Tuesday, September 25, 2018

Internal Rate of Return and Private Equity

Private equity funds like to report the returns on their investment using the internal rate of return metric. The IRR is the discount rate which results in the net present value of the stream of cashflows from the investment being zero. This article points out that it is only the true compound rate of return if you can reinvest the payouts that you receive over time at the same rate of return (r.o.r.). This is correct. But it then goes on to say that IRR is meaningless if you can't reinvest the distributions at the same r.o.r. I don't think that is right. If the IRR is higher than the r.o.r. that you can invest the distributions at, then your r.o.r. from investing in the private equity investment and reinvesting your distributions is greater than the r.o.r. you'll receive by just investing in your alternative investment (and vice versa). Your actual r.o.r. won't be as high as the IRR but the IRR is still useful for making decisions. The main issue is that you need to deduct the funds fees to get the true IRR. Often they will report that they made a $1 million investment and sold for $2 million and give the IRR without deducting fees. Probably as a back of the envelope calculation you could deduct 1/4 of the stated IRR in these cases and then compare to your alternative r.o.r.

So, for example, in Aura's latest report to investors they reported IRR's to date on two investments of 59.5% and 29.2%. So, yes, these are very good. Of course, those are the investments whose carrying values they are marking up. They report a 21.3% IRR on an investment they are exiting. But then there are others that are just breaking even.

Firetrail IPO

Another hedge fund IPO in the coming month. This one is also managed by Commonwealth Securities and so I could participate via the broker firm offer. It is a market neutral hedge fund that can lever up to 200% of NAV in both the long and short sides. The investment team used to work at Macquarie where they got decent returns (22.1% p.a. from July 2015 to October 2017). I'm not so impressed by their performance this year since starting up on their own:

This is not the sign of a high Sharpe ratio investment – it seems there is a lot of risk in this investment relative to the returns. I think this is a fund that is worth tracking over time and seeing if it settles down and performs better. Based on the above, I don't think the shares will trade above the offer price immediately after the IPO, though that is just a guess.

Sunday, September 23, 2018

2017-18 Taxes

Here are my taxes for another year:

A lot of items are down on last year. Foreign source income and unfranked distributions are up because the Winton Global Alpha Fund did well in this tax year. This also means that a chunk of the margin interest is directed to foreign source income and appears under "other deductions". Another new item this year is the Early Stage Venture Capital Limited Partnership offset due to my invest in the Aura Venture Capital Fund. Work-related travel expenses are up because the grants and other funding I had are winding down and so I need to spend more of my own money on travelling to conferences etc.

Franking credits (from Australian dividends), foreign tax paid, and the ESVCLP offset are all deducted from gross tax to arrive at the tax assessment. I expect to get a large refund.

Gross cash income deducts franking credits as these aren't paid out as cash and adds in net capital gains, which were around $60k to income before deductions. Net after tax cash income then deducts tax and deductions from gross cash income.

Looking forward to next year, net capital gains will likely become positive as I won't have any more past losses to deduct. Foreign source income will likely grow further as futures trading comes in.

Moominmama's (formerly Snork Maiden) taxes follow:

Salary was up as Moominmama came off maternity leave. Work related travel expenses were also up as she also went to one of the conferences in Europe. Still, we expect to pay extra tax. Next year there should be more in the way of investment deductions following our mortgage restructuring. There will also probably be a lot more foreign source income.

Saturday, September 22, 2018

Longer Term Planning

I was rejected for the two jobs I recent applied for. One in Australia after interview and one in the UK pre-interview. So, it looks like we stay in Australia in this city for the moment. It also looks like I will continue in my job next year, but I am seriously thinking about "retiring" at the end of 2019 when I will be 55.

Hopefully, the probate situation is finalized before the end of this year and we can start to restructure our finances. This is what I am thinking to do:

1. We will need to set up a trust account or something less formal for little Moomin for the relatively small amount of money he will inherit. Need to wait to hear what we need to do. According to the will, he won't get the money till he's 23 years old...

2. Almost pay off our mortgage and then redraw it and use it to pay off margin debt and add to a trading account. We can then deduct the mortgage interest from our taxes and it is a lower interest rate than the current margin loan.

3. Set up a self-managed superannuation fund (SMSF) and roll my existing Colonial First State superannuation fund into it as well as contributing AUD 300k for each of me and Moominmama. This would then have about AUD 900k to start with. The reason to go down the road of self-managed super is to be able to invest in managed futures, which are a tax ineffective investment outside super. We would put all our high tax investments into the fund as well as some Australian shares with franking credits to reduce the tax.

4. Scale trading up to full size. At the moment, I am thinking we will need to set up a company for trading. Corporation tax on small businesses is 27.5% vs. top personal marginal rates of 47% +.* My understanding is that you don't need to pay out all profits as dividends and so retained earnings are more lightly taxed. But I will need advice on this. It would also protect the rest of our assets against something catastrophic happening. The company could also be the trustee for the superannuation fund, which would allow us to maintain the SMSF if we left Australia.** These are just my current understandings – obviously I am going to need to get professional advice on all of this.

