Recently, trading speeds on stock markets have increased dramatically as technology has been brought to bear on decision making as well as the matching and execution of trades. High speed computers can now gather data, make a decision by applying complex algorithms and execute a trade, all in much less than 1,000th of the time taken to blink an eye.

The growth in HFT over the past 6 years has been extraordinary, and HFT trades now make up more than 50% of all share transactions in the USA.

This article by Charles Duhigg published by The New York Times on July 23, 2009 provides a good example of how HFT operates.

“Stock Traders Find Speed Pays, in Milliseconds.”

“It was July 15, and Intel, the computer chip giant, had reporting robust earnings the night before. Some investors, smelling opportunity, set out to buy shares in the semiconductor company Broadcom. (Their activities were described by an investor at a major Wall Street firm who spoke on the condition of anonymity to protect his job.) The slower traders faced a quandary: If they sought to buy a large number of shares at once, they would tip their hand and risk driving up Broadcom’s price. So, as is often the case on Wall Street, they divided their orders into dozens of small batches, hoping to cover their tracks. One second after the market opened, shares of Broadcom started changing hands at $26.20.

The slower traders began issuing buy orders. But rather than being shown to all potential sellers at the same time, some of those orders were most likely routed to a collection of high-frequency traders for just 30 milliseconds — 0.03 seconds — in what are known as flash orders. While markets are supposed to ensure transparency by showing orders to everyone simultaneously, a loophole in regulations allows marketplaces like NASDAQ to show traders some orders ahead of everyone else in exchange for a fee.

In less than half a second, high-frequency traders gained a valuable insight: the hunger for Broadcom was growing. Their computers began buying up Broadcom shares and then reselling them to the slower investors at higher prices. The overall price of Broadcom began to rise.

Soon, thousands of orders began flooding the markets as high-frequency software went into high gear. Automatic programs began issuing and cancelling tiny orders within milliseconds to determine how much the slower traders were willing to pay. The high-frequency computers quickly determined that some investors’ upper limit was $26.40. The price shot to $26.39, and high-frequency programs began offering to sell hundreds of thousands of shares.

The result is that the slower-moving investors paid $1.4 million for about 56,000 shares or $7,800 more than if they had been able to move as quickly as the high-frequency traders.
Multiply such trades across thousands of stocks a day, and the profits are substantial. High-frequency traders generated about $21 billion in profits last year, the Tabb Group, a research firm, estimates.”

History

In 1997 the NYSE stopped quoting stocks in eighths of a dollar and moved to increments of 1 cent. This reduced the revenue the market makers earn from the bid/offer spread, so the exchange began paying rebates to high-frequency brokerages if they bought shares at the best public prices.  This provided a financial incentive for the development of the high frequency, high volume, low margin approach that characterises HFT.

Meanwhile, HFT was supported by significant upgrades to trading systems in many exchanges, designed to dramatically cut transactions times.  Going even further, the extremely short period of time that it takes for a piece of information to travel from one computer to another in a network, which is known as “latency”, was shortened even more as exchanges began to rent space right next to the trading platforms in their own data centres. In consequence, many firms can now process an order in less than 3 millionths of a second.

Australia and Asia have been relative latecomers to HFT. Hong Kong is making a significant investment in the required technology, and our part of the world looks like the next region for explosive growth in this area.

It looks as though this growth will continue, with HFT not only spreading geographically but to other markets as well. HFT is now well established and growing in foreign exchange, futures and options markets, and bond markets are also joining in.

Infrastructure

Low latency infrastructure now looks for improvements in the millionths of a second range, and “extremely low latency” is the expression used for the best of it. Low latency provides information, including about competing bids and offers, microseconds faster than higher latency systems.

In Tseung Kwan in Hong Kong, work is underway on a data centre where stocks, futures, options and currencies can be traded on computers metres away from Hong Kong Exchanges’ own systems which are used to handle trades. The cost will be high and milliseconds will be saved, but in the world of HFT, milliseconds are precious.

The concept is referred to as co-location and it is being adopted widely. In Australia, the ASX plans to dramatically expand its co-location services with a new $32 million data centre which is due to be completed in August 2011.

Financial market news is also now being formatted by firms such as Bloomberg so that it can be delivered to, and read and analysed by, computers almost instantaneously after release.  Beyond even that, algorithms are now being designed to interpret stories and to make judgements about the likely effect of those stories on market sentiment.
In 2008 Dow Jones ran ads in the Wall street journal, proud that they had managed to report an interest rate cut by the Bank of England 2 seconds faster than their competitors.  In the world of HFT, 2 seconds is a very long time.

Strategies

Algorithmic trading can be applied to virtually any investment strategy, including pure speculation and trend following, passive benchmarking to replicate an index’s return or  exotically named techniques such as “Stealth”, “Iceberg”, “Dagger”, “Guerrilla”, “Sniper” and “Sniffer.

Typical HFT strategies involve a mix of high turnover of capital, very short holding times, multiple trades each day, very small returns per trade and all positions being closed out at the end of every day.

“Latency arbitrage” is a contentious strategy. It exploits knowledge that the trading system of a particular exchange is about to slow down under a processing load, providing a trader with an opportunity to set up a buy or sell order in advance. The method of ensuring that the processing load is then actually experienced is called “quote stuffing”.

