This article is authored by MOI Global instructor Roshan Padamadan, chairman of Luminance Capital, based in Singapore.
Roshan is an instructor at European Investing Summit 2023.
Crossover investors have this challenge often: How to compare ideas across asset classes?
There are two aspects to a comparison across asset classes:
– A comparison of fixed and variable return, which is more related to psychology (e.g., an 8% fixed return may well be more acceptable to many than a 10% average return, which can vary between 5-15%)
– Variations in liquidity or other conditions
Variations of this challenge exist within an asset class, too:
– How to compare securities across countries? Some countries have higher inflation than others.
– How to compare across sectors? Some sectors fluctuate a lot more than others.
Technically-minded investors will use beta, risk premia, cost of hedging, etc. to guide them through this maze.
I will use plain language illustration here to make some points. Investors have choices, such as whether to accept:
Asset A: An IRR of 5% from a government bond
Asset B: A 10% fixed coupon payment from a private unlisted corporate; monthly coupon
Asset C: A 15% (on average) return from an public listed equity
Traditional finance theory says that riskier instruments should offer a higher return to attract investors. Most people will say C is riskier than B; and B is riskier than A. They may say this even without studying the assets – the offered return is higher, therefore it must be riskier.
(Bias: They are assuming the market is efficient when they say this – they do not expect a bargain to be lying around)
Risk is in the eyes of the beholder. Warren Buffett may beg to differ on the riskiness ranking. He states his investment objective as beating inflation after taxes. He is :
• Mostly in C (doing closer to 20%, than 15% – which is a phenomenal achievement over 50+ years).
• With a sprinkling of A: just over USD 100bn, keeping some powder dry to buy more C, when the time comes.
He usually avoids A, as he feels government bond yields do not outperform inflation in the long run, especially after taxes.
Tax impacts
Taxes are very specific to investors and affect asset class choices too. Many East Asian countries (Singapore, HK) do not have capital gains taxes in the tax code for individuals. Many large asset owners in the USA have tax exempt statuses, being a pension fund or an endowment, etc.
So, in reality, the ranking is not as simple as A>B>C.
How investors think
Investors are not computers. They invest on the basis of, among other things:
• What they know
• What others are doing
• What the laws constrain them to do
They regularly make irrational decisions – but they are rational when you consider broader objective functions in life – stay in a job, stay married, have fun with your kids, have time to travel the world, and so on.
What they know:
Ideally, a profit maximising investor should invest around the world. It is highly improbable that the country they live and work in is always the best country in the world for investment opportunities. However the home bias is well documented. Most people invest 80-100% in their home country.
If you invest outside your country and lose money, you will get no sympathy from your spouse/your manager. This, in a simplistic way, explains the Home Bias. It takes a lot of concerted effort to learn things about a new country. There are language and regulatory barriers too, that hamper a global approach to investing.
What others are doing:
Keeping up with the Joneses is there in every facet of life. Homes. Fashion. Stocks.
An extreme version of this is the FOMO factor – Fear of Missing Out.
Meme stock investing has been around for centuries. People have made – and lost- money in so many bubbles and crazes throughout the years. Bubbles also have their uses: Britain has a good railway network due to the massive overbuilding in the 1850s. Indian IT Enabled Services benefitted from the super low costs of voice and data after the dot com bubble burst in 2000 (the bubble brought the funds for massive investment in undersea cables and transcontinental data capacity).
You may think institutions are paid to be sane and sensible, and don’t follow (‘foolish’) trends. This is not borne out in the real world, where there are many cases of (famous) fund managers who were fired or pushed aside when they did not back the craze du jour. e.g. the dot-com bubble.
Passive investing has increased from 21% of funds run by investment companies in the US in 2012, to 45% in 2022. To me, this is an unsustainable fraction. If everyone wants to copy everyone, there is hardly anyone left doing original research. Everyone just follows everyone else, like lemmings.
If you are indexed, you are a closet momentum investor. Today, this means buying NVDA at USD 1.2 trillion. (Sure, they will sell a lot of chips, but the chips last for a long time. It is a durables company, trading at a consumables multiple).
What the laws contain them to do:
Institutional investors have handcuffs on them. No retail investor would buy negative interest rates bonds, but this was a mainstay of European banks for almost a decade (2014-22). Insurance companies had no choice but to buy them, as only Government bonds are allowed in calculation of certain solvency ratios.
Retail investors are subject to the laws of their residence such as limits on overseas remittances, etc. e.g. If you are a Chinese resident, you do not have permission to take money out of the country and buy Coca-Cola. There is a general permission for upto USD 50,000 per year, meant for tourism and general spending – but NOT for investing. India has a more generous limit of USD 250,000 per year, which can be used for investing as well. Every person’s situation is different based on his/her residence, nationality, domicile (an UK tax law concept), source of income, etc..
Mandates limit the freedom of fund managers, as it is not their money. For this reason, a lot of opportunities cannot be exploited. Here is not the law of the land, but the terms of their management contract that limit choice. e.g. a Dividend fund has to sell a stock even if the dividend is stopped just for one quarter. (Which is why you see strange behaviour such as General Electric cutting its quarterly dividend (in 2019) from 12 cents to 1 cent. Why 1 cent? This allows dividend funds to continue holding them, if they want)
Assessing variable vs. fixed return
One core challenge in crossover investing is the relative value of a lower fixed return over a higher variable return. This choice primarily depends on the investor’s circumstance — and not on the instruments per se. One cannot say that it is always wise to take the former, or the latter. The answer is, it depends.