5. Estate planning. Currently we don't even have wills. This is an area I know little about but will need to deal with. What I want to avoid is the situation we faced with my mother where the government dictated investment policy to us after she wasn't capable of making decisions - despite giving us power of attorney.

* The downside of companies is that they don't get a capital gains tax discount. Individual investors in Australia only pay half the marginal rate on capital gains on investments held for more than a year. But the advantage of only paying 27.5 or 30% tax on trading income rather than 47% tax before investing it in other investments outweighs the discount. If Labor reduce the discount, this will be even more the case.

** You can't be the trustee of an SMSF if you aren't resident in Australia. Using a corporate trustee gets around that. There is a problem in leaving Australia and receiving income through an Australian company as it means we would suffer from double taxation. In Australia, dividends from the company would have attached franking credits so that we would only need to pay the difference between 27.5% and 47% on dividends. But if you live outside Australia in a location where you need to pay tax on foreign income (obviously one reason to move might be to reduce tax...) then we would need to pay the foreign tax on top of the Australian company tax. Investments already inside the company are invested in Australian stocks that pay franked dividends, then the franking credits on the dividends received would mean that the company wouldn't pay net tax on its investment income, so that won't be double taxed if we moved overseas. But trading income would be taxed at 27.5% and then again if paid out as dividends. So, we would need to do a restructure in the most tax-effective way at that point. In an earlier version of this post, I did think about having the company being the beneficiary of a discretionary trust that actually did the trading and then just changing the flow of income. But the trustee of the fund has to pay tax for offshore beneficiaries. So, that doesn't help.

Wednesday, September 19, 2018

Mean Reversion vs. Momentum Strategies

This is an interesting interview. About half way through he makes a deep point that if you use an oscillator type indicator and sell it when it is overbought and buy when it is oversold that is a mean reversion strategy. If you do the opposite - buying when overbought and selling when oversold then it is a momentum strategy. And those are really the only two options for directional trading using such indicators. Well, he also says that 95% of assets follow a random walk and can't be predicted. My system basically tells me when to switch between momentum and mean reversion. For me there isn't really something that is not predictable though when volatility is low predictability goes down.

Monday, September 17, 2018

How Many Households in Australia are Rich?

Every couple of years the Australian Bureau of Statistics surveys the distribution of household wealth in Australia. The most recent data is from the 2015-16 survey. It doesn't provide a lot of detail though. The downloadable data provides the averages for quintiles and the level at the top of each decile. They report that net worth at the 90th percentile is $1.979 million.

We can get more information by using the reported mean and the Gini coefficients and assuming that the data follow a log-normal distribution. You can get details of the necessary calculation here - use Wolfram Alpha to get the inverse of the erf function.

The distribution fits well for the 30th (ABS: $232k, lognormal: $240k) to 90th percentiles (ABS: $1.979 mil, lognormal: $2.1 mil). Below the 30th percentile the lognormal predicts too much wealth, while right at the top it would predict at most one billionaire in Australia. But I think we could use it up to the 99th percentile without too much error. The top 5% starts at $3.26 million, 4% at $3.7 mil, 3% at $4.3 mil, 2% at $5.3 mil, and 1% at $7.4 mil. All these numbers will be a bit higher now, of course. The most recent figure for mean household net worth is over $1 million rather than $929k here.

The ATO regards anyone controlling more than $5 million as wealthy, so that is the top 2 to 2.5% (with current mean net worth). To be a wholesale investor you need individually $2.5 million of net assets. So assuming a couple have $5 million, that also is the top 2.5%. So, the top 2.5% in Australia are considered "rich". That is roughly 250,000 households.

In 2015-16 we were at the 16th percentile.

If You Follow This Advice You Won't Be Able to Buy a House

If you follow this advice from Ramit Sethi, you won't have any money to buy a house or start a business, unless you have a lot left over after doing all these things. The image that accompanies the article is very apt:

If you follow this advice you will be locking all your time away in the piggy bank until you are 59 1/2 (or 60 in Australia). I think I should start writing my own financial advice:

The first step is the same - if your employer requires you to match to their retirement contributions in order to receive it, do it. In Australia that isn't normal, but in some jobs in the public sector there can be additional tax advantaged employee contributions on top of the employer contributions. I would suggest skipping those until you do my step two unless it really reduces the retirement benefits you will get.

Step two is also paying down debt, but only on high interest loans like credit cards. If you have debt where the after tax interest rate is lower than the after tax expected return on investment, pay those off as slowly as you can. So yes, get rid of credit card debt ASAP, but student loans and home mortgages are usually debt you don't want to get rid of in a hurry. Taking on a moderate about of extra debt if the rate is good (as in leveraged managed funds or even margin loans) can be good, but don't overdo it.