Algorithmic trading strategies often attempt to reduce costs by breaking large orders into several smaller ones which are then placed into the market progressively, a method known as “iceberging”. The algorithm called Stealth tries to find the large hidden orders that hide behind tiny obvious ones (icebergs) and to profit by subverting the intent of the iceberger. In this case, we have a science fiction-like battle of wits between two computers.

Some strategies are called “gaming” because they depend on the programming skills of other traders. “Dark pools” are alternative market-places where trading is anonymous, and most orders are “iceberged”. “Sharks” “ping” small market orders into dark pools, concluding if they are filled that they have discovered an “iceberg”.

Flash Orders

Some markets allow HFT traders to look at orders for very short periods of time (of the order of 30 milliseconds) before they are shown to everyone else. This is enough time, as we have seen, for traders to conduct a transaction and turn a profit by very quickly trading shares they know will soon be in high demand. The aim is to earn small amounts per trade on very large numbers of trades, sometimes millions of times a day.

The markets defend this practice as providing liquidity. Others claim that it allows one trader to probe the market with tiny orders that are immediately cancelled to provide an opportunity others don’t have of gaining insight into the other side’s willingness to pay. On the face of it, it looks like an unfair advantage.

A turning point seems to have occurred on May 6 in the USA, when an event took place which became known as the “flash crash”. Rapidly delivered, computer generated orders were widely held to be responsible for sending the Dow Jones Industrial Average down by 1,000 points in 20 minutes. This has led many commentators to question whether there is any inherent difference between flash orders and the misbehaviour called “front-running”.

Nanex has plotted the flows of orders from HFT traders, and they form very distinctive and unusual patterns which have been given names such as “Bandsaw II” and the “Boston Zapper”.

Polarised Opinion

HFT has supporters and detractors, but the growth seems to roll on in disregard of the arguments for and against.

Fully automated markets such as NASDAQ, Direct Edge and BATS, in the US, have prospered at the expense of less automated markets such as the NYSE, providing a warning to other world markets of the dangers of being left behind.  The expansion of volumes and contraction of margins has led to economies of scale, in turn generating pressure for lower commissions and fees, and mergers or consolidation of financial exchanges.

Finally, HFT seems to benefit from and also cause, in a loop, fragmentation of markets.  Fragmentation produces diverse trading venues with slightly different trading systems, speeds and fee schedules, providing opportunities for traders to exploit the differences through their computer algorithms.

Perhaps the clearest evidence of the changes and fragmentation that dark pools, and platforms like Chi-X Europe are causing is the fact the London Stock Exchange now accounts for only 55% of trading in the stocks that comprise the FTSE 100 index. This should give the ASX and all market participants pause for thought as Australia prepares to ramp up its involvement in this area and alternative exchanges to the ASX are introduced.

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While there is a lot of evidence that stock markets are simply unpredictable, there are times when prices get a long way out of kilter with any sense of reasonable value. The term used is “bubble”.  Bubbles are harder to avoid than might appear. Herd instinct seems to be firmly embedded in the human psyche, and many studies have shown that quite bizarre behaviour can seem “normal” if enough people are doing it and accepting it as such. Also, abnormal market valuations can persist for very long periods of time, and even hardened sceptics can sometimes get worn down when their dire predictions fail to be realised for years on end.

Nevertheless, it is important to try to recognise the characteristics of a bubble in advance, because they invariably are very easy to recognise in hindsight when they burst, and clients can be unforgiving when they get caught.

Famous Bubbles

Bubbles can sometimes be limited to a particular commodity or stock, but can also describe speculative behaviour across wide regions or investment areas. Many bubbles start in small areas and then spread. An example was the mining stock bubble which followed an announcement of a large nickel deposit by Poseiden NL in Australia in 1969. Prior to the announcement, Poseiden had been trading at .80c, and after the announcement the price moved to $12.30. A fifteen times price hike looks impressive, but the bubble had a lot more than that to come. With very scant information provided and considerable uncertainty about the grades and size of reserves, the price ultimately ran to $280 before finally collapsing. At least Poseiden did have a real find, albeit it dramatically over-valued, but as with a typical bubble, contagion soon followed, and companies with nothing more than a location close to Poseiden or deposits that existed only in the Directors’ imaginations, took off. A rumour started that a company called Tasminex had made a discovery at Mount Venn (nothing ever was discovered there) which sent the share price from $2,80 to $3.30 on the day the rumour started, then to $16.80 on the next trading day and finally on to $96 overnight in London.

Tulip mania in Holland in the 17th century is often cited in discussions about bubbles, and it does serve as a great example of just how silly things can get. At the peak, a single tulip bulb traded for 6,700 guilders at a time when 150 guilders was an average annual income.

Characteristic of bubbles

Essential to bubbles is the suspension of disbelief by most participants. There is a failure to recognize that traders are engaged in a speculative exercise in which people pay too much in the hope of passing the commodity quickly on to a greater fool. High turnover is a feature of bubbles which can look similar to a game of “pass the parcel”.

