Bonds Versus Shares .... Which Is The Right Option For The Investor?

Should you be investing in bonds or shares? That’s a tough question to mull over.  Let’s take a look at both financial instruments.

Bonds are supposedly less risky to invest compared to shares. This is so because in the unfortunate event of business insolvency/bankruptcy, the bond holder (investor in bonds) comes ahead of the equity shareholders in terms of payouts should the entity be made insolvent. On the other hand, the equity investor is last in line to be paid and more often than not business failure to an equity investor equates to an almost certain loss of their entire capital that he/she has invested in the failed business. With respect to bonds, the bond holder is promised by the party receiving the money (the Issuer), to repay the face value of the bond (the principal) at a specified date (maturity date.) In view of this, it becomes apparent that capital is more exposed to risks when it is invested in shares rather than bonds.  

In terms of providing an income there is also a distinction between shares and bonds. In the latter, the investor in bonds is often provided with fixed yields, the main advantage here being that he/she is able to predict income from their investments. This is an attractive feature for investors approaching retirement, when regular income from their investment is more favorable investment strategy than exposing their capital to higher risks.                                     

For example, if an investor where to buy a bond with say 10% coupon at its 1,000 USD par value, the yield is 10% (100 USD/ 1,000 USD).  That seems straightforward. But the investor in bonds needs to bear in mind that the price of bonds fluctuates on the bond market. So assuming the bond price goes down to 800 USD, then the yield goes up to 12.5%. This occurs because the investor receives the same guaranteed 100 USD on an asset worth 800 USD (100 USD/800 USD).

Conversely, if the bond goes up in price to USD 1,200, the yield shrinks to 8.33% (100 USD/1,200 USD).

Shares do offer income to the investor in terms of dividend payments, but income from this is not predetermined and can be unreliable.  Note that dividend payments on shares usually depends on the performance of the company throughout its financial year and the amount of income paid, if any, is recommended by the company’s board directors. So the investor has no real way of deriving a stable income from shares. In some years the shares may pay dividends, whilst in other years, little or no dividends may be paid out. 

Despite the uncertainty of income that shares offer investors their main attraction as an asset class is their potential to offer the investor capital growth. However, the general rule of thumb for investing is applicable in share investing, that being the higher the potential risk to the capital the higher the rewards received by the investor and visa versa.

In other words, there is a positive relationship between rewards and risks. 

If the investor is willing to forsake higher risk for the potential of greater returns, then equities may be the suitable financial instrument for him to achieve his goal. This is one of the main advantages of share investments compared to bonds-the potential of capital growth.  A young investor, a long way from retirement may prefer an investment strategy where their investments are more geared towards growth, rather than immediate income. This means that their investment portfolio may be orientated more towards shares rather than bonds.  So the investment goal of the investor could determine whether investing in bonds is more suitable than shares. 

Indeed, volatility is another distinction between the two financial instruments. Share can fluctuate widely on the future potential profitability of the business, on the expected earnings.  Technology stocks, pharmaceutical stocks investigating in new drugs for say cancer, or prospecting oil/ mining stocks share prices have the potential of gyrating widely on the stock market based on the prospects of positive events influencing the company’s profitability.  Investing in these types of companies before the positive event has been factored into the share price offers investor the potential of large capital gains. A photo looking like a bunch of long haired hippies, featuring micro soft founders in 1978, states, “would have you invested.”

 

If an investor were fortunate enough to have bought 100 shares at 21 USD in MicroSoft in 1986, an investment 2,100 USD, those shares over the course of nine stock piles would have mushroomed to 28,800 shares. Assuming the investor then sold those shares in December 1, 1999 he would have bagged a massive 1.4 million USD.  Sure, this is easier said than done, but no doubt this will probably wets the appetite for shares, even amongst the diehard cynics among you.    

Another bonus of share investing is that the investor owns a piece of the company. There are different classes of shares with different voting rights. Shareholders are invited to attend annual meeting of the company, they can vote on issues that influence the business, such as takeover and acquisitions of the business, changes to members of the board. Naturally, the larger the shareholdings in a company the more voting clout the shareholder investor has in selecting senior executives who will run the company and voting on import issues that could influence the business.   In contrast, a bond holder doesn’t acquire ownership in the business; they have no voting rights and no way of influencing the business.

So the theory goes that bonds are a supposedly the safer bet than shares-they are the more preferred asset by the grey haired people among us.  But so is gold considered the ultimate safe haven, the ultimate rat hole to climb into when things go pair shaped. Despite this common held view gold investors eroded 28 percent of their capital in 2013, it was the worse year for gold since 1981. Bond investors also experienced the worse year in living memory in 2013.  Indeed, playing safe last year has left some investors feeling very sorry for themselves, but will the appetite for risk continue into 2014…? 

