Through the major part of Reliance Growth’s portfolio consists of quality stocks, it hardly holds anything for long. No matter what the stock, the fund will keep on selling and buying at every rise or fall in their share prices. Thus on occasions it gets out of stocks before any gain is realised. The other thing of note about this fund is that is does not hesitate to be the only mutual fund to own a new stock.
If it isn’t already apparent from its performance, the fund is also more partial to mid-caps that other diversified equity funds. This bias towards mid-caps since August 2002 to now has been the biggest contributing factor for the funds excellent performance. The fund’s mid-cap holdings like Polyplex Corporation, Jindal Steel, Ipca Laboratories and ABB (Reliance Growth fact sheet) have seen their prices surge many fold since then.
Some smart sector moves have also been made by the fund. Post 9/11, the fund took the lead by keeping a higher exposure in the then ‘hot’ sectors, PSU and technology. It then lost less in the subsequent bear phase of mid-2002 due to a low FMCG allocation. Following the recent rally in bank and auto stocks this year, Reliance Growth has increased exposure in its top holdings like Punjab National Bank and Hero Honda. However, it did not make the most of the rally in energy stocks, which has gotten much attention in recent times.
The fund has a habit of not being fully invested. Even in the current bull-run, it has maintained an average of 17% cash exposure, which might have resulted in the fund missing some opportunities. All in all though, the Reliance Growth fund has a well-diversified portfolio, but it is not a conventional diversified equity fund due to its mid-cap bias, high turnover and high cash component. Because it is part of a much larger portfolio Reliance Growth will not be a core holding, which clearly is not what it should be. Giving us some great exposure to the US equity markets, it has a great appeal despite its risk, due to the returns it has garnered and sits comfortably with our US investment strategy. Transaction costs will be built into the fund prices, whilst the impact of our investment will have minimal bearing on the unit prices because of the fund’s size. (*Check Appendix 4 for statistics)
Australian market
With our US strategy taking equity type focuses; our Australian strategy will take a view to rounding out this position. In trying to diversify our position there is one obvious candidate and that is gold. The reason for this is basic in that the economic forces which determine the price of gold are different from the forces which determine the price of financial assets.
With the current state of global affairs, and particularly in the wake of 9/11 never was it more made more convincingly that if one is concerned about a market turn down, as we are at the moment, “you may be aware that gold is an excellent hedge - the most negatively-correlated asset to U.S. equities.” (World Gold Council, 1997) After the attacks of 9/11 the only stocks that held up consistently across the board were gold stocks, most of them gaining in the aftermath.
With gold being used as a pragmatic investment to hedge against uncertain times, the basis in which we have chosen our recommendation has been equally pragmatic. Newcrest Mining Ltd has been chosen simply because it is Australia’s largest listed goldminer, and has a capitalisation of around $3.7 billion USD. With strong recent performances with the last annual profit rising 33% and the constant rumours of takeover bids by overseas companies such as South African company Gold Fields, the stock also has much merit as a standalone medium term investment. The gold price has been touted as breaking through the $430 USD/oz mark, and from there, there could still be much upside (AFR, 2004). The company is hedged however so rises or falls in the gold price will be somewhat forgone/hedged.
Being an investment in an Australian company made in US dollars, the issue of protecting our investment returns from foreign exchange risk emerges. A currency risk hedge will become a critical foreign investment in this situation. It must be taken into account in the investors’ portfolio, or a possible adverse change in exchange rates may offset the expected return of unhedged foreign investments, to the point where investors suffer exchange losses greater than the gains made on investment in foreign currency terms.
Though studies have indicated that the compounded annual returns on hedged foreign stock portfolios have been similar to the returns of unhedged foreign stock portfolios over long run our investment in the Newcrest Mining is a medium term investment which could be held for about a year. In that time there might be a marked movement in the exchange rate. Moreover, in recent months the exchange rate between the USD and the AUD has fluctuated frequently, giving this investment a high currency risk. We decide to fully hedge the investment in Australia in order to reduce this risk.
According to some analyst estimates we have an expected EPS for the end of year June 2005 of $0.937. Given an industry PE ratio of 15, the price would be a bit over 14.05, and hence we roughly estimate a return of 6% including dividend yield in one year’s time on our investment in Newcrest Mining. This will then be subject to an AUD currency exchange risk and consequently we want to hedge against the possible fluctuations of converting the investment back into USD. After assessing the available alternatives, we decided to recommend the use of exchange-traded AUD futures contracts on the Chicago Mercantile Exchange (CME) to hedge the impact of any currency exchange rate movements.
The trading unit of Australian Dollar futures is 100,000 AUD in CME. AUD currently has a trend of appreciation to the USD, which though could benefit our investment in Australia, could also go against us if the trend turns around. Either way, one enters the futures market under this situation to eliminate such a possibility. To do this one would sell contracts of AUD futures to hedge against the risk of AUD exchange rate rising below the rate when we entered the Australian market and exchanged our USD currency for AUD. This leads to the following scenarios.