In virtually all cases, a bubble is followed by a spectacular crash in prices. Bubbles burst, they do not slowly deflate.  Frequently a lot of collateral damage is involved. When the 1980s Japanese bubble burst, a prolonged period of stagnation for the whole Japanese economy followed. Even now, 20 years after the stock market peak, the Japanese stock market index is only one quarter of its level then. Those who invested at the peak are still at a 75% loss, and are unlikely ever to see a return of the real value of their investments.

Of course more recently, the damage caused by the bursting of the U.S. housing bubble was extensive and severe. Banks and financial institutions throughout the world held hundreds of billions of dollars worth of securities ultimately backed by toxic sub-prime loans, and by the first week of January, 2009, the 12 largest financial institutions in the world had lost half of their value, many businesses went bankrupt and the stability of whole countries and indeed the whole global economy was under threat.

Minsky’s Theory of Financial Instability

Economist Hyman Minsky was Professor of Economics at Washington University. Before his death in 1996, he proposed an unorthodox theory that the causes of financial instability “Stabilizing an Unstable Economy” (1986) centre on speculation and debt. Unsurprisingly, his work has attracted increased interest in recent times.

Five Steps of a Bubble

Minsky identified five stages in a typical bubble cycle – displacement, boom, euphoria, profit taking and panic.

1. Displacement: Something new occurs which excites people and captures the imagination. This might be a mining discovery, the introduction of new technology or even a collapse in interest rates that opens up the possibility of making large investments at little cost. In the USA, the rate on federal funds rate moved from 6.5% in May, 2000, to 1% in June, 2003. And the interest rate on 30-year fixed-rate mortgages fell by 2.5 percentage points to historic lows. The possibility of buying a home suddenly appeared real to many who previously could not have considered it, and the ide was seductive. This displacement effect laid the foundation for the housing bubble that followed.
2. Boom: After displacement, prices rise; slowly at first, but then more quickly as more and more participants enter the market and participation is validated by the numbers and the early success stories.  The boom phase gets underway accompanied by widespread media attention and success by the early players as the “greater fools” to whom increasingly over-priced assets must be passed are to be found in great abundance.The predominant emotion of those rushing in is the fear of missing out on a once-in-a-lifetime opportunity.
3. Euphoria: As prices sky-rocket and fortunes are made, abstainers look foolish and conservative. New valuation methods and measures are introduced to justify the relentless price increases. We’ve seen the extremes reached by Poseiden and tulips. 
In Japan in 1989, land in Tokyo changed hands for $139,000 per square foot; $14 million for an area the size of a small bedroom.
4. Profit Taking: This period has been described as being like riding a tiger; exciting, dangerous and living in the hope that you can get off before you’re eaten. The smart money starts selling down. But no-one can know exactly when a bubble will burst, and once confidence begins to fail and euphoria gives way to fear, the collapse is usually very quick.
5. Panic: When panic sets in asset prices plummet, margin calls are widespread, buyers disappear and investors want to, or have to,  liquidate at any price. Supply overwhelms demand.

In the single month of October 2008, weeks after Lehman Brothers declared bankruptcy and Fannie Mae, Freddie Mac and AIG almost collapsed, global equity markets lost a staggering $9.3 trillion of 22% of their combined market capitalization.

Case study

The web site “Investopaedia” relates the story of eToys in the USA, a classic illustration of how a bubble progresses through these stages. Here’s what they say.

“In May, 1999, with the internet revolution in full swing, eToys had a very successful initial public offering, where shares at $20 each escalated to $78 on their first trading day. The company was less than three years old at that point, and had grown sales to $30 million for the year ended March 31, 1999, from $0.7 million in the preceding year. Investors were very enthusiastic about the stock’s prospects, with the general thinking being that most toy buyers would buy toys online rather than at retail stores such as Toys “R” Us. This was the displacement phase of the bubble.

As the 8.3 million shares soared in its first day of trading on the Nasdaq, giving it a market value of $6.5 billion, investors were eager to buy the stock. While eToys had posted a net loss of $28.6 million on revenues of $30 million in its most recent fiscal year, investors were expecting for the financial situation of the firm to take a turn for the best. By the time markets closed on May 20, eToys sported a price/sales valuation that was largely exceeding that of rival Toys “R” Us, which had a stronger balance sheet. This marked the boom / euphoria stages of the bubble.

Shortly afterwards, eToys fell 9% on concern that potential sales by company insiders could drag down the stock price, following the expiry of lockup agreements that placed restrictions on insider sales. Trading volume was exceptionally heavy that day, at nine-times the three-month daily average. The day’s drop brought the stock’s decline from its record high of $86 to 40%, identifying this as the profit-taking phase of the bubble.

By March, 2000, eToys had tumbled 81% from its October peak to about $16 on concerns about its spending. The company was spending an extraordinary $2.27 on advertising costs for every dollar of revenue generated. Although the investors were saying that this was the new economy of the future, such a business model simply is not sustainable.

In July 2000, eToys reported its fiscal first-quarter loss widened to $59.5 million from $20.8 million a year earlier, even as sales tripled over this period to $24.9 million. It added 219,000 new customers during the quarter, but the company was not able to show bottom-line profits. By this time, with the ongoing correction in technology shares, the stock was trading around $5.

Towards the end of the year, with losses continuing to mount, eToys would not meet its fiscal third-quarter sales forecast and had just four months of cash left. The stock, which had already been caught up in the panic selling of internet-related stocks since March and was trading around at slightly over $1, fell 73% to 28 cents by February, 2001. Since the company failed to retain a stable stock price of at least $1, it was delisted from the Nasdaq.

