Wednesday, January 31, 2007

A More Sophisticated Approach to Portfolio Construction

I don't think this article is as novel as the author and the blogger are making out. All it really says is build a balanced portfolio out of uncorrelated assets and then lever it up. Modern Portfolio Theory allows for that. But it is a more sophisticated approach to constructing an efficient portfolio than you will hear about in articles geared to the small investor that appear in the mainstream financial press. But you don't want to use very high margin lending rates to achieve this. You can achieve similar results by investing the stock portion of the portfolio in leveraged mutual funds, stock index futures etc. This means that less of your capital needs to be devoted to investing in stocks and more will be directed to real estate, bonds etc. The end result is a leveraged balanced portfolio. It will probably have lower volatility for a similar level of returns as an unlevered all stock portfolio.

This isn't far from the way my portfolio is currently constructed with a balanced mix of stocks, bonds, real estate funds etc. and then using leverage to trade stock index futures and ETFs. In the long run, I want to have a core of more hedge fund like investments for perhaps 50% of the portfolio, about 40% in funds which I will change the mix of over the 4 year stock cycle to have more stocks or more bonds and about 10% as capital for leveraged trading. Or up to 100% invested and then borrowing using low margin rates for the cash needed for trading. Currently Ameritrade are charging my account size a 10.5% margin rate which is ridiculous. CommSec in Australia are charging 8.9% (and interest rates are higher in Aus!). Interactive Brokers rate is less than 7%. The latter is economically viable.

Tuesday, January 30, 2007

Merger Mania

Two of my stocks are now in merger talks: Powertel - a small Aussie telecom firm - and Symbion Health - an Aussie healthcare firm (what else?). Powertel is in talks with Telecom NZ, which I really shouldn't have sold. It has gone up around 10% since I sold it! Talk is that Telecom NZ will acquire Powertel and merge it into its underperforming Aussie subsidiary, AAPT. AAPT was one of the first stocks I bought - I bought it at the IPO and sold when Telecom NZ acquired it. Symbion is one half of the former Mayne conglomerate that remained after Mayne Pharma was spun off in a demerger. Yup, Mayne Pharma was acquired too. An advantage of investing in mid and small cap stocks is that they are more likely to be acquired than mega-cap stocks are. That's one reason I made my disastrous investment in Croesus Mining. Sometimes it works out and sometimes it doesn't...

There is a global wave of mergers, acquisitions, and privatization buyouts going on that rivals the previous peak of such activity in 2000. In theory this suggests that shares are cheap as most of the acquisitions are being made with cash or borrowed money, not other shares. But I don't think the evidence is that acquirers are actually that smart and the high level of such activity could be seen as a sign of an overheated stock market instead.

P.S. Tuesday, 30 January

Telecom NZ is offering $A2.30 per share for Powertel. I paid $A1.20. The stock is trading at that level. The only issue is I bought on 6 May 2006. So I need to hold on till this 6th of May to get the long-term capital gains rate. This is worthwhile when considering the tax saving vs. interest paid in the meantime. Only question is whether I'll be able to hold on till then. The news release talks about Powertel shareholders voting on the deal in late April. If the acquisition (for cash) proceeds immediatately there is going to be no point in waiting till then - unless a better deal comes through. I'm skeptical about that, because one potential bidder already dropped out earlier saying that the price of Powertel was already too high then!

Monday, January 29, 2007

Indexing vs. Active Management Again

New research attempts to do a better job at assessing whether indexing or active management performs better for long-only mutual funds. They examine each capitalization class (small cap, mid cap, large cap etc.) for both active and passive funds. The bottom line is that there appears to be some gain to active management in the mid-cap sector. I recently blogged about the advantages of small funds. This new research also confirms that active management has some advantage in periods of market underperformance though they found that active management just underperformed less in that time period.

I would be very skeptical about buying a long-only actively managed large cap fund. I don't own any currently unless you count Colonial First State's Global Resources Fund. But actually it's not a large-cap only fund. In the past I have owned Colonial First State's Geared Share Fund. It is a large cap long-only Australian stockmarket fund that uses leverage. Of course most Australian large cap stocks would be mid-caps in the US. And the real reason to use the fund is for the built in borrowing at a very low interest rate.