Scenario A:
Suppose the USD exchange rate for AUD falls, our trading account in CME is credited the gains on the position by the exchange clearing house. We have a positive return on the future contracts but a currency loss on the stocks we hold. At the same time if the stock price rises or falls, or position will be solely determined by the stock price itself and will not be influenced by currency issues.
Scenario B:
Suppose the USD exchange rate for AUD rises, our futures trading account will be accredited with a loss which will be offset by a currency gain on the held stock.
The transaction costs related to this investment includes the brokerage fees and market impact costs related to investing in Newcrest Mining. Despite being capitalised at $3.3 billion USD, to invest millions in this company very quickly will still come at a market impact cost. This is due to the fact that daily turnover for this company is usually not much more than what we recommend investing. In regards to the exchange rate hedging, transaction costs include brokerage fees and clearing fees which are the premium paid for the portfolio. The main benefit of fully hedging the currency risk of our investment in the Australian share market would be in the form of a reduction in portfolio volatility. Our entry and exit strategy will revolve around short term technical analysis of the charts, but the main reasoning in having this in our portfolio is for its negative correlation towards the US equity market.
Asian Market (Taiwan)
To round out our investments we decided to enter the Asian markets, and more specifically the Taiwanese market. In the past few years Asian markets have been hit by the regions own issues, such as the bird flu virus and SARS, and also because of rising commodity prices due to demand from the fast growing Chinese economy. Due to the above factors as well as others that have been mentioned in this report, world economic growth has undergone a rather gloomy period. However, mainly thanks to the decisions by the central banks around the world, lead by US Federal Reserve, to decisively cut interest rates, the world economy has shown signs of a recovery, beginning around late 2003 and early 2004. Many export orientated industrialised Asian economies have benefited from this recovery. Taiwan is one of those economies that has benefited from the strength of this recovery.
The main stock market index in Taiwan, the Taiwan Stock Exchange Capitalisation Weighted Stock Index (TAIEX) has risen from its lowest point at 3400 in mid-2001 to the current figure of 6000 points. This thus equates to 25.5% annual return. The negative GDP growth figure of -2.2% in 2001 was the first ever for this economy and in the subsequent year GDP growth rebounded to 3.6%.The GDP forecast for Taiwan in 2005 by the World Bank is 4.5%. The Taiwanese government has also set out an economic development plan that will be implemented to up to the year 2008, injecting US$75b into the economy over the six years. This budget is aimed at increasing the nation’s research and development capabilities whilst meanwhile facilitating economic growth. The market composition TAIEX is dominated by the high-tech electronics sector and the financial services sector. According to WFE (2004), the market capitalisation of the TAIEX was US$379b with an annual turnover rate of 190.7% for the year 2003. The Taiwanese Futures Exchange (TAIFEX) was established in 1998. Today, its trading activity is amongst the highest in the world and is still growing fast. According to WFE (2004) the notional value of stock index futures trading on the TAIFEX in 2003 was US$9,127b compared to the CME which was US$15,292b and the Eurex (US$6,660b). Also the notional value of stock index options trading on the TAIFEX in 2003 was US$201b which ranked second to the Osaka Exchange in the Asia-Pacific region.
Overall, the macro-economic situation in Taiwan suggests that it is a fundamentally robust growth prospect and is ready for further economic recovery ahead with the next 2-5 years seeming promising. In terms of market structure, data suggests that it is highly liquid and the dominance of the high-tech electronics sector on the index has a potential to offer high growth as the world economy recovers over the next 2-5 years. From the optimistic information gathered, it is expected that the index is going to perform equal or better than previous years, with a 25.5% annual return. Currently the TAIEX index is trading at around 6000pts. If one were to take the forecast using 25.5% annual return then at same time next year it would rise to around 7500pts. However, to taking a more conservative view, our strategy will be based on if it goes above 7000pts. This conclusion is the drawn from currently available information.
The principle protected is the strategy that we would recommend using to capture the opportunities in the Taiwanese market. It is most suited for investors who have no urgency to access money in the short term (eg. 1-3 years) and cannot tolerate unexpected losses. The principle protected strategy has two portions, risk-free and risky. The risk-free portion is used to guarantee (a certain proportion of) the value of the principle. In our case, the one-year Australian government bill will be used to secure this portion of our Asian investment, because of its high credit rating and also high yield. Around 80% of the investable amount will be allocated to make up the risk-free portion. The risky portion will then be used to capture returns from the high risk Taiwanese securities we recommend. In our case, a bull spread is to be constructed using TAIEX call options to capture upward movements on the TAIEX index. Around 20% of the investable amount will be assigned to constitute the risky portion. To hedge currency risk on positions invested in Australia, currency futures will again be used to provide one-for-one hedge. To hedge currency risk on the positions invested in Taiwan, because there is no available product that can be used directly, and also considering that the New Taiwan Dollar (NTD) is under a managed float regime with the USD, meaning their values will tend to be positively correlated, it has been considered most suitable to apply a partial hedge with a hedging ratio of 1:2 using USD index futures. The actual implementation of this procedure is attached in Appendix 1.*
To elaborate further on the risky portion of the investment, this portion will be further split into four parts. The amount of cash for each part is to be used to construct options spreads for four different time periods. Profit from one period is not to be reinvested for the next periods, and hence will avoid the escalation of commitment habits in investment behaviour. Dividing the risky portion into four parts has several advantages including:
- Providing more flexibility; with limited positions entered in each round, with the ability to implement a change from either a bullish outlook or a bearish outlook.