A month after it had reduced its workforce by 70%, eToys let go its remaining 300 workers and was forced to declare bankruptcy. By this time, eToys had lost $493 million over the previous three years, and had $274 million in outstanding debt.”

Conclusion

Speculative bubbles appear to be unavoidable in market economies, but clients should be on the lookout for the tell-tale signs of a bubble. That means not only recognising the disconnect of prices from fundamental valuations, but also looking out for the psychology of greed and wishful thinking that accompanies the typical bubble.
 

Note: The accreditation for this CPD article is no longer current. Please visit our CPD section for current CPD quizzes. 

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A financial planner is someone who provides personal advice to individuals and small businesses concerning financial strategies and products in areas such as superannuation, investment, insurance and personal financial management.

To practice as a financial planner, an individual must both;

• operate under an Australian Financial Services Licence (AFSL), either as a licensee or as a representative of a licensee, and
• be competent to practice

Australian Financial Services Licence (AFSL)

Licensees may be individuals or companies, so an individual offering financial planning services can choose to:

• apply for a licence either personally or for a company they control, or
• operate as an employee or authorised representative of another licensee. Large institutions such as banks and insurance companies who offer financial planning services hold licences, sometime authorising hundreds of smaller corporate or individual financial planning practices to act as representatives under their licences.

Because of the difficulties and cost of replicating the support available from large licensees and of meeting onerous compliance obligations, new entrants to the profession are usually best advised to begin by acting as an authorised representative. Even large, successful practices often do not find the move to holding a licence justifiable.

Competency

A person is competent if they have either;

• completed a course (or courses) that is listed on ASIC’s training register(see:  http://www.asic.gov.au) or
• been assessed as being competent by an authorised assessor. This second option is only available to people with relevant industry experience.

Note that there are no other options. One consequence is that a person who has relevant industry experience and who has completed training that is not listed on ASIC’s register can opt for assessment and have that training taken into account. A person who does not have industry experience, however, has no option other than to complete courses that are listed on the register, regardless of what other qualifications they may hold.

The courses or assessments which are completed must cover;

• generic knowledge of financial markets and products, and
• specialist knowledge and advisory skills for each of the particular areas (“Content Areas”) in which advice will be provided, such as:
  • Financial planning
  • Securities
  • Managed investments
  • Superannuation
  • Insurance—general and  life

A financial planner will need to complete a course (or courses) which covers all of these areas, while an insurance adviser, for example, will only need to complete a course (or courses) which covers generic knowledge and insurance.

Financial planners who advise in other specialist areas, such as derivatives or foreign exchange, will need to complete courses covering those areas as well.

Some areas, notably direct property, which is covered by State licensing laws, are not covered by RG146. Nevertheless, advice on property based securities such as REITs is caught, as is advice against securities/superannuation etc in favour of property. The production of financial plans that range more broadly than advice that is strictly limited to property also requires authority under an AFS licence and compliance with RG146.

Course standards

In order to be listed on ASIC’s register, courses must be at or beyond the standard required for a Diploma. A Diploma qualification is equivalent to 1/3 of a three year bachelor’s degree; that is, it is equivalent to one year of full time study at a university or TAFE.

BE VERY WARY OF COURSES THAT OFFER UNREALISTICALLY SHORT TIMEFRAMES, EVEN IF THEY APPEAR ON ASIC’S REGISTER. It is not possible to complete a third of a bachelor’s degree in 14 days.

Completion of courses or collections of courses that are listed may entitle the student to a qualification such as the Diploma of Financial Services (Financial Planning) {DFS (FP)} or, in the case of courses listed by universities, degrees.

Note that completion of a Diploma of Financial Services (Financial Planning) or a university degree does not automatically mean that the training requirements have been met. To be effective, the course must;

a.    be listed on ASIC’s register, and

b.     cover each of the Content Areas required. Details of the Content Areas covered are published on the training register by ASIC for each course listed.

Continuing education

When practicing as a financial planner, continuing education will be required by

a.    the law, which requires that individual training plans are prepared by the licensee, and records of training are kept, so that the competency of  each advisor is maintained, updated and developed, and

b.    the AFS licensee and any professional associations, such as the Financial Planning Association of Australia (FPAA), that are joined. These will have explicit rules about the continuing training that they require.

Further study

A popular next step from the entry level Diploma training is to complete the Advanced Diploma of Financial Services (Financial Planning) {ADFS(FP)}. Beyond this, many advisers undertake a Master’s program, complete the FPA’s Certified Financial Planner (CFP) program or undertake specialist study in areas such as self managed superannuation.

CFP

Full details of the FPA’s Certified Financial Planner (CFP) program can be found under the “Education and CPD” tab at www.fpa.asn.au, and this short summary does not pretend to provide all details.
The program comprises 4 units of study and a 5th assessment unit.

