Delevering

I just made a big switch in my Colonial First State superannuation account to reduce risk. Stock markets still look bullish but the Fed shows no sign of stopping raising interest rates, risking an inversion of the yield curve. They have been saying that this time is different and that an inverted yield curve doesn't mean that there will be a recession. But though the sample size is very small, it has been a good predictor in the past. We are not yet at yield curve inversion but it still could make sense to reduce risk. My CFS superannuation account has been invested very aggressively. At the end of September this was the allocation:

CFS Geared Share Fund: 48.9%
CFS Geared Growth Plus: 20.2%
CFS Conservative: 10.2%
Platinum International: 10.2%
CFS Developing Companies: 10.5%

So about 70% was in geared (leveraged) funds. Geared Share Fund is large cap Australian shares. Geared Growth is diversified. The new allocation, which is much closer to our new long-term allocation is:

CFS Geared Share Fund: 15%
CFS Geared Growth Plus: 18%
CFS Conservative: 4%
Platinum International: 23%
CFS Developing Companies: 20%
Generation Global Share: 20%

Both Platinum, which is a hedge fund (long and short global equities) and Generation performed well in the Great Recession. Doing this transaction in a superannuation account is tax free - capital gains tax of 10% is paid on unrealised gains on a continuous basis. There is just the cost of the entry/exit spreads.

I changed the allocation for new investments in Moominmama's CFS account, which is not a superannuation account to only buy the non-geared funds going forward. If things look more bearish, we may yet do a switch there too.

September 2018 Report

The Australian Dollar rose from USD  0.7201 to USD 0.7228. The MSCI World Index rose 0.48% and the S&P 500 rose 0.57%. The ASX 200 fell 1.04%. All these are total returns including dividends. We lost 0.63% in Australian Dollar terms and 0.26% in US Dollar terms. So, we  outperformed the Australian market and underperformed international markets.


The best performing investment in dollar terms was NASDAQ futures gaining AUD 2.6k –  and the worst the CFS Geared Share Fund losing AUD 10.7k. The best performing asset class was private equity, gaining 1.28% followed by commodities (this includes trading), gaining 1.22%. The worst performing asset class was Australian large cap, losing 1.57%.


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 positive alpha compared to the Australian and a negative alpha compared to world markets. We 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 made USD 2.5k trading futures. This is the second best result to date and ocurred as the NDX declined for the month. The table * compares my performance to the market and the model:



This month was the sixth 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 improving the model. I didn't trade in the first half of the month as I was traveling to Europe and Singapore and the model was short and based on relatively low volatility I thought the profit potential was low. This was a mistake as the model did very well. Then when I got back into trading we were in a corrective phase with the market trading sideways. I traded long NQ short ES for the last few days of the month. The model outperformed the market this month, though its return was not that high. The model is bearish and under-performs when the market is strong and outperforms when the market is weak. It got stopped out a couple of times, which is unusual. As a result the model made 4 trades in 4 days. The second time the model was stopped out, the market ended up on the day and so the stop was too tight. The first time, the stop reduced losses.

What I want to do next on the trading front is write the model's decision algorithm in computer code. At the moment I estimate the indicators I use with an econometric model but I then make decisions manually and record the details in an Excel spreadsheet. It is quite quick to do to make daily decisions in a single market but it is quite hard to do backtesting of different ideas. This will be much easier once we have the decision algorithm coded in the same program as the estimation model. Also, in the long run I plan to automate trading or at least automate data acquisition and decision making for multiple markets. Coding the model in the language of my econometrics program is a first step towards that. Once the model is written in one computer language, converting it to another shouldn't be hard.

I did our tax returns this month. I should get a big refund and Moominmama had to pay a little under AUD 1,000 in extra tax. Otherwise, I am waiting for the probate process to play out before undergoing a big round of financial restructuring.


We made a little bit of 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.

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. Major moves tbis month:

• I redeemed the Janus-Henderson Global Resources Fund, which reduced exposure to ROW stocks.
• I reduced cash and the margin loan in preparation for investing in the Tribeca IPO. As a result our allocation to hedge funds will increase substantially next month. 
• I added to the Yellow Brick Road position which is now about 1% of net worth.

* The statistics at the bottom of the table are based on only 5 months of data and so are not at all reliable yet.
    

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.

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.

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.