I get large cap exposure in the short-term using futures and ETFs. If you want to get large cap exposure in a buy and hold fashion it probably does make sense to buy an index fund. But does it make sense to buy and hold large cap stocks anyway?

Sunday, January 28, 2007

Don't Worry So Much About Saving Enough for Retirement

The NY Times discusses something I have commented on from time to time. Most people in the US end up saving enough for retirement. Poverty is concentrated in fact among families with children rather than seniors. The retirement planning tools provided by brokerages and funds management firms tend to over-exaggerate how much you need to save. As Lawrence Kotlikoff comments in this article - you could end up squandering your youth rather than your money which you will likely come to regret. My mother has a high net worth but hardly at all touches the income from these investments. She primarily lives on government and employer pensions (the employer pension from my father's employer is very low). She gets free government health care and owns her own apartment. Sometimes I try to persuade her to spend more. The main point is that the research also shows that the old spend less than the young. You only need to replace what you spend and that spending shouldn't include things like mortgage principle payments, spending on children etc....

I'll probably end up with "too much saved" (even though I had nothing in a retirement account till age 31, and a negative net worth for most of my 20s) but I am still saving rapidly now because I don't plan on retiring at 60-65 but becoming financially independent long before that. IMO my $1million goal is more than sufficient for achieving that as long as after I reach the goal I at least maintain the inflation-adjusted value of the money.

Friday, January 26, 2007

Overnight Trading Proving its Worth

I'd credit a signficant portion of the rising profits I blogged about in yesterday's post to adoption of the overnight trading tactic. And today proves the point. I closed my short position early yesterday but didn't go long till late in the day when the market had risen considerably. I bought 3 QQQQ call options in my Roth IRA account (300 QQQQ shares equivalent). This morning the market started up and then began to fall. I then bought 500 QQQQ in my Ameritrade account and after that 1 NQ contract (800 QQQQ) @ 1810.75. But the market kept falling all day... late in the day I bought another 2 NQ contracts @ 1791.75. Using the overnight trading approach I should have either dumped my 3 options contracts for about breakeven early in the session today or kept them and suffered a small loss and then gone more significantly long late in the day after prices had fallen. Trying to position myself in line with the model during the session resulted in significant losses - even though the market had already fallen when I started buying. The model is still long, which is why I bought two more contracts late in the day. They are now a little in the money but my earlier buys are underwater. I also should have put in place a hard stop at a 1-1.25% loss in the index for the day.

The overnight trading strategy does seem to work well for part-time traders who can't sit and watch the market all day. At least it works well with my psychological makeup. Today showed what happens when I deviate from it. Living and learning :)

Wednesday, January 24, 2007

IB Account Profit and Loss Curve

The chart shows the cumulative profit in my Interactive Brokers account since I opened it in late October 2006 trade by trade. All closed trades are shown here. Initially, things were a bit erratic and then an Aussie Dollar trade went very bad. I shorted 3 contracts and the AUD rose 1 US cent against me... that resulted in a loss of $US3000. Since then I have had a pretty smooth ride along an ascending profit curve. As I blogged, yesterday, that might make me a bit too complacent. In fact I made a new short AUD trade yesterday - but only 1 contract - and again the AUD rose against me. But this evening, on the release of the SPI report in Australia the Aussie plummeted and that trade (now closed) turned out OK.

The chart also shows the importance of cutting losses. If I just halved the size of those two big losses the track record would look very different.

I did one of these reports before for non-futures trading. It also looked pretty erratic. I am still waiting for the decisive breakthrough where my trading looks consistently profitable.

Tuesday, January 23, 2007

Cushion of Profits

I've managed to build my Interactive Brokers account which I use for trading futures up to $12,000. I originally put $10k into the account. After the Aussie Dollar trading debacle in early December the account had fallen to $7,000. So at this point I am achieving the first part of my second goal for 2007 by bringing one of the three accounts back to profit. As I begin to rebuild profits I start to feel less anxious about losing money in trades. This doesn't make a lot of sense economically. $2000 is about 1/2 per cent of my net worth and shouldn't make much difference to my decision making if I was really a neoclassical rational optimiser. It shouldn't matter that the $2000 is the profits in a specific account. This is a classic example of behavioral economics.