1. To commence the first 4 units of the program, a person needs:
   • 1 year’s relevant experience {usually means as an Authorised Representative (AR)},
   • to be a member of the FPA, and
   • to have a finance related degree or an Advanced Diploma (Financial Planning).
2. To enrol in the 5th unit a person needs, in addition:
   • an extra years’ (ie a total of 2 years’) experience.
3. After the study program is successfully completed, to be accepted as a CFP a person needs:
   • yet another year’s (ie total 3 years’) experience.
   • to sign on to a Code of Ethics.
   • an approved finance degree, or alternatively, any degree plus an ADFS(FP).

This means, regarding the education requirements, that:

1. the holder of an ADFS(FP) with no degree can enter and complete the CFP program. They will not be granted CFP status, however, unless at some point they complete a degree of any kind,
2. the holder of a degree that is not finance related will have to complete an ADFS(FP) to start the CFP program. On completion, they will be able to apply for CFP status, and
3. the holder of an approved, finance related degree can go straight into the program and ultimately apply for CFP status. They will not need an ADFS(FP).

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Decisions by investors to buy, sell or hold assets are based on a comparison of the price being asked with the investor’s idea about what the asset is worth.

There are many different ways to investigate what an asset might be worth. A property, for example, might be valued by looking at comparative recent sales, by adding development costs to an estimate of the land value, by discounting future income returns from the property and so on. Often it is wise to use a variety of methods and to be cautious if there is a wide difference between the lowest and highest.

Irrational valuation

Some conclusions about value are drawn rationally, but many are not. On the irrational side, perhaps the most common fallacy is what behavioural economists call “anchoring”; the tendency to derive a number by using another irrelevant but readily available number as a reference point (the “anchor”).

Retailers make good use of this tendency to anchor when they advertise reduced prices in sales. Good merchandising demands that the old price, often crossed out, should appear on price tags as well as the new, lower one. A rational buyer will disregard the old price completely, of course, and only consider whether the new price represents good value for money, but marketers are able to rely on the fact that many customers will anchor on the old, higher price, and conclude, perhaps subconsciously, that the new price represents value that might not exist.

Similarly, anchoring may cause an investor to think that a share that has dropped in price is good value (or vice versa) without much more investigation. If the previous price is used as an anchor, the tendency is to think that a price that is low compared with yesterday’s price is a price that is low compared with “good value”, but that might not be the case at all. The fact that a price has fallen does not mean that it can be expected to return to its previous level at some point. As we know, stocks do not always return to their previous prices. Some continue to fall, and some go into liquidation, disappearing altogether. The price fall has probably occurred for a reason, which usually means that all previous prices, calculated before the change in circumstances, will be out of date and of no relevance. Market participants are re-assessing the intrinsic values of companies continuously, and a well advised investor will also be trying to measure prices against assessments of value which incorporate the most up to date information available. Yesterday’s calculations and prices are of little relevance.

Incidentally, there is evidence that even hard-nosed professional market analysts are not immune to the intrusion of bias and irrationality when assessing value. To a certain extent, that is the reason for the existence of quant programs. By leaving the decisions to computer models, the possibility of human bias is claimed to be removed

Traditional valuation methods

The valuation of listed shares is of particular interest to financial planners, who advise on long term needs, and try to optimise the balance between the investment, longevity and inflation risks that clients face. A large range of financial ratios is available from brokers’ web sites, or in company financial reports, that can help in forming a rational view of the value of a company. These include profitability ratios (eg ROE), liquidity ratios (eg quick ratio), capital adequacy ratios (eg gearing ratio), market ratios (eg P/E), management efficiency ratios (eg debtor turnover) and the bankruptcy predictor, the Altman Z score.

While all these measures can provide valuable insights into a company’s worth, they suffer from the problem that they are mostly derived from past events on a short-term basis while the true values of companies emerge from future events over the long-term.

Of course, the future is unpredictable, but to help to deal with this, in recent years a new measure of company performance has emerged; Economic Value Added.

Economic Value Added (EVA)

EVA measures the difference between the return on a company’s capital and the cost of that capital. In practical terms, EVA is calculated by reducing Net Operating Profits After Taxes (NOPAT) by the total cost of capital, including both debt and equity capital. A positive EVA indicates that value has been created for the owners of the company. Conversely, a negative EVA indicates the destruction of shareholder value.

To see the difference between EVA and more traditional performance measures like net income, take the example of a newly established company called Allen’s After-market Accessories (AAA). The company earns $1,200,000 on a capital base of $10 million thanks to the success of a single imported product line. Traditional accounting would show that AAA offers an above average return on capital of 12%.

However, AAA has only been operating for a short time, and the reliance on a single product line carries significant risk. The lenders to such an enterprise will no doubt charge premium interest rates, and owners will also be looking for higher than average returns. If we assume that in combination these lenders and investors expect 15%, then the EVA calculation will show a loss of value of 3%. So although AAA reports an accounting profit, it has not met the requirements of the providers of capital, and the result has been a reduction in shareholder value.

On the other hand, if AAA were less risky and better established with a cost of capital of 10%, then the same first year operating result would have produced surplus income equal to 2% of capital. That amount would represent an addition to the company’s economic value.

Another way to look at this measure is to consider that the shareholders charge the company rent for tying up their cash to support operations. EVA captures this hidden, opportunity cost of capital that conventional measures miss.

Incidentally, astute readers will notice similarities between this idea of EVA and the controversial “resource rent tax” which initially sought to tax economic “rents”; defined as earnings beyond the risk-free cost of capital.

