A financial planners investment strategy

Hi guys,

Often clients ask me what's my strategy and I just can't tell them. Why? well its difficult to explain and frankly my dealer group will not let me reccommend the product, so why bother.

so I thought I share it here, as I'm interested to know what other advisors/investors think of its merrits.

Its one of the few investment strategies (and not widely known) thats positively geared from day one...

My strategy is essentially writing rolling covered call options over low volatile stocks. Essentially I write over just one and thats the streetTRACKS S&P/ASX 200 Fund or STW.

I use the Macquarie Hi-Notes facility as this is the lowest cost option for sums I have invested and is quite simple to use.

Tailored Equity Soluions - Macquarie Hi-Notes

how it works is as follows:

1. select an ASX 200 share or STW.
2. Select a term you wish to invest 30, 60 or 180 days.
3. Select the opening level 80% - 100%
4. Macquarie will give you a quote for the value of the option you are selling or check the rate sheet hinotes_interest_rates.pdf
5. At the end of the term there are 2 possible outcomes.

The first:
If the share price of the underlying investment i.e. BHP, STW, ANZ, CBA is > opening level(%) x initial share price($) you get your initial investment back + the option premium.

the second:
If the share price of the underlying investment i.e. BHP, STW, ANZ, CBA is < opening level x initial share price you get the value of the underlying investment (in $ or shares) + the option premium.


so for example using the rates sheet say you purchase $100,000 of the STW hi-note for 90 days at an opening level of 100%. the premium on this is 26.82% pa. and for arguments sake the value of STW is currently $55.80


Scenario 1 STW goes from $55.80 to $56.00 after 90 days:

in this scenario you get back your $100K + $6,705 (90/360 x 26.82% x $100K)


Senario 1 STW goes from $55.80 to $55.00 after 90 days:

in this scenario you get back $98,566K + $6,705 (90/360 x 26.82% x $100K)


The way the premium is roughly calculated is as follows:

- the shorter the term the higher the interest rate.
- The greater the chance the underlying investment will fall in value the higher the interest rate.
- The higher the opening level the higher the interest rate.


Tips on this strategy are:
- Don't chase the high interest rates, they are high for a reason.
- Choose low volitile stocks
- if your underlying investment falls in value take the proceeds in cash not shares and reinvest. (better tax treatment for a loss)
- don't invest in stocks that have high growth potential as your better off just owning these shares outright. (Trust me on this, Damn you BHP & WPL!)


A little about Macquarie Hi-Notes:

Fees - Nil (but MQ makes money from you, trust me)
entry / exit fees - Nil
Advisor fees - Nil if you don't have one & 0.5% per trade if you do.
Minimum investment $20,000 per Hi-Note

Other things to note:

this strategy limits your upside but reduces your losses. So at the start of each period you will know the maximum profit of your investment which is equal to premium you will be paid. So if your underlying investment doubles, you won't see any of that growth, you'll only get your money back and the premium.

This strategy I believe is lower risk than owning shares but can provide a superior return. If you can average a compond return of 25%pa - 30%pa per month over the long you will be doing pretty bloody good!

It's a gold mine these HI-Notes and they are not very well know either.

 

Thanks for that..

Can you do a worked example of what would happen with a volatile stock, if it dropped by >10% and another if it went up by >10%. Does the time frame matter much, how would the example look if you choose 30 day term rather than 90.

What's a worst case scenario for example?

 

Hi Young Gun,

How did this go from October 07 to March 08?

Cheers,

Dan

 

It does look like gambling (or trading if you prefer).

The upside seems to be limited to the interest they will pay you ( based on the term and the % level that you are investing at (100% assumes that there is no drop in value of the underlying stock and therefore they will pay you a higher interest rate, if you choose 80% then the stock can drop 20% and you will still get your deposit back plus interest, but they offer lower interest))

The downside seems to be if stock drops more than 100 - the level you chose, then you make a capitol loss. You still get the interest though, which may be enough to cover a higher % drop.

Perhaps technical analysts will have the skill to more accurately pick where a stock will be in 30,90, or 180 days time, but I'm pretty sure thats a skill I dont have as yet.

It looks like risky proposition especially if I was to use borrowed money (eg from a LOC)

 

"It does look like gambling (or trading if you prefer)"


My friend, there is a BIG difference between gambling and trading.

 

probably not if I was doing it

 

This looks very much like a covered call strategy. What is the advantage of doing this though Macquarie instead of directly on the ASX? The returns look similar.