Anyway, I'm not sure if this is good or bad. On the one hand, I am likely to be less jittery and more likely to let profits run etc. On the other hand, I might start to take unreasonable risks. Need to remain dsciplined.

Sunday, January 21, 2007

Small Caps and Small Funds

Following up from the discussion about mutual fund costs, Friday's WSJ had an article about top performing small cap funds (pointed out to me by Rich Gates - sorry no link as it is subscription only - I read the hardcopy at the office - I subscribe online to Barrons but not the WSJ). This showed that not only have small cap stocks outperformed large cap stocks in recent years but many of the top-performing small cap stock mutual funds are very small in terms of assets under management. TFS Capital's own analysis showed something very similar. It is well known that large mutual funds can have a hard time in getting high returns compared to small funds. This is especially likely to be true if they try to invest in smaller stocks. These small funds tend to also often have high expense ratios. 2% of $50million say is only $1million and from that you have to pay all overheads and several salaries.

The only really large cap stock I own is Berkshire Hathaway. I was thinking about making a post about the market caps of each stock and funds under management of each mutual fund I own. The biggest mutual fund that I have shares in is the Hussman Strategic Growth Fund. But the size of some of my other mutual and closed end funds could be misleading as those are in some cases products of management firms that also have other similar products. For example, Colonial First State runs very similar funds, under retail, retirement (superannuation), and wholesale labels. These are really different share classes of a single fund. They also have direct institutional mandates that may well be managed in the same fund pools. So this was just getting too hard, when I started thinking about all this!

Wednesday, January 17, 2007

Five Things You Probably Don't Know About Me

I finally got tagged by Clifford with this so-called "meme" that is all over the blogosphere. So here goes:

1. I was born on the same day as my mother. 33 years apart that is.

2. I've lived on four continents - at least five years on each. I guess that leaves Africa, South America, and Antarctica to go.

3. I rode my bike from Lands End to John O'Groats - the southwestern tip of England to the northeastern tip of Scotland and from London to Nice - across France.

4. I can read the Old Testament in the original language.

5. I hate mashed potatoes.

OK, who can I pick - most personal finance bloggers seem to have done this already. Here's a new idea - please comment on this post and either volunteer yourself or nominate someone else :) Like one of those committee meetings where everyone decides to nominate the member who didn't show up :P

Blame it on the Nucleus Accumbens

My insula must be very active!

Monday, January 15, 2007

Mutual Fund Costs are not Important!

I'm fed up with hearing how people should look at the expense ratios of mutual funds when deciding which to invest in as if that was the most important factor. I just turned off a radio show I was listening to because the host was going on about this again. There is so much propaganda out there that I think a lot of people think that these costs are deducted from the reported mutual fund returns. This is not the case. Mutual fund returns are always reported after all costs. Therefore, what is of first order importance is the return not the cost. Vanguard use the line "if you don't get to keep it is it really yours" to try to get people to believe otherwise.

The argument that costs are important is based on the unproven theory that the market is totally efficient and no managers add any value. In such a world the best fund would be the one with the lowest expenses. But that isn't the world we live in. Managers can add value but most don't on average add more than their fee which is what we would expect from economic theory. However, there are some managers that do add a lot more value than their fees. On the other hand, the average individual investor won't have the neccessary insights to pick these out.

Index type funds do have an advantage of being very tax efficient relative to most actively managed funds. This is irrelevant, however, in US retirement accounts (not in Australia though where retirement account earnings are taxed at 15% at source - but a levered managed fund can end up being even more tax efficient under Australian tax rules!).

Even when choosing among index funds, the expense ratio isn't the most important thing. A fund which charges high expenses should lag the index. Looking at the reported returns is good enough. Perhaps the higher cost fund manages to offset those costs by slightly outperforming the index before costs.

Loads - the entry fees into funds are another matter. These are there in order to provide commissions for brokers. The very high rates are a throwback to the times when the cost of trading stocks were also very high (though never that high) just like trading property still costs several percent. I would try to avoid paying a load unless a fund was very interesting and there was no way around it. For example, the Australian fund manager Colonial First State charges a load of 4% on its equity funds. If you make an application direct to the firm you pay that fee and they just pocket it. If you apply through a full service broker the broker gets the fee. If you buy it through a discount broker like CommSec the broker rebates the fee to you and you pay no load! (I have accounts with both these firms).