Calculating EVA

Four steps are involved in calculating EVA. Note that these steps appear to be quite straightforward, but the items on income statements and balance sheets will have been calculated in accordance with traditional accounting standards and methods, and will require many adjustments to achieve a “pure” calculation of EVA.
Step 1: Calculate NOPAT (Net Operating Profits After Tax)
Gross Profits (Sales – Cost of Goods Sold) less Depreciation & Amortisation less Tax.
Step 2: Determine Total Capital Deployed
Net Working Capital + Net Fixed Assets.
Step 3: Calculate WACC (Weighted Average Cost of Capital)
The WACC calculation will take account of the company’s capital structure (proportion of debt and equity on the balance sheet), volatility, and the market risk premium.
Step 4: Calculate Capital Charge to NOPAT & EVA
Total Capital Deployed (Step 2) x Weighted Average Cost of Capital (Step 3)
Economic Value Added will be NOPAT less the Capital Charge.

EVA should help to identify good investments, if calculated consistently. Companies with high EVAs should outperform those with low or negative EVAs over time.

Eva momentum ratio

Arguably, the actual EVA levels matter less than changes in those levels. A positive EVA that is expected to become less positive may be a selling signal, just as a negative EVA that is expected to rise into a positive territory may indicate a “buy”.

The EVA Momentum Ratio compares changes in EVA in a given period to sales in the prior period; in other words, it provides a size adjusted measure of change in EV. For example, if EVA moves from $ 1 million to $ 1.1 million in consecutive years, then EVA in the second period is up by $100,000. If sales in the first period were $5 million, that gives us an EVA Momentum Ratio of 2% ($ 5 million divided by $100,000).

The EVA Momentum Ratio is straightforward and easy to read, yet has many advantages over other common means of establishing value.

• It consolidates earnings and assets into a single score and automatically corrects for many accounting anomalies in the process
• It is one of the few measures where an increase is unambiguously a “good thing”. For example, an improved ROC might point to underinvestment in research and development
• It is scale neutral, enabling comparisons to be made of businesses (or business units) of differing sizes.
• It is a relative measure of improvement, so will not be distorted when comparing companies starting with a strong platform of brands or infrastructure with others.
• It is a leading measure, showing improvements or deterioration in shareholder value before the traditional accounts log the profits or losses.
• It is market calibrated, automatically adjusting for risk, and measuring always against the owners’ expectations.
• It is difficult to manipulate, as the rules surrounding EVA tend to remove many of the distortions that are embedded in financial statements

It is the job of the management of a business to increase shareholder wealth and EVA is an excellent metric to add to the other indicators of financial performance. Everyone involved in advising on investment in business enterprises should be conversant with EVA.

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Given the usefulness of an IPS in helping to clarify the investment aims and methods for institutions and superannuation funds, it is surprising that their use is not more frequently encouraged by advisers for individuals for their ordinary investment portfolios. A good IPS provides an anchor for an investment plan and guidance for specific asset allocation strategies and portfolio construction. Planners who do prepare them for their clients find them useful when establishing investment goals, documenting risk profiles, choosing suitable investments, reviewing investment performance and defending decisions in the event of legal challenge. They form a logical component of a comprehensive Statement of Advice.

A good investment policy will be customised to each individual’s needs, along with the rest of a financial plan. Nevertheless, there are common components, including time horizon, goals, investment risk and reward profile, liquidity and cash-flow requirements, rebalancing guidelines, preferred asset classes (and assets to be avoided) and a control framework that will guide the strategies in all market conditions.

Off-the-shelf policies are available, but if clients are to treat their IPS as the backbone of their approach to their investments, they will need to be involved in its preparation and fully convinced of its relevance to their circumstances.

Insights from behavioural finance indicate that investors have many irrational biases. Some are a tendency to hold bad investments too long, overconfidence, a readiness to follow the herd, allowing sunk costs to influence present decisions and beliefs that losses aren’t real until an asset is sold. Not many ideas are as damaging to the implementation of a disciplined approach to investment as this idea of the “paper” loss.

The antidote to these irrational impulses is to lay down the ground rules before decisions are required, and then to apply them rigorously when those decisions should be taken; in other words, to prepare an IPS containing detailed investment guidelines and then to follow them.

Components of an IPS

A fund manager’s IPS is effectively an agreement between the investor and the institution. For individuals managing their own assets, it still has the feeling of an agreement with oneself about how investment decisions will be dealt with. A common temptation with all IPSs is to write them in terms that are too general. The detail should be quantified. The main matters that will be addressed will be these.

• Time horizon
• Investment objectives
• Investment risk and reward profile
• Liquidity and cash-flow requirements
• Rebalancing guidelines
• Preferred and allowable assets
• Monitoring and control
• Special considerations

Time horizon

Time horizons are frequently underestimated. We still see SoAs containing superannuation advice that puts the planned retirement date as the time horizon, despite the fact that the investments may be required for 30 years or more beyond that date. For clients who do not intend spending down their entire capital in their own lifetimes, the time horizon will extend to a new generation.

That realisation can avoid asset allocation mistakes and a reminder of time horizons in an IPS can help clients to resist the temptation to panic in downturns, or to overspend during long bull markets.