Step three is the "emergency fund" or equivalent. Get some cash together to cover emergencies and opportunities. Having the ability to borrow more is good too of course, but don't just rely on that. I had about $20k in cash before I started to invest. As that is 20 years ago, you probably should double that number now.

Step four is probably investing outside of retirement accounts. This means your money isn't locked up till you retire. The supposedly lower tax of retirement accounts comes at a heavy price. With low long-term capital gains tax and reduced rates on dividends (especially in Australia) the tax on non-retirement accounts may be not much higher than on retirement accounts in Aus (and you can make bigger contributions later in Aus as I am now contemplating when you have plenty of money). US 401ks are taxed heavily on withdrawal in retirement though they have no tax during accumulation. The US Roth IRA though is an attractive investment as it leaves options more open.

Step five - if house prices are reasonable relative to rents in your area and you aren't planning on moving a lot, once you have more than enough for a downpayment, buying a house is probably a good move. But do a proper cost benefit analysis of this.

Step six - once you have done these and if you aren't thinking of getting into business, now you can look at maxing out retirement accounts.

I didn't mention trading - unless you have a proven model and want to pursue this as a real business you can do this as a hobby alongside Step 6. Most traders lose money though, so it is definitely an expensive hobby for them.

Mercantile's Bidder Statement Provides No Rationale for 9 Cent Offer Price

Mercantile (MVT.AX) released a bidder statement for Yellow Brick Road (YBR.AX) which provides no justification whatsoever for the 9 cent per share offer price. I think that is quite remarkable. Normally, such statements provide a detailed justification from "independent experts" for the price. Mercantile's bidder's statement for IPE did. YBR shares are currently trading at 10.5 to 11 cents.

Wednesday, September 05, 2018

August 2018 Report

The Australian Dollar fell from USD 0.7432 to USD 0.7201. The MSCI World Index rose 0.83% and the S&P 500 rose 3.26%. The ASX 200 rose 1.76%. All these are total returns including dividends. We gained 2.04% in Australian Dollar terms and -1.13% in US Dollar terms. So, we  outperformed the Australian market and underperformed international markets.

The best performing investment in dollar terms was CFS Geared Share Fund gaining AUD 9.2k  followed by Unisuper (CDM.AX) gaining AUD 6.9k and Bluesky Alternatives (BAF.AX), gaining AUD 4.5k. The best performing asset class was "real estate", gaining 2.45% followed by US stocks, gaining 2.28%. The worst performing asset class was hedge funds, gaining 0.26%.

The following is table of investment performance statistics computed over the last 60 months (extended from 36 months previously) of data:

The first two rows gives the annual rate of return and Sharpe ratio for our investment performance in US dollars and Australian dollars. The other statistics are in comparison to the two indices. Based on beta, compared to the MSCI World Index we seem to be slightly geared, while compared to the Australian index we are less sensitive to market movements. We have a slightly positive alpha compared to the Australian and a negative beta compared to world markets. Finally, we now capture more of the up movements and less of the down movements in the Australian market and the reverse in the international markets. The fall in the Australian Dollar over this period explains the poor performance compared to international benchmarks.

This month I only made a relatively small amount of money trading futures – USD 1.8k – though this is the second best performance so far in dollar terms. The table * compares my performance to the market and the model:

This month was the fifth month of the futures trading experiment. The first month was the model development phase, and since then I have been trying to get disciplined at trading and further incrementally improve the model. August was rather erratic. At one point I was up AUD 11k over the amount originally put into this trading account and then blew almost all of it in a mixture of bad model trades and bad trading in and out of positions. One of the bad model trades would now not happen, due to improvement of the model, so I have learned something from this experience. In the early part of the month I was trading two NQ contracts. After the bad trading I cut it back down to one contract again. So we are back in Stage 2 of the trading experiment, which is learning to consistently trade one contract. I am only doing long trades for the moment, due to the reduced volatility at the moment. Still, I unnecessarily sacrificed about USD 1,500 by closing a long position early. The model slightly underperformed the market this month. The same thing happened in May when the market had a very strong result. The model is bearish and under-performs when the market is strong and outperforms when the market is weak.

We reversed progress towards the new long-run asset allocation:

Total leverage includes borrowing inside leveraged (geared) mutual (managed) funds. The allocation is according to total assets including the true exposure in leveraged funds.

The deterioration in allocation, came mostly due to investment activity. We invest AUD 2k monthly in a set of managed funds, and there are also retirement contributions. Then there are distributions from funds and dividends. During the month, I also:
    • I added another AUD 10k to the Winton Global Alpha fund, but withdrew AUD 50k from the trading account, for a net reduction in the allocation to commodities.
    • I received the payment for the takeover of IPE but bought some more shares in OCP.AX, overall reducing the allocation to private equity.
    • Added to positions in PMC.AX and CDM.AX, increasing the allocation to hedge funds. 
    • I added a small position in Yellow Brick Road (YBR.AX), increasing the allocation to Australian small cap stocks.
    * The statistics at the bottom of the table are based on only 5 months of data and so are not at all reliable yet.