Sunday, January 14, 2007

The Croesus Mining Saga Continues

It now looks like Croesus mining shares will again be traded on the Australian Stock Exchange. A reverse split of 1 for 15 and a new capital raising is being proposed subject to approvals, though the details are a bit fuzzy to me. The Sydney Morning Herald reports:

"IN A development that has stunned the mining industry, the gold assets of collapsed Croesus Mining have been sold to a little-known UK second-board company for $71 million. Perth explorer Avoca Resources had been considered the hands-down favourite to pick up the Norseman goldmine, 50 kilometres south of the Trident mine it is developing in Western Australia. But administrators for Croesus, which collapsed due to poor hedging last year, said yesterday that an offer from Perth-based AIM-listed Davos Resources was significantly higher than two other final offers. Eight parties conducted due diligence, but the final bidders were Davos, Avoca and an overseas syndicate. Avoca shares, which had risen earlier this week on speculation the company would win the Norseman assets, fell 13.5c, or 9 per cent, to $1.355 yesterday. Croesus administrator Vincent Smith said the deal with Davos was signed a week ago but was not announced until the company lodged an $8 million deposit on Tuesday. Avoca managing director Rohan Williams said he was not informed of the winner until just before Croesus announced the deal to the stock exchange yesterday. "It was all pretty well kept under wraps," he said. "We were outbid. That's what happens in administration processes. I'm OK with that." Avoca has been tagged the "market darling" of the WA mining industry in recent months, due to its promising Trident project and expectations it would acquire the Croesus assets capable of producing about 100,000 ounces a year. "Trident is an excellent project and it's got lots of exploration upside ... but Croesus was a bonus on top of that," Hartleys analyst Andrew Muir said. "It was a bit of a shock to the market that they didn't [get Norseman]." Davos chairman David Steinepreis said his company would raise the necessary financing to complete the acquisition in London but that it intended to pursue a dual-listing on the Australian exchange in the future. Norseman mine manager Barry Cahill will be appointed the new chief executive of Davos, which might make further acquisitions. "I think there is an opportunity to rationalise the smaller goldmines in Australia," Mr Steinepreis said. Davos will re-inject money into Croesus, which will be left as a shell company with barely any assets after the Norseman sale. Croesus would then buy other exploration opportunities, offering its long-suffering shareholders the chance to recoup at least some of their funds."

Friday, January 12, 2007

Nobody Ever Went Broke by Taking a Profit, or Should you Let Your Winners Run?

Beginning (and more experienced traders too) are often confused by the conflicting advice they get from different sources. Some argue that because losses are inevitable you should let any winning trade run and close any losing trade fast so that you can generate a good ratio of the size of the profits of winning trades to the losses of losing trades. Others argue that you should take some profits if you are shown to be correct about a trade. Maybe you won't be correct for long...

I think this largely depends on the nature of the system or model you are using to trade with. Here is a nice diagram that lays out the two most important parameters: How often your trades win, and how much they win when they win relative to how much they lose when they lose. If your system is only right slightly more often than it is wrong or maybe even is right less than it is wrong, then you need to let winners run in order to be profitable. However, if most of your trades are correct the amount you win when you win versus what you lose when you lose is less important. My formal trading model is right most of the time. The winning profit/losing profit ratio though is close to one. Profitability doesn't depend on letting winners run. But if this is the case, letting winners turn into losers is very detrimental to results. Therefore, it might make sense to take some profits when we can. Does this make sense?

So far in January on my IB account I have 11 winning trades and 2 losing trades. The profit to loss ratio is more than 6. So no problems on either score here. But in December I had a couple of big losses than brought my profit to loss ratio down to 0.21! I won 24 times and lost 10 times. So cutting losses is also extremely critical. In December I let losers run and took profits too fast. Even with being right much more often than I am wrong this results in losing money.

