes any money and the contract will be closed.

If the spot price is now higher than the contract price of $20/barrel, the supplier will owe the buyer the difference between the current spot price and the contracted forward rate.

If the spot price is now lower than the contract price of $20/barrel, the buyer will owe the supplier the difference between the contracted rate and current spot price.

As you can see, forward contracts are mainly used to hedge against potential losses while ensuring a fair share of returns. This guaranteed price is especially important in industries that commonly experience significant volatilities in prices, providing protection against uncontrollable macroeconomic risk.

FUTURES CONTRACTS

WHAT IS A FUTURES CONTRACT?

Future contracts carry similarities with forward contracts. This type of derivative is an agreement to buy or sell an underlying asset at a later date for a predetermined price. Investors may purchase the right to buy or sell the underlying asset at a later date for a predetermined price. By purchasing the right to buy, an investor expects to profit from an increase in the underlying asset. Likewise, by purchasing the right to sell, the investor expects to profit from a decrease in the price of the underlying asset.

WHAT DO FUTURES DO?

Future contracts are an effective way of protecting against volatile price movements in the underlying asset. Take for example, the hedging between a sugarcane farmer and wholesale distributor for the sugar. The sugar farmer would want protection from sugar prices decreasing whereas the wholesale distributor would want protection from sugar prices increasing. As such, to mitigate the risk, the sugar farmer would purchase the right to sell sugar at a later date for a predetermined price, and the distributor would purchase the right to buy sugar at a later date for a predetermined price.

WHO USES FUTURES? Additionally, future contracts are also frequently used by speculators that are willing to bet on the future price of the underlying asset. As there is greater volatility within the futures market, it provides traders with more opportunities to profit from short term price fluctuations.

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HOW DO FORWARDS AND FUTURES DIFFER? Futures contracts trade on a centralised public exchange and are standardised, meaning their terms and conditions cannot be altered once the contract is made. Conversely, forward contracts T&C can be varied from one contract to another. Furthermore, cash settlement occurs at the end of a full forward contract, whereas changes are settled on a daily basis when trading futures until you reach the end of the contract.

Parties that want to hedge their risk tend to trade forwards in order to avoid the volatility of an asset’s price, as the terms of agreement are set at the beginning of the contract.

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No price fluctuation will have any effect on the price at the end of the forward contract.

On the other hand, traders are constantly seeking opportunities to profit from asset price fluctuations in the futures market. As future contracts are settled on a daily basis, both parties must ensure that they have enough funds available to withstand the fluctuations in price throughout the duration of the contract. As such, traders will often close out the trade early and future contracts will be terminated.

Finally, the clearinghouse involved in future contracts guarantees the performance of a transaction, which is not available for forward contracts. This means that a forward contract will be more susceptible to credit risk and may default a transaction.

SWAPS WHAT IS A SWAP? A swap is a contract between two parties to deliver a certain amount of money against another sum of money, at periodic intervals, where the ‘sums of money’ are the cash flows or liabilities from different assets. The two payments are the legs of the swap, where each cash flow represents a single ‘leg’.

Typically, one leg is fixed, and one leg is floating (subject to market fluctuations).

TYPES OF SWAPS

If a swap is combined with an underlying position, one or both parties can change the profile of the cash flows, and therefore impact their risk exposure.

There are 4 common swaps: Interest Rate Swap: One leg floats with market interest rates Currency Swap: One leg is denominated in a certain currency, the other leg is in another Equity Swap: one leg floats with market equity returns Commodity Swap: one leg floats with market commodity prices

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WHERE DO SWAPS TRADE? In terms of market organisation, swaps trade largely in an ‘Over the Counter’ environment, where swap specialists ‘fill the role’ of broker or market maker. Similar to the conventions of a ‘swap bank’, the market is typically made by large banks. Usually, one of the parties in the contract transaction is a ‘swap dealer’, also called a ‘swap bank’, because it is typically a large bank that facilitates these transactions.