Investment Objectives

Few would disagree with the idea that investment objectives or goals are a crucial part of an investment strategy, but a common failure is to document goals that are either too loosely defined or simply not realistic. Expressions such as ”maximise returns” and “minimise risk” are so broad that they become meaningless as a guide for actual “real-world” decision making. More specific, measurable goals would be to generate an income stream of 4% pa after tax, with growth over any year to equal the performance of an indexed growth fund (one should be nominated) and over a business cycle to equal the growth in average weekly earnings. Some clients may choose the goal of keeping pace with the growth in consumer prices, rather than maintaining their relative position with wage earners. The preparation of an IPS gives an adviser the opportunity to have the discussion, and for the investor to decide.

Investment Risk and Reward Profiles

Every adviser will have a risk profiling procedure that is carried out with clients before recommendations are made. But these tools are frequently targeted almost exclusively at tolerance for investment risk and the ability to withstand investment volatility. Also, there is often a very tenuous link between the profile of the investor and the profile of the investments. An earlier article in this magazine pointed to the equity like risks that can be experienced in some fixed interest like investments, and the breaking down over the last few years of simplistic assumptions about diversification and volatility. Finally, the crucial inflation and longevity risks must be addressed. An IPS should list all the common risks that face investors and outline the specific strategies that will be used to deal with them.

Liquidity and Cash-flow

Financial plans will invariably include detailed cash-flow forecasts, and the investment plan must take account of liquidity needs. The IPS will consequently include the plans for significant additions to and withdrawals from the portfolio, and take account of these in describing the asset allocations and the selection of individual investments.

Rebalancing guidelines

Rebalancing guidelines specify when the investor will rebalance the portfolio. This can be at specific time intervals (quarterly, semi-annually, annually) or when target ranges have been violated. The rule might be, for example, to re-balance if the Australian equity component falls outside the range of 40% to 55% of the portfolio value. Of course rules like this need to be backed up by appropriate administration. How is the client to keep track of the asset allocation, which varies constantly?

A review of the asset allocation might also be required by the IPS if performance varies dramatically from plan. For example, if real interest rates increase strongly, then a re-weighting towards equities might assist growth objectives while maintaining income goals.

Preferred and allowable assets

Some assets may be out of the question for ethical or religious reasons; others because of the risk profile or simple dislike by the investor. Rules might be set about the use of derivatives, for example, from an outright prohibition to the use of covered positions only.

Private equity and family support  are other matters to include. It is better to consider whether or not investment funds can be used to support the entrepreneurial activities or personal needs of family members, and if so to what extent,   well before a request is made, when the emotional component may be high and bad decisions made.

Monitoring and control

Investors typically review their investments too frequently, and consequently over-trade. On the other hand, if rules are in place in the IPS regarding re-balancing or “stop loss” points at which particular assets or asset classes will be sold down or acquired, then monitoring will be required. Some, such as “stop-loss”, might be automated through broker software, some might be out-sourced to an adviser such as a financial planner, and some might need information to be assembled and examined by the investor. Preparation of an IPS will force consideration of these options, decisions to be made and the implementation of those decisions in a workable schedule of review and monitoring activities.

Special considerations

An IPS should also cover any unique or unusual aspects applying to the investor. Perhaps some parts of the fund need to be quarantined in a special account for a family member with particular needs for financial support. This component may have a feel of “trust”, even if a formal trust fund is not established. There may be delegations of authority to deal with assets which are described here; for example, a student may be given emergency access to a CMT which should only be used under circumstances described. An objective might be to support charities, in which case a policy can be described. How much is to be given, and when? Under what circumstances would donations cease or be subject to review?

Summary

An IPS is a very useful document for any investor to have at hand. In the preparation, it will be useful in forcing decisions concerning the many issues that should be considered. In operation, it will drive a much more disciplined approach to investment management than would otherwise be the case.
It should be concise, (perhaps 3 to 5 pages) written in plain English and contain a minimum of generalisations and a maximum of specific guidelines concerning the management of the investment portfolio.
 

Note: The accreditation for this CPD article is no longer current. Please visit our CPD section for current CPD quizzes. 

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Consequently, the stock exchange, like many other markets, has developed special procedures to allow for Buy and Sell orders to be placed before and after normal trading, and for any of these orders which match or overlap to be settled at prices which are established differently from those applying to orders placed during the normal trading day.

The Pre-opening pricing formula involves 4 steps. If the price is established at any step, then the remaining steps are not needed. This method, used to establish prices in the Pre-open period, also applies in precisely the same way to establish;

• closing prices at the end of the trading day,
• float prices,
• prices following a trading halt or suspension, and
• prices of new listings.

It is often said in all of these circumstances that the market is in “Pre-open”, even though that might seem to be a strange way to describe the state of the market at the close of the day.

This approach enables optimal opening prices to be established, maximises order matching when the regular trading session begins, reduces the load on the exchange’s trading system (ITS) and helps manage price fluctuation and manipulation at the beginning and end of the normal trading session.
Some investors are very suspicious of these arrangements. This quote from a blog on the internet shows a lack of confidence and knowledge that is not uncommon. Advisers who discuss direct shares with their clients should be ready to explain why these sentiments are not accurate, and how the prices of these trades are calculated.