Thursday, January 11, 2007

Annual Report 2006: Part V

I promised that yesterday's post would be the last in this series, but then I came up with a new idea: the contribution of each security or fund to my annual investment result for 2006:

It's too much hassle to compute rates of return and so these are just total contributions in US Dollars. Gaining investments outweigh losing investments 4.5:1 in dollar terms. Not surprisingly the CFS Conservative Fund contributes about a quarter of the gains as it is more than half my net worth in value. Forex contributed even more. All other is the net of interest received and interest and fees paid. Interestingly investments dominate the gainers at the top of the table and trades dominate the losers at the bottom of the table. Investments that lost money are: Ansell, Telecom NZ, and Croesus. All of these are the single industrial firm stocks I wrote about yesterday. Now you can see why I'm not enthusiastic about them. On the other hand, Ansell has generated significant profits in previous years and Mayne/Symbion and Powertel made great contributions this year. But all the mutual funds, closed end funds, fund management companies, and hedge fund investments made money. These are the main patterns I can see.

As far as learning from this record in order to improve my trading in 2007, the main lesson is that avoiding the losses on my two worst trades (each is actually the sum of several trades in that security) would significantly have improved my results - adding about 1.75% to the annual return on investment. I'd like to think I can now avoid the kind of mistake that generated the losses in trading News Corp. That is the whole point of developing a trading model, though money management is a big part of it too. On the investment side the loss on Croesus was unexpected, I really believed the company was turning around, sorting out production problems, and making significant new gold discoveries. I didn't realize the size of the hedging book and how that was going to bring down the company. The lesson is to be very wary of individual stocks of companies that seem to be experiencing any kind of problem.

Wednesday, January 10, 2007

Annual Report 2006: Part IV

This is the final part of the annual report where I review my current investment allocation and strategy:

This is a screen shot of part of the allocation spreasheet I set up each month to keep tabs on my investment strategy. 2/3 of my net assets are in Australian Dollar related investments. Australian based international investments that aren't hedged into the Australian Dollar are listed in the "Other" column. Yes, over half my net worth is in the CFS Conservative Fund - this fund is 30% invested in equities with the remainder in bonds and cash. I've listed it under Australian Bonds even though it also includes foreign bonds and equities and Australian shares. I have 1-2% of net worth allocated to any individual stock investment. Larger shares can be allocated to closed end funds or trading positions (e.g. 15% allocated to a SPY trade). Unlike the majority of PF Bloggers I don't have any index funds as investments. I use ETFs as trading vehicles.

Here is a different view of the portfolio:

My strategy is to invest 100% of my net worth and borrow against this to fund trading. At the end of 2006 my net trading position was long. The beta exposure column shows how much each category adds to the portfolio's beta (which measures its sensitivity to the S&P 500 index). The investment portfolio contributes a beta of 0.45. My trading positions added a beta of 0.553. So currently I have a very conservative investment portfolio. The overall portfolio's beta can range from 0.9 when I have long trading positions to -0.1 when I have short trading positions. IMO this is a much better approach to market timing than trying to swing an entire portfolio for and against the market. I developed this philosophy from Soros' approach as described in "The Alchemy of Finance".

The overall investment portfolio is conservative at the moment because the yield curve is inverted and there is a strong risk of a recession. Bonds do well in economic slow downs and recessions when the Fed cuts interest rates. So I do adjust the investment portfolio but over the course of years, trying to only incur long-term capital gains taxes. When I am bullish on the economy the beta of the investment portfolio will be above 1.

Breaking down the investment portfolio I have the following kinds of investments:

Core Investments (22%): Loftus Capital, Clime, EBB, EBI, Challenger Infrastructure, Berkshire Hathaway, HCBK, TFS Market Neutral Fund, Hussman Strategic Growth Fund, TIAA Real Estate, Newcastle, Platinum Capital. I don't intend to change these investments with changes in the economy. The investments are a mix of hedge funds, real estate funds, and investment management companies. I would like to have more of this type of investment.

Market Related Mutual Funds (71%): The four Colonial First State Funds, and CREF Bond Market Fund. In fact I have never adjusted the CFS Global Resources Fund since I bought it many years ago, but often wonder if I should. So maybe that too is a core investment. I hold onto positions in the CFS Future Leaders and Developing Company Funds because they are closed to new investors. In order to expand my holdings in the future I need to remain in them. I used to hold a much higher percentage in these funds. My holdings in these funds will change dramatically when I get bullish on the economy.