 

I'll try and answer every question at once.

- This strategy should be compared to an odinary investment in shares when you do an analysis. so when looking at this if your happy to invest in XYZ this strategy should suit. becuase if you were happy to invest in BHP and it fell 10% over 90 days, you be happy to this strategy as you end up when the same cash equivilent but you also get the bonus interest. you just miss out if BHP goes up 10%.

- a 10% fall would mean your assets drop by 10% less the interest you receive. a rise by 10% means you miss out that 10% growth & just get the interest.

- This strategy limits your upside to the interest you recieve but lowers your downside risk. This strategy is less risky than owning shares (provided you know what your doing)

-This strategy works best over a stock that is slowly rising, falling or staying the same.

- If you had invested 100K in this strategy at the beggining of Oct 07 you would still have lost money by the end of march. however you would have lost less than if you just held the investment. For example $100K of STW bought back then would at the end of march be worth $87,600 vs this strategy at $95K.

- you can set this up to be a passive investment, by doing nothing your investment & the income you receive just get reinvested.

- this is not gambling this is just extracting a high income out of an asset.

- this is a covered call strategy, why do it through Macq rather than directly? well directly, the minimum contract size is 1,000 shares. so to sell one contract of STW the minimum is $55,000. so if you wanted to add extra choices you need a large amount of funds to get the diversification. i.e IPL at $173 per share equates to $173,000 for one contract. I have no problems with going direct but this allows you to reinvest easier (you may have $55,000 to buy 1 contact but you cannot reinvest the interest until you have another $55,000).

 

Young Gun, thanks for bringing this to our attention.
So for someone like myself, who's long term strategy involved accumulating an index tracking share such as STW, this strategy could allow me to dollar cost average into the share whilst collecting some bonus interest along the way?
ie if the price of the share were to drop below the deal price I could then choose to hang onto the shares and then transfer them over to my margin lender for inclusion in my margined portfolio, correct?
However if the price were to end the period above the deal price, I then take the bonus interest in addition to my original capital and reinvest the lot for another period.
So in theory, if one were to have 100k invested for the full year, gaining 26800 interest in your example, then the share price would need to decline 27% before you actually made a loss (disregarding opportunity costs on the capital).
Please let me know if I am understanding it correctly.
One final question, if you were to select say the 80% level at outset, the share price declined over the period, but you decide to hang onto the shares rather than take a capital loss, how many shares do you end up with? 80% of the original amount?
Thanks very much

 

This is all well over my head.

Do you think this strategy would be any good for someone with a limited amount of funds. Let's say I could only meet the minimum requirement ($20,000 I think you said). Do you think this would still be an effective strategy?

Sounds interesting.
Almost sounds too good to be true, and you know what they say about that...
(I wont pretend I really understood what you were explaining though).

 

your are 100% correct on the first part. this product is actually market to clients as a way to generate income while they wait to invest.

on the loss part, you sort of right. if the market experiences 12 months of equal declines, it would have to fall greater than 27% for you to lose money. however if it lost 50% in the first month, gained 23% the next month you would be worse off than if had just held the shares normally. ($100,000 - $50,000(loss) + $2,500(income) = $52,000, then $52,000 + 0 (capital gain) + $1,300 = $53,300 vs $83,000 if you held the shares normally). This is why the strategy only works well on low volatile stocks like STW. In circumstances like the above you would elect to take shares rather than the cash and reinvest.

however the tax treatment of a loss using this strategy is different than owning a share. A loss on an ordinary share is a capital loss and can only be offset against future capital gains. A loss using Hinotes is treated as a loss of taxable income therefore you would get a 100% tax deduction on the loss at your MTR.

on the last part if you invested at 80%(of the current share price) and at the end of the month the shares went down. you could elect to take the share equivilent had you bought the shares 30 days ago at 100% of the price. ( so you get 100% of the shares at 100% of the price you would have paid 3 days ago).

 

Can you explain this a little further? I haven't seen the PDS - MQ haven't sent it yet - but how can a loss be treated a loss of taxable income? It isn't a deductible expense and isn't a CGT issue, so I don't quite understand....

Makes as much sense to me as being able to write off pokie/gambling losses as loss of taxable income.

 

you'll be waiting a while for that PDS, Macquarie couldn't send you one to save their lives! call them directly and have one posted to you.

the tax treatment for this is different as your essentially trading options. i.e. all the income you generate is taxable and all the losses are tax deductible. Its in the PDS. have a look when it eventually arrives.