ETF's - Exchange Traded Funds - Are They Right For You?

What is an ETF?:- An ETF is similar to a mutual fund in as much as it represents an investment in a collection of stocks, bonds, commodities etc, but with one significant difference - it can be traded on the stock exchange. 

To illustrate this difference more clearly, it helps to understand what happens when you buy units in a mutual fund. The price of these is based on the net asset value of the fund, which is calculated once a day. No matter what time of day you buy, you're getting a fixed price for that day. ETF's also have a daily net asset value, but the shares can differ in price throughout the day, which provides an opportunity to buy and sell at a profit. If the shares are trading below net asset value they are said to be at a discount, and if they're above NAV, they're trading at a premium.

Most ETF's are index trackers - they hold securities that mirror those that make up the index itself, the objective being to replicate the performance of that index. The advantage of this from a trading perspective is that it gives the trader an opportunity to benefit from intraday index moves by buying or selling ETF shares accordingly. Or he/she can take a longer term position if that's the preferred strategy.

ETF's have been around in America since 1993, with the introduction of the SPDR (Spider), which tracks the S&P 500 index. Since then the number of ETF's in the U.S. has grown to over 1500. ETF's came to Europe in 1999.

Types of ETF's: - the most popular ETFs are those that track indexes, like the SPDR mentioned above. In the UK they include the iShares plc FTSE 250 and the FTSE 100 UCITS. There are also Bond ETF's, which are seen as attractive investments in times of recession when the stock market is not so popular, and commodity ETF's, which hold investments in precious metals like gold, silver, and palladium. Agricultural and energy ETF's also fall into this category. Finally there are currency ETF's, which track the performance of all major currencies and some of the minor ones too.

Cost advantages: - Most ETF's are passively managed, which means the manager simply tries to replicate the relevant index by investing in a representative sample of the assets that make up that index. The passive manager is not trying to outperform the market, but is just attempting to replicate the performance of the index. A lot of this is done using computer modelling. This needs less hands on management, which results in lower fees. Active management on the other hand, which some ETF's are subject to, is an attempt to outperform the market. In this respect there is a similarity with mutual funds, and the charges are subsequently higher for ETF's managed this way. If you're contemplating an ETF investment, find out which style of management is in operation.

Generally however, ETF's have cheaper charges, averaging less than 1%, whereas mutual funds can range from 1% to 3%. Over time this becomes a significant difference.

In terms of taxation, the UK investor needs to be aware of the taxation status of any gains accrued from ETF investment. If the tax status is either 'reporting' or 'distributor' you'll pay capital gains tax. Otherwise it will be income tax, which can be much higher. Also bear in mind that any dividends received are seen by HMRC as income, and are treated as such. And remember that if your ETF was issued in another country you may be subject to the tax laws applicable there.

ETF's vs Mutual funds: - Some of the differences between these two have already been mentioned above, so the question here is, which one is right for you?

It depends on what kind of investor you are. If you like to be active in the market the ETF's offer you the opportunity to trade all day every day. You can go long or short as you wish. Management costs are usually lower, though if you trade a lot you need to take into account the costs of buying and selling.

If on the other hand you're more passive then mutual funds might be the better option. You buy at that day's price and hopefully watch your units increase in value, a process assisted by the ostensibly superior expertise of the fund manager. You might pay a bit more for the privilege of course.

In performance terms ETF's and mutual funds seem to be close. In researching the year to date returns for the top performing funds I can find figures for both mutuals and ETF's ranging from 16% to 100% for ETF's, and from 14% through 1,290% for mutuals! Would seem to give the lie to the often quoted opinion that professional fund managers tend to underperform. I would only add the also often quoted caveat that past performance is no guarantee of future performance either....

The ETF market has come a long way since its inception in the U.S. in 1993. There are ETF's to track just about every index around. With China and other emerging markets making their mark on the world economy, we are seeing ETF's coming through that are targeting this sector. At the moment, with the Chinese economy in a slower growth period, the year to date returns don't look impressive. But if you are a prospective investor in ETF's this could be an interesting and potentially profitable way to go longer term. The same principle applies to Brazil, Russia and India, the so called BRICs countries.

To conclude: - ETF's offer similar attributes to mutual funds, but give the more active investor the option to trade shares, with lower management fees and easy liquidity. You are free to hold onto your ETF shares long term if that is your preference, and it would seem that if you do you'll make returns comparable to mutual fund returns, without the higher charges. So in a sense it's the best of both worlds.