RISK

The dealer is exposed to risk when it makes the market, including: Credit Risk: the risks that a counter-party will default on its end of a swap Mismatch Risk: it is difficult to find a counter-party that wishes to borrow the exact amount of money for the exact amount of time Sovereign risk: the risk that a country will impose exchange rate restrictions that impact on the performance of the swap

WHAT DO SWAPS ACHIEVE?

Using swaps help achieve the following, surrounding risk and return.

1. MANAGE RISKS

This impact is achieved by being able to change the profile of cash flows. If company X currently has fixed payments on debt, but it will benefit from floating debt, a ‘fixed-for-floating’ debt helps them achieve this.

2. ARBITRAGE

In the case two companies have a comparative advantage in borrowing in a certain currency, they can borrow according to their competitive advantage and then exchange these cash flows, benefiting both companies. Hence, it helps parties benefit from ‘riskless profit’.

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OPTIONS WHAT ARE OPTIONS? An option contract gives its owner the right, but not the obligation, to either buy or sell an underlying asset at a given price (the exercise price or strike price). The option buyer can choose whether to exercise an option, whereas the seller is obligated to perform if the buyer exercises the option. The price of an option is also referred to as the option premium.

OPTIONS POSITIONS 1 2 3 4

Long call: the buyer of a call option—has the right to buy an underlying asset.

Short call: the writer (seller) of a call option— has the obligation to sell the underlying asset.

Long put: the buyer of a put option—has the right to sell the underlying asset.

Short put: the writer (seller) of a put option— has the obligation to buy the underlying asset.

TYPES OF OPTIONS

American options: may be exercised at any time up to and including the contract’s expiration date.

European options: can be exercised only on the contract’s expiration date.

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CREDIT DERIVATIVES A credit derivative is a contract that provides a bondholder (lender) with protection against a downgrade or a default by the borrower.

A credit default swap (CDS) is an insurance contract against default. A bondholder pays a series of cash flows to a credit protection seller and receives a payment if the bond issuer defaults.

A credit spread option is typically a call option that is based on a bond’s yield spread relative to a benchmark. If the bond’s credit quality decreases, its yield spread will increase and the bondholder will collect a payoff on the option.

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PROPERTY

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INTRODUCTION

8

Whilst owning a property may seem like a pipe dream for young investors, the property market is still accessible via Real Estate Investment Trusts (REITs). Put simply, REITs are bundles of property owned by a company, and investment in REITs is similar to holding equity shares in that company.

This chapter will introduce the major categories of REITs, the risks associated with investment and provide an overview to some topical trends affecting the Australian property market.

CATEGORIES OFFICE REITS

Office REITs can invest in property where they develop, manage and sell office buildings. Landlords lease the offices to companies that need space to accommodate their employees. In return, tenants pay rent per square metre of office space. In a premium office building like Chifley Tower in Sydney, be expected to pay up to gross rent of $2,000 per square metre for the top floors! Rental income can be used to maintain the building and the net profits are distributed as dividends to shareholders.

Central Business Districts or suburban areas are popular location points for leasing as the demand for office space is high. REITs can focus on leasing to specific classes of tenants such as multinational corporations, NGOs, banks or government agencies. One of the largest pure-play office A-REITs is Dexus (ASX:DXS) with a market cap of $11.72 bn as of 17 September 2021.

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BENEFITS One of the benefits of investing in Office REITs is the predictability of long-term income as major corporations tend to sign 5 to 10 year leases which build rent increases of 3% p.a into their terms. As such, office buildings tend to demonstrate a relatively low turnover which allows investors to gain a stable investment.

However, the onset of COVID-19 has disrupted the use of traditional office spaces as employees are forced to work from home. In a crisis, tenants focus on trying to reduce fixed costs like offices, and may realise they don’t need space for 100% of the employees if they can manage with 60-75% working in-office and the rest from home.