Industrial Stocks (9%): Ansell, Croesus, Symbion, Powertel, Telecom NZ. Croesus is probably worth nothing in fact (but has not been delisted). I have subsequently sold Telecom NZ. Ansell and Symbion are in the health related field and so I think will not be affected much by recession. Powertel is a small Australian telecom that has done very well and recently reached profitability. I will sell these when I think future gains don't look promising. I may buy new single stock investments when I see opportunities.

Weak Economy, Low Inflation, Record Low Bond Yields?

John Mauldin forwarded his subscribers (subscription is free) an interesting article by Hoisington and Hunt today. They point to low inflation and low growth this year rather than an outright recession but also what they describe as "record low bond yields". A continuing fall in interest rates has been one of my themes for a long time and the reason I hold so many bonds (in mutual funds). Falling interest rates mean rising bond values. Periods like this are when bonds perform well and tend to outperform stocks if the reason for falling rates is economic weakness.

Monday, January 08, 2007

Annual Report 2006: Part III

The following table compares my rates of return on investment to the MSCI World Index and the S&P 500 Total Return Index:

Both those indices include reinvested dividends and in the former case tax credits too. The MSCI World Index covers all countries indexed by MSCI is expressed in US Dollars. I consider the MSCI index the benchmark I measure my performance against. This post has a chart comparing my USD Total Asset Return to the MSCI World Index.

Anyway, getting back to the table - it is divided into four sections:

  • The first two columns of figures only cover non-retirement assets. I give the return in Australian Dollar and US Dollar terms. The latter look a lot better due to the rise in the Australian dollar from 2001. The returns are the total gain over the relevant period - not annualized rates of return.

  • The next two columns also include retirement accounts. In the long-term these returns are a lot better with a 123% gain over ten years but are poorer for 2006 itself. Recently, my retirement accounts have been invested more conservatively than non-retirement accounts. In earlier years this wasn't the case and I chose some very successful funds including Colonial First State's Geared Share Fund.

  • Columns 5 and 6 present the same data for the two stock indices. Over 1, 2, 3, and 5 years the MSCI has outperformed the S&P 500. I have just about matched the S&P 500 over 10 years and outperformed it on all the shorter horizons. I outperformed the MSCI over 3, 5, and 10 years but not over 1 or 2 years. My 2005 rate of return was particularly low.

  • The final three columns give the same information in terms of annual rates of return. This shows that my rates of return have been extremely strong over 3 and 5 years. The S&P 500 performed poorly over the 5 year horizon. The fall in the US Dollar is one reason that both I and the MSCI outperformed the S&P 500 - foreign stock markets have also performed better in terms of local currencies during this period. So are my returns just luck? I could have moved all my non-retirement assets to the US in 2002 when I moved here from Australia. I deliberately chose not to do so. I also chose to invest most of my Australian retirement account in Australian shares rather than other alternatives. These were deliberate choices based on my view of the value of the currencies. I now see the Euro, Pound, and Aussie Dollar as fully valued and so will focus on accumulating US Dollars. Only time will tell if I am right.
  • Sold Telecom NZ

    I sold all my shares in Telecom NZ. I've owned this stock since 2000 when they took over AAPT - an Australian telecom start-up which I bought at the IPO. I've bought in and out over time, so this final sale registered a loss for tax purposes. The stock fell sharply in mid-2006 after the New Zealand government tightened the regulatory regime to encourage more competition. The stock price has recovered since then, but the high dividend yield has been cut and the company is struggling to gain traction IMO. Neither the company nor analysts are forecasting any earnings growth. The five analysts who track the company each have a different opinion ranging from strong buy to strong sell! The bottom line was I asked myself if this investment will return more than the margin loan interest I am paying to maintain it and my answer was no. I hold very few individual stocks of non-financial companies. After selling this, my remaining such investments are: Powertel, Ansell, Symbion, and Croesus Mining. I don't believe I have any edge in choosing these investments. But, occasionally there are situations which look favorable to me and turn out well and sometimes very badly.