- An easier and less costly way by arranging smaller trades four times a year as compared to a simple one-off large block trade.
- Being in phase with options expiry cycles.
For the next three upcoming checkpoints, a decision is going to be made and implemented as such:
- For a bullish outlook at entry, set long (short) call strike with 300pts minus (plus) the current spot index point. Later, after entry, if market outlook end up as:
- Bullish, offset before expiry (T) if reaches cap return short call strike, else exercise at T if still in the money.
- Bearish, let it expire worthless at T.
- For a bearish outlook at entry, set long (short) call strike with 300pts plus (minus) the current spot index point. Later, after entry, if market outlook end up as:
- Bullish, let it expire worthless at T.
- Bearish, offset before T if reaches cap return at short call strike, else exercise at T if still in the money.
Distribution of cash for the first period with bullish outlook has set out in appendix 1. Payoff pattern of the strategy is shown in appendix 2.*
As always transaction costs have two aspects, implicit and explicit. The implicit costs or the iceberg cost is highly associated with market volatility and liquidity. In a highly liquid market such as this one, volatility and transaction costs tend to be low. This relationship is according to studies by Swan and Westerholm (2004). When trading large orders on liquid markets, the market impact cost can be minimised. And it is the case for our investments, because of the liquid markets that has been chosen and the splitting of the risky portion of the investment. For explicit costs, many brokerage firms charge a fixed nominal amount for a given transaction, thus the larger the amount we trade the less the proportion of the transaction cost on a given transaction we will have to pay. However, transaction costs charged on percentage terms can become very expensive, especially if the investment outcome turns out to be a failure. Thus investment decisions have to be carefully planned to avoid unnecessary and unexpected costs.
The growth opportunity will come from the bull/bear spread, and by estimating the magnitude and market direction carefully we hope to be in-the-money. The maximum return expected in one year from our estimations is around 41% and this is possible if the assumptions of the strategy made at entry prevail. Risks may this time also arise from the currency risk due to only partial hedging between USD and NTD, in this situation. When the option spread persists in being out-of-the-money, the maximum one year loss is expected to be around 18% of the principle amount. In other words, 82% of the principle amount will be guaranteed by the end of the one year investment horizon for this particular investment. Although those extreme cases have not been shown on the binomial model that has been used to simulate the investment outcome, based on our assigned figures to the binomial model, we determine the expected return to be 19.4%. Please refer to appendix 3 for further detail.*
Summary and conclusions
As outlined above, we have chosen three different markets with which we have picked our main investments and also our hedging instruments. To get the best exposure in equities, we chose Reliance Growth, and to complement this, we chose to invest in an Australian gold miner because of its negative correlation to US equities. We also chose to speculate in Asia, because of its high growth, but tempered this by only investing a portion of what we set aside for this. We have chosen to allocate funds equally across our three major recommendations, with each investment viewed on its own merits first. Because of this, our Asian investment includes a large Australian bond component to protect out principle as well as a foreign exchange hedging component while our Australian investment includes USD futures to also hedge foreign exchange risk. We believe we have uncovered three excellent opportunities, and when viewed as a whole as part of a larger portfolio, we have given excellent exposure across a class of assets and one that we would be more than comfortable in recommending to our valued client. Given the large amount we needed to recommend upon and time frames, we have chosen appropriately liquid markets and securities to invest in, and as such transaction costs will be kept low in pursuing these recommendations. Our strategy has been based on holding our investments over the year, with the Taiwanese options market being the one we will have to actively watch and possibly manage. All in all we hope that these investments do meet with our client expectations and our justifications will entice them into taking our recommendations on board.
References
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World Federation of Exchanges, 2004. Retrieved on 27th September 2004, from World Wide Web:
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Swan P. L., & Westerholm J., 2003. The impact of market architecture and institutional features on world equity market performance.
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The Australian Financial Review, 5th October 2004, Gold finally to break through $US430, Sandra Ward
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BBC, Stephen Evans “IMF: Growth is strong, but for how long?” 29 September, 2004
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Karvy-Mutual Fund Services, , 2004
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World Gold Council, Gold and the Stock Market: A Negative Correlation, 1st September 2004
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Reuters, Gold, copper lifts Australia's Newcrest profit 33%, 26th August 2004
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Yahoo Australia and NZ Finance, Research Newcrest Mining Ltd:
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Reliance Growth Offer Document 2003 , pp89-91.
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Reliance Growth fact sheet