WHAT TO LOOK OUT FOR When you’ve decided you would like to invest in an Office REIT, it is important to evaluate the occupancy rate of the office buildings. The occupancy rate is the percentage of the square metre available in the portfolio of office buildings owned by the office REIT and gives an indication of the expected cash flow. For example, the average occupancy of the DXS portfolio is 95.4%. Office buildings with low occupancy rates often generate low returns since the company needs to provide significant tenant incentives to increase demand or re-develop the office building such as a new lobby or shower facilities to attract tenants.

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TOP INDUSTRY PARTICIPANTS AND GROWTH Industry participant

Ticker

Dexus

DXS

+22.65%

+8.63%

Centuria Office REIT

COF

+32.43%

+5.60%

GDI

+6.07%

+20.74%

GDI Property Group

1 year return

5 year return

RESIDENTIAL REITS Residential REITs own and manage residential units for renting out tenants (e.g. singlefamilies or multi-families) for non-business occupation purposes. They may include condominiums, vacation homes, student housing and apartment buildings.

BENEFITS The demand for residential REITs is often quite stable, as people always need somewhere to live. Moreover, even when there is a downturn in the economy, most individuals strive to pay their rent first. Other luxuries will be cut before rent.

TOP INDUSTRY PARTICIPANTS AND GROWTH Industry participant

Ticker

1 year return

5 year return

Lendlease Group

LLC

+9.09%

-10.91%

Peet Limited

PPC

+45.24%

+28.42%

Cedar Woods Properties Limited

CWP

+34.33%

+42.89%

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INDUSTRIAL REITS Industrial REITs manage properties that are used for producing, manufacturing, storing and distributing goods. This includes warehouses, storage facilities, factories or e-commerce fulfillment centres. They are often located close to transportation hubs (e.g. railroads and seaports) to enable an efficient supply chain for all parts of production, generally outside of the central business district due to large land size requirements. Recently, the burst in ecommerce has lured industrial tenants closer to metropolitan areas to better facilitate customers, satisfying the “last mile” logistics concept. Warehouses and production hubs close to major metropolitan areas speed up order fulfilment (between when a customer makes an order and when it is delivered to their doorstep). As such, industrial REITs have become the biggest beneficiaries of the e-commerce and online shopping boom and have had significant growth in the last 3 years. Goodman (ASX:GMG) is the largest industrial AREIT by far, with market cap of ~$39Bn.

BENEFITS

Industrial REITs are said to be ‘recession resistant’ as industrial properties have relatively low maintenance costs after all the infrastructure and transportation routes have been set up. Unlike the other commercial REITs (e.g. office, retail and residential), where properties are tailored to each tenant’s preferences, industrial properties are generally more versatile depending on the level of use (it is just a big shed really!). If there was a downswing in the economy, the rate of manufacturing new goods may decline as consumers demand less. As inventory piles, floor space can be converted into a storage facility. Investors are currently paying a significant premium to buy industrial property given the economic tailwinds with e-commerce.

TOP INDUSTRY PARTICIPANTS AND GROWTH Industry participant

Ticker

1 year return

5 year return

Goodman Group

GMG

+33.41%

+207.90%

Centuria Industrial REIT

CIP

+17.73%

+41.64%

APN Industria REIT

ADI

+36.89%

+48.44%

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RETAIL REITS

Retail REITs lease out retail space such as shopping centres, grocery stores or boutiques and they can be located in CBD locations (think ‘high fashion’) or in suburban locations. When developing real estate properties, owners focus on acquiring the strongest possible anchor tenant to become the first tenant in the building, particularly important in retail. Anchor tenants are often associated with prestige and name recognition, such as a supermarket or major fashion retail chain, as they attract more customers and tenants. Scentre Group (ASX:SCG) famously holds Westfield shopping centres, and have a market cap of A$13.18bn.