Fear And Greed - The Ongoing Battle For the Trader!

Let’s imagine a simply game, where participants are enticed to play it due to the potential rewards on offer. The players are not required to make anything useful, or provide any needed service, nevertheless a few of the participants, maybe less than 5 per cent of them consistently win at it reaping huge rewards.  Perhaps you are wandering how this could be; bearing in mind that in this hypothetical games no tangible products or services are being created. It occurs because the winners' profits are generated from the losers’ losses.  This type of game is known as a zero sum game, in which the winners, a small minority of the participants, enjoy huge profits from playing it, which incidentally equates to the losses of the other 95 percent of the participants. Put simply, Bob’s win is Jill’s loss.

Naturally, for this game to continue functioning it would need to draw in a constant stream of new participants, since many of the players would either give up, believing that they can’t make money out of playing it. Sadly, for a few they may even be expulsed by the game, playing it to the bitter end, kidding themselves that a big win was around the corner, but in realty finish up, penniless, hopeless and in the poor house.  

Now assuming the game has been deliberately designed to tap into the two most powerful human emotion; fear and greed. Then, new participants could be drawn into playing, enticed by the perception of huge wins.   So greed would ensure a steady stream of new suckers to the game.  Moreover, both emotions could be extremely useful in bamboozling players to make the wrong decisions, to hand over their hard earned money in the form of losses to the fortunate winners of the game. To spice things up a bit a few entertainers, such as clowns, magicians, charlatans and glamour beauties could be hired to further seduce the players, make them even more bewildered, but keep them eager and playing.

This game isn’t fiction, it actually exists and probably if it were masterminded by America’s best known gangster, Al Capone, he would have been arrested by the authorities and charged for running a racket.  But that is not going to happen because this game is played by those respectable, eloquent, suited and booted men and rubber stamped by our own political masters.

So the stock market, like in the game mentioned above, is driven by similar emotions, fear and greed. Emotional investing/trading is akin to holding a match to a stick of gelignite. The results can be equally damaging to you and your wealth. 

So those who invest using their logical analytical side of their brain, rather than their emotions tend to perform better than their rivals. These types of alpha investors are different to the rest, in a sense that they tend to have a well thought-out plan by their side, ready to implement should things go pare shaped.  By doing this, somehow they have managed to suppress the primitive side of their brain, which controls the emotion of fear.  

Somehow, and perhaps this is due to the forces of natural evolution, way back when homosapians lived in caves and carried clubs they had to react fast, for survival reasons, to the sounds of a roaring lion. So modern humans are hardwired to respond to negative event, which tend to spark off stronger emotional behavior and a cognitive response, than positive event. Perhaps this explains why sharp falls on the market are often steeper, rapid and more violent, than rises. Indeed, that shear blind panic, as people are desperate to avoid losses can be devastating, resulting in a stock market crash.  

Nevertheless, if investors over react to bad events and oversell the market due to their irrational fear this could also offer a buying opportunity for cool headed bargain hunters.  Again another strong emotion, greed would draw the bulls in.  

Keep an eye on the FTSE big losers of the day and track their share price the following day, notice how the big losers yesterday sometimes are the big winners the following day.

But over optimism can equally be detrimental to investors’ decision making, as can excessive pessimism.  Are we now witnessing over optimistic investment in parts of the technology sector today with some companies exhibiting colossal PE ratios with titanic market capitalizations.  Have you heard the expression a “suckers rally?”  Fair enough, keep dancing while the music plays, nobody likes a party-pooper but make sure you’re near the exit door when the bulls make a dash for it.

On the other hand, investors with well thought-out investment plans, which clearly outlines what they should do if the financial markets move against them. Who offset potential losses that they may occur from other investments in their portfolio, an investment strategy known as hedging; tend not to panic in a market crash because they have already factored in their tolerance to risk. Moreover, by not acting on their emotions they tend to make better investment decisions and outperform their competitors. They are able to see buying opportunities in an oversold market and profit from the fear of others. They are also able to avoid buying bubbles. Indeed, these alpha investors profit from the erratic mood swings of the market.   

So the cost of emotional investing to an investor is huge, moreover it fuels the profits of the others who act with their head rather than their emotions. By having a plan in place you won’t be like a startled, rabbit staring frozen at the headlights when the market moves against your investments.      

Real Estate Investing - The Role Of REITS

If you have a mortgage then you're already invested in real estate, no doubt with the not unrealistic expectation of seeing your asset appreciate in value. In spite of the periodic concerns about rising prices fuelling an unsustainable bubble, real estate in the UK, especially in London, continues to promise a healthy return on investment. 