Some investors may very well be happy with Asset A, if their total demand from their portfolio is only 5%.
However, if they can calculate and get comfort that Asset B may very likely not lose more than x% in a given time frame, Asset B can be less risky than Asset A.
For example, Asset B:
The coupon is paid monthly.
In 6 months time, 5% of principal is received.
In 12 months time, 10% of principal is received.
This covers the expected coupon from Asset A over 2 years. Over time a buffer is created, that can compensate for the perceived higher risk of Asset A over Asset B. Also, the cash flows that come in can be invested too, in Asset A, or any asset of choice. This choice is of value too.
An alternative scenario:
If, for example, Asset B is available to invest, with a credit guarantee that costs 2%, Asset B becomes B-1, yielding a net 8% per annum.
B-1 can be considered superior to A in all aspects of risk and return. (Assume same tenor as A; and that the credit guarantee is from a high quality insurer in this example, say, AAA)
If you believe governments are zero risk, please be aware that this is no longer the case for international investing. Governments are low risk ONLY in their home currencies.
As a global investor, we only have 9 countries left at AAA, as agreed by all 3 Credit Rating agencies : 7 European nations, Singapore, and Australia.
Asset C is abhorred by people who hate volatility. The 15% average hides periods when the asset can fall 30-50% in a single year. On the flip side, it could – and does- go up by 20%-60% in good years, to make up the long-term average. The key is to survive. Along the way, if money needs to be consumed for needs, selling at the bottom, or at a low price, will mean significant erosion – and the investor will end up far below the 15% average. That 15% average is only available if you stay invested, without withdrawals.
A variation of investing in Asset C is to average in over time. Easier said than done.
People find it easy to average into a stock when the markets (and the stock) are going up. Their earlier investments have risen in value. They can see they are richer.
Averaging is much harder on the way down. People find themselves paralysed with fear. You are becoming poorer by the month, and your averaging process says you should buy more of, say, Alibaba, while property bonds are blowing up in China. Your net worth has fallen. You think, maybe I should pause on this buy. This inaction will mean you will end up far below the average 15% return indicative of Asset C.
You may be aware of studies that show that dollar-weighted investor returns are far below that of the index.
Meeting income needs
If the investor has an income need of 5% of capital every year, it is possible to construct an income variant of C, let us call it C-1, with a dividend yield of 5% per annum. While dividends are not as sacrosanct as government bond payments, we can use this construct to compare:
A: Yields 5% every year. Capital value fluctuates,* but is guaranteed at maturity.
B-1: yields 8% every year. Capital value remains constant.**
C-1 : yields 5% every year. Capital value fluctuates all the time.
* Due to interest rate risk, government bonds can still lose you money, or sink you, even without defaulting. See Silicon Valley Bank (2023), First Republic Bank (2023) for lessons on mark-to-market impacts. Even though the banks held the government securities in a Hold-to-Maturity bucket, the loss that they did NOT have to recognise due to rising rates worried depositors. The capital ratios were not hit. The accounting rules were made to protect the banks. However, depositors did not want to take academic comfort, and left with their funds. The banks were forced to sell bonds at a loss/ accept that their capital ratios were insufficient.
** It is an illusion that the price is stable because the private company bond is unlisted. If it were listed, you will see the same type of fluctuations as asset A (with higher amplitude). Typically, private assets show higher Sharpe ratios due to lower price volatility. Just remember that it is not reality. Illusion in, illusion out.
In this new set, B-1 seems to beat C-1 for yield investors. This will be true for all investors for whom variation of capital will be unacceptable.
For people who still need income, but can live with the fact that their asset values may fluctuate, C-1 is the way to long term wealth creation. The 5% yield covers income needs, while the remaining portfolio will grow at about 10% each year – on average.
Of course, now you cannot get 15% per year- you took out 5%, so now Asset C has less money to grow itself. C-1 may grow at 10% a year – on average.
Think needs, not asset classes
Keep an open mind, and learn about different types of structures – they can help reduce, or transfer risk, and you can even beat Government bond yields – without necessarily taking on more risk.
Hopefully this article helps you think much more clearly about crossover investing.
Over time, I hope it helps investors, where they don’t just say: I never do bonds/ I never do equities/ I do not do unlisted securities.
Break it down into what you need — income, capital protection, etc. Learn about risk transfer measures, and guarantees, if available, or hedging tools (e.g. covered calls, etc).
• You can even create a bulletproof debt instrument from a risky young company with the help of a liquidation preference.***
• Distressed debt can behave like equity.
• Some stocks have stable dividends that give them a bond-like aura.
• Covered calls can be used to create artificial dividend (harvesting theta)
• Some bonds are listed, but never trade, making a mockery of the listing requirement. (Everyone plays a game, as if listing it lowers its risk profile. Only real liquidity is real liquidity – just having an exchange ticker is not liquidity. Just another illusion)
The number of combinations is infinite.
*** Note: Liquidation preference gives special terms to a class of investors in a capital structure.e.g. If that class is the top 5% (say) in a company, then the company has to lose over 95% of its value before that named class would see any erosion in its capital. While not risk-free, it is fairly high on the margin of safety.
Once you expand your toolkit, you can build up things in a modular way, which mixes the different asset classes and structures in a way that meets your requirements — and maybe exceeds them.
Happy crossover investing to all.
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