BENEFITS In the past, shopping centre REITs are known to be an investment opportunity with strong returns and above-average dividend yields. Shopping centres are tenant-diverse, such as restaurants, theatres, gyms, pharmacies and convenience stores, with high replaceability if a tenant leaves due to high demand for space. However, this is changing as brick-andmortar retailers are suffering with the increase in online retail. Despite the move to online retail, the Australian retail landscape hasn’t been as hard hit as the US malls which are typically anchored by large department stores. The Australian business model sees shopping centres are anchored by large groceries, which are far more resilient to economic downturns.

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TOP INDUSTRY PARTICIPANTS AND GROWTH Industry participant

Ticker

1 year return

5 year return

BWP Trust

BWP

+7.05%

+12.02%

Scentre Group

SCG

+34.03%

-50.48%

Vicinity Centres

VCX

+27.56%

-51.64%

Industrial and Office 6.1%

Retail REIT subsector has had 28.6% growth from FY20-21 Residential REIT subsector has had 4.8% growth from FY20-21 Office REIT subsector has had 22.0% growth from FY20-21 Industrial REIT subsector has had 43.8% growth from FY2021

Diversified 26.1% Residential 26.1%

Retail 41.7%

RISKS

Risks are inherently present for REITs, due to the mechanisms of demand and supply. When there is greater demand (for Office, Industrial, Retail or Residential spaces) than supply, property owners will have greater pricing power. However, the converse is also true, in that when there is greater supply than demand, tenants can bargain for lower pricing. Uncertainty surrounding demand and supply has been elevated, particularly since the beginning of 2020, due to the unpredictability of the COVID-19 pandemic on both domestic and global economic environments.

OFFICE REITS

Risks for office REITs are highly cyclical. Preceding the pandemic, demand for office spaces was relatively stable, as it was perceived as a necessary expense. However, due to the stay-at-home provisions employed by the Australian government, the transition to online work is predicted to have long-term implications.

According to the Property Council of Australia Office Market Report, Australia’s office market vacancy rate increased from 9.6% to 11.7% in the six months to January 2021. This exemplifies that despite improving conditions of the pandemic, office workers are incentivised to work from home due to increased flexibility and decreased travel time to work. Additionally, due to the increased prevalence of technology and its ability to facilitate working from home, improvements in office-related technology pose a risk to returning to in-person work in offices.

Moreover, an oversupply of large office spaces generally occurs during times of sustainable economic growth and low borrowing rates. This is because there has been an increase in demand for smaller, more innovative office spaces that are conducive to greater collaboration between workers. Thus, when there is an oversupply of office spaces, there is a decrease in the pricing power for owners. However, due to the high construction costs and the time taken to complete such projects, the risk is partially mitigated.

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RESIDENTIAL REITS Residential REITs are fairly recession-resistant, meaning that in times of economic downturn, tenants would be likely to cut discretionary spending (such as shopping and other household goods) before vacating their residence. This makes residential REITs far less sensitive to market fluctuations than its counterparts.

However, such REITs operate under the structure of a gross lease. Since the lessee is only required to pay rent, the lessor is subject to paying property taxes, maintenance, insurance and other expenses which are incurred through ownership. Thus, as these payments may often vary according to fluctuations in the economic environment or, in the case of maintenance, may be incurred unexpectedly, the lessor must have consistent liquidity.

Furthermore, the typical shorter lease length of one year poses a potential risk for lessors in an uncertain economic environment. An annual lease structure provides tenants with the flexibility to vacate the premises if they need to cut expenses, resulting in the possibility for owners to lose pricing power in an economic downturn as they attempt to sustain occupancy.

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INDUSTRIAL REITS Industrial REITs are subject to significant risks from their respective economic environment. The demand for industrial facilities, particularly distribution centers, is highly contingent on consumer sentiment and their predilection for purchasing discretionary goods and services. Typically, during times of economic downturn, consumer confidence is dampened and so too is their tendency to purchase discretionary goods.