    Annual Report 2006: Part II

    A focus of many who seek financial independence is building passive income. Payments that come without you having to do any work for them. My passive income in dividends, interest, and mutual fund distributions was about $13,000. Short-term capital gains from trading - which isn't passive income - generated about $6,000, but I spent about $4,000 on investment interest (mostly margin interest). If I wanted to maxmimize capital appreciation I could gear up a lot more and have the cash-flow to cover the interest payments. I've really been very conservative in this regard, though the vast majority of investors in the stock market do not borrow to invest at all. On the other hand, margin loan rates I am paying are actually very expensive relative to other sources of leverage (futures, options, levered mutual funds). Taxwise, in the US it is optimal to not exceed the sum of short-term capital gains, interest, and US non-qualified dividends in margin interest payments. For example, if tax is with-held on foreign dividends you can't claim it as a foreign tax credit and simultaneously deduct margin interest against the income. The built-in interest component of futures, options, and levered mutual funds is at a much lower rate - close to the risk-free rate - than most brokers lend at to small accounts.

    Again, I need to at least double the combination of passive income and short-term active trading gains. The cash flow would then cover my expenses and price appreciation (this year around $20,000) would more than cover the effects of inflation in eroding the value of my taxable accounts. Given that my retirement accounts would continue to grow undisturbed, running down the value of the taxable accounts a little wouldn't really be a problem, but it is better to have rising rather than falling income!

    Sunday, January 07, 2007

    Annual Report 2006: Part I

    This is my first annual report. I covered some basics a few days ago. Here are the more or less final numbers for income, expenditure, and saving:

    The format is the same as my usual monthly reports. Current income is actual cash received from salary, tax refunds, and other sources including inheritance. Retirement other income is total employer and employee retirement contributions to my 403(b). I note the transfer of money from current savings to my Roth IRA account separately. Total retirement contributions were, therefore, $15,432. Total income and realized and unrealized investment gains summed to $53,429. About 2/3 of the gains were in non-retirement accounts which have been more aggressively invested on the whole. About a quarter of the US Dollar gain was due to the rise in the Australian Dollar ($12,092).

    It is exciting to see investment gains begin to rival income from employment and exceed saving from current other income and retirement contributions that totalled $42,430. Current investment income ($34,728) exceeded spending ($25,676). There is no guarantee that this will continue in the future. But as assets increase the chances are higher that it will. Investment returns on current accounts for this year are close to long-run expectations based on an alpha-beta analysis. I would like to double this income stream - so that it would be close to my current pre-tax salary - before quitting my current job and looking to make a living from trading and investing. If I can achieve the same rate of return this year I would yield $50k in current investment income.

    Net worth grew by $94,675 with about 2/3 of the gain in non-retirement accounts. This imbalance is an additional factor that lead me to start maxing-out my 403(b) contributions.

    Changing Distribution Method

    I've decided to stop reinvesting the distributions from my non-retirement Australian mutual funds managed by Colonial First State and receive cash distributions instead. These funds constitute 35% of my net worth. The reasons for this decision are as follows:

    1. After maxing out my 403(b) contributions investable cash flow from salary is much reduced. Last year these funds distributed $A13,200 (USD 10,400). This cash will largely replace the funds now diverted to my 403(b). Cash is needed to take advantage of emerging investment opportunities and from 2008 onwards I will probably need cash to make tax payments - up till now salary with-holding has been sufficient. This year I will exhaust carried forward capital losses.

    2. Tax is payable whether a cash payout is received or not. So using this money to invest in new investments is more tax efficient than selling existing investments.

    3. There is no discount for reinvesting the distributions and no load for new fund investments so no actual costs to this choice.

    4. The Australian Dollar is currently strong and the US Dollar weak. I want to increase US Dollar investments. I can easily transfer this money back to the US for investment. In fact, that is what I plan to do. Up till now I have been using Australian dividends received to reduce my margin loan with Commonwealth Securities.

    I need to send my request in writing. The next distribution is at the end of March - some funds have quarterly and some half-yearly distributions. I am still reinvesting my dividends from Telecom New Zealand and distributions from Everest Brown and Babcock, the TFS Market Neutral Fund and the Hussman Strategic Growth Fund. My other Australian investments do not allow dividend reinvestment by foreign investors. I'm not planning on changing these instructions at the moment.

    December Report

    Got back Friday from a long trip to Vermont and am getting up to speed - the coming week will be spent mainly on preparations for teaching the next semester. Good news is that Thursday I got an e-mail from my lawyer that she has received the documents to go to the next stage in my green card application - the actual application for the visa itself. The process started in 2003 and looks like being finally concluded this year. With a green card I will have much more freedom of employment and location than I do now as an H1-B holder.