 

Apart from direct investment in a property, another way to enter the real estate market is to buy shares in a REIT - a Real Estate Investment Trust. REITs come in three flavours: -

1. An equity REIT, which uses your money to buy and manage commercial and rental property.

2. A mortgage REIT, which buys the mortgages on properties at an advantageous rate of interest, with the intention of profiting on the difference between that and the higher interest rate the occupiers of those properties are paying.

3. A hybrid REIT, which contains both property and mortgage elements.

The principle is similar to ordinary investment trusts - you are pooling your money with other investors to own a portion of a real estate asset, which will ideally gain in value, and provide you with an income stream in the form of a guaranteed dividend. It's a bit like owning property without the hassle of maintaining and selling it. 

 

A word of caution though - not all REITS are publicly traded. The untraded versions are obviously less liquid, and can be subject to early redemption penalties. There's also less company information available to the prospective investor in many cases. So if liquidity is an important factor in your investment decision you need to sort the traded REITS from the un-traded before proceeding.

REITs are seen as a good vehicle for investors seeking income, because in order to exist as a REIT the company must pay out 90% of its operating profit in the form of a dividend. At the same time (where publicly traded), the shares retain the characteristics of an ordinary share tradeable on the stock exchange.

REITs originated in America in the 1960s, and were introduced into the UK in 2007. So as an investment vehicle they are arguably less familiar to investors here. Since then however, a number of property companies have converted to REIT status. From their perspective, being structured as a REIT has significant tax advantages - there is no corporation or capital gains tax payable, which means there's more capital available to add to the dividend pot.

From the investor's point of view, the advantages of being in a REIT as opposed to direct real estate investment include:

• Being invested in a company with multiple categories of property that provide a level of diversification, thereby diluting risk.
• High rate of distribution of profits of the company to investors in the form of a guaranteed dividend (unlike a regular company, which pays dividends on a discretionary basis)
• Liquidity. Unlike regular property, you can sell your shares quickly in a publicly traded REIT.

Some disadvantages include:

• In a financial crisis such as that of 2008, A REIT heavily invested in mortgages is susceptible to mortgage defaults, which affects its profitability.
• Paying out 90% of profits in dividends, while good for investors, leaves only 10% to re-invest into further propery acquisition, possibly slowing growth.
• The very liquidity that makes a REIT attractive also makes it volatile.

So if you were thinking about buying into a REIT, here are some factors to guide your research:

• Check out the management team. What is their track record like in terms of strategy and property investment choices? Are they paid on performance? If so, their interests co-incide with yours.
• How are they diversified? Is there a spread of investment across different property categories? Good diversification reduces risk.
• Look at past financial statements to see how much cash was available for distribution, and whether that amount is increasing annually.
• Are the types of property they invest in likely to produce good returns? For example, if they are heavily into retirement and nursing homes there is an argument that the ever aging population will ensure a continuous occupancy rate. On the other hand, if they're concentrated in commercial property and the economy suffers, then tenancy of offices will also suffer.

 

In terms of performance, there is data showing that REITs outperformed the S&P 500 index on a consistent basis over 30- 40 years at around 2%. But currently there are concerns in some quarters that higher interest rates will adversely affect REIT performance. Higher interest rates hit building industry borrowing costs. The riposte to this argument is that higher interest rates also mean higher levels of income for REITs holding mortgages, and that it's a sign that the economy overall is doing better, which should boost property values. 

This year started strongly, with the FTSE NAREIT All REIT Index gaining 3.3%. In February this increased to 4.69%, fell in March to 0.32%, and ended April at 2.88%. An alternative to a REIT is a Real Estate Mutual Fund, which invests in REITs and other property companies. Instead of receiving an income your money is retained in the fund itself, so your units continue to appreciate. There is of course the issue of management charges and the tendency of mutual funds to underperform the broader market, but there is arguably less research to do before taking the plunge. 

 

A couple of links that should assist you in getting a handle on the performance of mutual funds are:

1.http://fundresearch.fidelity.com/mutual-funds/category-performance-annual-total-returns/REAL  

2.http://finance.yahoo.com/funds/lists/?mod_id=mediaquotesmutualfunds&cat=%24FOCA%24SR%24%24&rcnt=50 

In conclusion, REITS offer the investor an opportunity to get involved in the real estate market and receive a regular income, while at the same time offering liquidity in the form of a tradeable instrument (for tradeable REITs). Real Estate Mutual Funds offer the same market segment without the income, but with the potential for growth in unit value over time.