However, since the pandemic, there has been a surge in e-commerce sales, increasing demand for further industrial space. As predicted by McCasker from UBS, the increase in e-commerce sales could result in demand of between 800 000 to 1 million square metres from online retailers by fiscal 2023. Hence, despite cyclical risks to industrial REITs, the demand for industrial space to support e-commerce sales is a significant mitigating factor.

Moreover, the profitability of industrial REITs is impacted by capital expenditure requirements, as they are required to pay for all property repairs.

Industrial REITs are responsible for ensuring compliance with safety regulations and incur the costs for potential structural problems. There is potential for such costs to exceed their budgeted expenditure, which can result in lower property valuations and reduced distributions to investors.

RETAIL REITS Retail REITs are significantly impacted by cyclical factors in both the domestic and global economic landscape, as well as structural factors.

Prior to the pandemic, retailers in Australia (in particular bricks-and-mortar retailers) were experiencing dampened profit margins due to the competition from large international and online retailers. The pandemic “accelerated” this trend, substantially reducing the ability for retailers to pay high rents, thus, decreasing the demand for physical retail premises. Since the majority of retailers provide discretionary goods, their ability to pay rents is highly contingent on demand from its consumers.

Moreover, as retail REITs have “ample liquidity” and diversified portfolios with assets across a range of other property segments, the risk to earnings is partially mitigated, according to the RBA. Despite an initial sharp decline in profitability at the beginning of 2020, a rebound occurred towards the end of the year as the demand for discretionary goods increased and tenants resumed paying rent. Thus, further illustrating the cyclical nature of risk for retail REITs.

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CURRENT TRENDS

The unprecedented COVID-19 environment (July 2021) witnessed a rapid housing boom, as reflected by the prediction of a 17% rise in the national level of Australian housing prices. Offsetting the temporary price decline seen in late 2020, the change has been driven by various themes which have supported greater investment in property, residential or otherwise.

LOW INTEREST RATES

Record low interest rates of 0.10% have encouraged increases in property investment, where a 1% cut in long-term interest rates results in an approximate 28% increase in housing prices. Retail banks have added further contribution, such as NAB cutting its variable interest rate from 3.09% to 2.79%, facilitating growth in investor lending. In addition, border closures and forced home office environments have shifted consumer demographics and increased the rate of savings, thereby enabling potential investors to save for home deposits earlier than expected.

Unlike previous booms, high demand has been driven by owner-occupiers and particularly first home buyers. However, attracted to the potential of capital appreciation, property investors are steadily returning and potentially replacing the demand from first-time buyers as prices drive higher. This is particularly prevalent in New South Wales, with investors borrowing twice as much as First Home Buyers in May 2021.

Investment confidence has been buoyed by the RBA’s largely unyielding response to the housing boom. The RBA has reiterated that their interest rate policy will not explicitly target housing prices to allow greater focus on recovery in the economy, job and wages.

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FIRST HOME OWNER GRANT The Government has presented a number of schemes to assist first homeowners, including the 2000s’ First Homeowners Grant and 2020s’ First Home Loan Deposit Scheme which allows first home buyers to purchase a home within 5% deposit and avoid paying Lender’s Mortgage Insurance. The 2021-22 Budget further builds upon such prior strategies through providing greater accessibility to home loans for particularly first home buyers. Re-branding the extension of the First Home Loan Deposit Scheme as the New Home Guarantee, the scheme included an additional 10,000 places for new dwelling purchases.

This aimed to incentivise the purchase of new property to funnel new demand into home construction, creating more opportunities for first-home buyers and generating economic activity within the construction sector. However, such demand-side policy has been unmet due to increased supply chain costs and labour shortages, further driving prices up.

SUPPLY OF HOUSEHOLDS

FOREIGN INVESTMENT

The number of housing being listed for sales has plummeted to a record low, reflected by its 30% fall below the fiveyear average. Contributing to the decline has been a lack of construction of new homes, alongside soaring timber prices, which have catalysed supply constraints. Hence, with the increase in prospective homeowners and property investors flooding the market, the demand-supply dynamic continues to add to the rapidly increasing housing prices.