    Income and Expenditure

    The monthly report for February explained the basic layout of these monthly statements. This month there is a new line for "tax credits". The current (non-retirement) investment returns are reported on a pre-tax basis. Part of the total return on investment includes foreign (mainly Australian taxes) paid on dividends. I get to claim these back on my annual US tax return. The "current other income" includes my net tax refunds (this category is mainly salary). If it wasn't for these credits my reported "other income" would be lower as my tax bill would be higher. Up till now I have been doing a kind of double-counting on these reports and slightly exaggerating my actual saving and income. For the moment I've chosen to compute saving by deducting both expenditure and tax credits from total income. I guess I should report all income on a pre-tax basis and then include a line for taxes. This would mean changing my accounting systems to actually record gross income monthly and then include stuff like health insurance in spending. At the moment my reported salary figures are take home pay after all deductions. So my expenditure is also somewhat under-reported too I guess...

    Anyway, getting to this months results:

    Expenditure was $US2,092 - $500 more than last month partly due to travel and spending on my trip to visit my girlfriend in Vermont - 64% of take home pay ($3,290) which is much reduced due to maxing out my 403(b) contributions from this month forward. Only one of my two new higher retirement contributions posted to my account and so expect to see retirement contributions ($1,180) higher next month. Non-retirement invesment returns were very strong this month ($6,564) and were the most significant factor in increasing net worth by $10,149.

    Net Worth Performance

    Net worth rose by $US10,149 to $US364,714 and in Australian Dollars gained $A13,322 to $A462,366. A net worth of half a million Aussie Dollars is now clearly in sight but one never knows what fluctuations could occur on the way there...

    Investment Performance
    Investment return in US Dollars was 2.21% vs. a 2.26% gain in the MSCI World Index, which I use as my overall benchmark and a 1.40% gain in the S&P 500. Non-retirement accounts gained 3.51%. The contributions of the different investments and trades is as follows:

    The returns on all the individual investments are net of foreign exchange movements. Foreign currency losses appears at the bottom of the table together with the sum of all other investment income and expenses - mainly margin interest. Powertel again had one of the best percentage gains. The Everest Brown and Babcock entry covers returns on a listed fund of hedge funds and the management company itself which are both listed on the Australian Stock Exchange.

    Asset Allocation
    At the end of the month the portfolio had a beta of 0.90. 58% of the portfolio was in stocks, 45% in bonds, 7% in cash, and loans totalled -21%. The remainder was in the hedge fund type and real estate investments, futures value etc.

    Monday, January 01, 2007

    Accounts Restatement

    As I am tidying up my accounting spreadsheets for the end of 2006 I am also fixing some issues from the last several years. The major issue was loans I made to friends in 2002-3 which I then cancelled in July 2004. I have now restated the loan payments to those friends as consumption expenditure for those periods. This results in lower net worth and higher expenditure in the 2002-4 period but also higher estimated investment returns as a given investment return is now attributed to a smaller capital base. I've gone back and updated all my NetWorthIQ entries. The following chart shows the MSCI World Index vs. an equivalent index for my own investment portfolio over the last decade:

    Initially I was conservative and underperformed the index and then in recent years have generally outperformed the index - catching up to the MSCI index and then tracking it more or less. This pattern is also shown in the next chart which displays estimates of the alpha and beta of my portfolio over the last several years:

    Each alpha and beta pair is estimated on 3 years of monthly returns data. Generally, my alpha - my excess risk-adjusted return - has tracked upwards. In earlier years I subtracted value while in recent years I have added 10-24% return above the market rate of return while taking relative risk into account. The linear regression line tracks this learning curve.

    The final picture shows rolling twelve month totals for earning (salary etc. plus all investment returns on non-retirement and retirement accounts) and spending for the last 17 years:

    The main feature is the lack of correlation between my earning and spending. I don't spend a lot more now than I did when I was a graduate student in 1990-93. And, these data are NOT adjusted for inflation. I spent much more than I earned in that period. The two big bumps in the spending profile are the periods when I moved to Australia from the US (1996) and then back to the US (2002). From October 2001 to August 2002 I was dependent on investment returns which at first were positive and then very negative. This combined with rising expenditure - including two round the world trips in three months in January and March 2002 resulted in the big fall in net worth in that period.