Foreign investment has mistakenly been painted as a contributor to Australia’s housing boom. However, total foreign investment has fallen to a record low during March 2021, only making up 3.7% of new home sales and 2.2% of established homes in the March quarter.

Rather, the current upswing has been a function of low interest rates, high levels of owner-occupier demand and relatively low levels of supply.

ALTERNATIVE INVESTMENTS INTRODUCTION

“Alternative investments” collectively refers to the many asset classes that fall outside the traditional definitions of stocks and bonds. This category includes hedge funds, private equity, real estate, commodities, infrastructure and others such as collectibles.

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Managers of alternative investment portfolios may use derivatives (see chapter 6), leverage (use of debt), and short securities (when a trader sells security first intending to repurchase it or cover it later at a lower price) to execute these investments.

Fee structures for alternative investments are different from those of traditional investments, with higher management fees on average and often additional incentive fees based on performance. Alternative investments as a group have had relatively low returns correlations with traditional investments (meaning they often move opposite to the stock and bond markets- this feature makes them suitable portfolio diversification!).

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CHARACTERISTICS Compared to traditional investments, alternative investments typically exhibit several of the following characteristics:

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Less liquidity of assets held cannot be bought and sold quickly due to few market participants More specialization by investment managers as they are not commonly traded assets Less regulation and transparency More problematic and less available historical return and volatility data Different legal issues and tax treatments Relatively low correlations with returns of traditional investments High fees Restrictions on redemptions Relatively more concentrated portfolios

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CATEGORIES HEDGE FUNDS These types of funds (a.k.a pool of money) may use leverage, hold long and short positions, use derivatives, and invest in illiquid assets. Managers of hedge funds use many different strategies in attempting to generate investment gains. They do not necessarily hedge risk as the name might imply! When talking about hedge funds, the term ‘generate alpha’ is commonly used, which essentially refers to how well a manager can outperform the market. Anyone has seen the TV show Billions? Heard of BlackRock? These are hedge funds.

PRIVATE EQUITY FUNDS As the name suggests, private equity funds invest in the equity of companies that are not publicly traded yet or invest in the equity of publicly traded firms that the fund intends to take private one day. Leveraged buyout (LBO) funds use borrowed money to purchase equity in established companies and comprise the majority of private equity investment funds. A much smaller portion of these funds called venture capital funds to invest in, or finance, young, unproven companies at various stages early in their existence.

EBITDA growth is a central tenet of private equity fund operations. Funds actively search for value creation, and the creation of value is derived from improvements to revenue and operating efficiency. Topline revenue improvements through new active management strategies or efficiency increases derived from a stronger focus on automation all have a material impact on EBITDA. Investment in non-publicly traded firms also means that stock price is no longer a determinant of value. EBITDA multiples can be used as an alternative, however, would not be employed in a venture capital context where companies are unlikely to be generating EBITDA. In this context, a Discounted Cash Flow (DCF) may be employed.

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INFRASTRUCTURE Infrastructure refers to long-lived assets that provide public services. These include economic infrastructure assets such as roads, airports, and utility grids, and social infrastructure assets such as schools and hospitals. While often financed and constructed by governmental entities, infrastructure investments have more recently been undertaken by private-public partnerships, with each holding a significant stake in the infrastructure assets constructed.

An example of privatisation is the infamous ‘WestConnex’ which is a huge tunnel connecting Sydney’s west to the city. Christopher Standen, a transport analyst at the University of Sydney, slammed the WestConnex privatisation as “the biggest waste of public funds for corporate gain in Australian history”. Essentially, privatisation is raised a lot during parliament discussions, where looking at today’s context, governmentbuilt infrastructure which is then taken over by private companies, seems to limit the potential revenue (some say) that the government's structure will produce in the future.

Across 2020 and into 2021, there has been a strong increase in demand for infrastructure and private equity investments, opposed to listed equity ownership. AustralianSuper has moved to increase its infrastructure exposure from $27 billion to $50-60 billion by 2024, and current deals in the pipeline include a proposed $22 billion takeover for the Sydney Airport (ASX: SYD) and the $1.67 billion sales of Qube’s property assets at the Moorebank Logistics Park in Sydney’s South West. Increased transaction volumes and sizes have been primarily driven by stronger market demand for defensive assets with predictable cash flows, and investors increasingly looking toward the post-COVID world.

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COMMODITIES

To gain exposure to changes in commodities prices, investors can own physical commodities, commodities derivatives, or the equity of commodity-producing firms. Some funds seek exposure to the returns on various commodity indices, often by holding derivatives contracts that are expected to track a specific commodity index.

REAL ESTATE

Real estate investments include residential or commercial properties as well as real estate backed debt. These investments are held in a variety of structures including full or leveraged ownership of individual properties, individual real estate backed loans, private and publicly traded securities backed by pools of properties or mortgages, and limited partnerships.

OTHER This category includes investment in tangible collectible assets such as fine wines, stamps, automobiles, antique furniture, automobiles and art, as well as patents, an intangible asset. Collectible assets have the benefit of being widely accessible at a range of different price points and can serve purposes outside of being investment vehicles. One significant detriment of tangible collectibles is the high transaction cost involved - think auction fees, storage fees, shipping fees.

RISKS

RESEARCH STRENGTH

The variance and general risk levels of publicly traded, liquid investments is something that can be determined frequently and on demand. Increased exposure to alternative investments can increase investor risk as they do not provide as much liquidity or transparency to undertake risk analysis. For example, real estate and private equity investments are priced quarterly, so the chance of losing investment cannot be actively tracked as projections can be ‘reflective’.

For private equity explicitly, they will often provide transparency into the underlying companies, but these companies are not valued frequently, and detailed cash flow information is generally not provided, or is outdated as the company was made private a certain time long ago.

INFORMATION ASYMMETRIES Warren Buffett once said, “risk comes from not knowing what you are doing”. A key way to minimise risk is through gathering and interpreting information. However, alternative investments like those facilitated through Hedge Funds do not share this information freely. Instead, periodic statements may be made to investors. This absence of free and accessible information alongside the absence of structured reporting conventions accordingly increases risk levels.

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CURRENT TRENDS As of writing, there are a number of powerful themes that are driving investors to invest more in alternative assets. These include:

LOW INTEREST RATES

Investors are investing in real assets and private credit in the quest for yield (returns) and longer duration (long time before maturity and greater exposure to interest rate risks) which they once received from investing in sovereign or corporate debt.

ALPHA

Outperformance in public equity markets was always hard to achieve but it has only become more difficult or arguably impossible. Alpha is a measurement used to evaluate the performance of an investment against benchmarks. Investors are now seeking outperformance (higher alpha) through alternative assets that are less informationally efficient.

LIQUIDITY

Investors are becoming more sophisticated in the way they manage liquidity so that they can invest more in illiquid assets, thereby earning an illiquidity premium (additional return received for the additional risk of tying up capital in a less liquid asset).

ALLOCATION OF FEE BUDGETS

Investors are investing more in low fee (or no fee) passive public equity or fixed interest strategies and allocating their fee budgets to higher returning, higher fee alternative assets.

ACCESS

There has been enormous innovation and many areas that were inaccessible to investors are now available. For example, even retail investors can now gain access to private equity, private credit, infrastructure, venture capital, insurance-linked securities, opportunistic property etc.

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CONCLUSION

Overall, alternative investments have the potential to make an investor a lot of coins.

However, they are typically riskier than standard asset classes, hence investor expertise in each area of alternative assets is highly recommended. It goes to show that investors can essentially make money out of anything, from cars to sports cards, from real estate to jewelry and gemstones. Maybe it's worth holding on to grandma’s old stereo after reading this!

STUDENT'S GUIDE 2021