“We all know it goes on: before 10 am, any number of stocks are quoted with sort of reverse quotes, phoney quite obviously. The sellers selling dirt-cheap, the buyers offering prices way above last night’s close, right up to the official start of trading…
I’d like to know, what is the rationale behind all this? Does it serve any practical purpose? if these people are joking, isn’t it time the exchange put a stop to this silly practice?”

Prohibited conduct

Pre-open periods are particularly vulnerable to manipulation, and some practices which are always prohibited but which are particularly relevant to the Pre-opening periods are;

• Order Stacking or Layering of bids (placing Buy orders at various price points below the market to create a false appearance of buying demand).
• Marking the close (trading a stock near the close, with the objective of affecting the closing price).
• Wash trades (both Buy and Sell orders are entered by the same party to artificially inflate turnover, or influence the price of a security).
• Matched Orders (placing an order in the knowledge that an associate intends to make a corresponding offer to buy or sell the same securities on the same terms).
• Placing orders then cancelling them without apparent reason, especially close to the market open or before or during the afternoon Closing Single Price Auction.

Market Phases

Before we look at the pricing calculations, the following is a reminder of the various phases of the Integrated Trading System (ITS) throughout a normal trading day.

From 7 am to 10 am, no trading takes place. Brokers and investors enter orders which are ranked in order of price then time. This is the morning Pre-open.

At a time randomly chosen by a computer to be within 15 seconds of 10 am, share codes beginning with A or B commence trading. Existing orders that can be matched are traded at the Match Price (see below) established in the Pre-open.

The remaining stocks open progressively in tranches every two and a quarter minutes (+/- 15 secs) until the 5th and last block of stocks (S to Z) starts trading at 10:09 (+/- 15 secs).

Up to 4 pm the market trades normally.

For 10 minutes after 4 pm brokers enter, change or cancel orders ahead of the close. Trades do not take place, but Match Prices are calculated, updated and displayed. This period is known (oddly) as the Pre-open prior to closing.

For just 2 minutes from 4:10 pm (+/- 15 secs) a Closing Single Price Auction (CSPA) takes place. The auction takes place with all trades in any particular stock taking place at the Match Price which was determined in the Pre-open according to the rules discussed in this article.

The system is then available for adjusting then purging orders, and finally for system maintenance, before closing for 12 hours from 7 pm.

Match Prices in the Pre-Open

Because orders can be entered during Pre-open but trades do not take place, orders may ‘overlap’. This means that highest Buy orders may be at a higher price than the lowest Sell orders. Special rules are required to resolve the difficulty this creates.

For example, a stock in Pre-open has a Buy order at $10 and a Sell order for the same quantity at $8. ITS will not trade these ‘overlapping’ orders. When normal trading (or the CSPA) resumes, these ‘overlapping’ orders will trade at a price known as the Match Price or Single Price Auction. The Match Price is continually updated as new orders enter the system.

But what should that price be? If the system set the price in our simple example at, say, $9.00, then both parties would be satisfied. The buyer would be buying more cheaply than her order specified, and the seller would get more than he was prepared to accept. However, this will be the case at any price between $8 and $10. While it may appear to be fair to “split the difference”, that may not be the fairest solution in the real world, when many orders at various prices and volumes will often exist.

Note that the method described only has effect if there are overlapping orders. If the highest Buy order for a stock in Pre-open is lower than the lowest Sell order, then no trades take place and those orders will remain in the queue established by price and time in the system until cancelled, amended, purged or traded in the normal way in the open market.

Calculating the Match Price 

To calculate the single Match Price, four principles are applied in order. Each stage provides a filter for the next, so that only those possible prices that survive from the first stage are considered in the second. If only one price is possible after applying the rules at any stage, then that becomes the Match Price and it will not be necessary to go to a further stage.

Consequently, if a price can be established under the first of the principles, then that will be the Matched price. The fourth principle always establishes a single price.

The principles applied are these.

1. The price should be the one that provides the maximum volume of executed trades.
   For example, if there are 70,000 buy orders at a price of $10 or less, and 30,000 sell orders at $10 or more, then clearly 30,000 shares would trade if the price were $10. If there were a price at which a higher number of trades would take place, then that would become the Match Price under this first principle.
If the exactly the same volume of trades would be executed at more than one price, then a choice among them will be made by applying the second principle
2. The price should be the one that leaves the least quantity of shares in unfilled orders.
   For example, in the example used in principle 1, 30,000 shares would trade if the price were $10, and 40,000 buy orders would remain unfulfilled. If any other price that was still a possibility after principle 1 resulted in fewer unfulfilled orders, then it would become the Match Price.
If the same quantity of shares in unfilled orders would arise at more than one price, then a choice among them will be made by applying the third principle
3. The highest potential price should be used if market pressure is on the buy side, the lowest if the pressure comes from sellers.
   For example, using the same example again, if two prices remained from principle 2, then the higher of them would become the Match Price, because the unfilled orders are on the buy side. If pressure comes from both sides, the final principle will be applied.
4. The price should be set with reference to the last traded price.
   If the last traded price is within the range of potential prices that are still possible after applying Principle 3, then that will be the Match Price. Otherwise, the Match Price will be the potential price that is closest to the last traded price. For example, assume two prices, $10.90 and $11, are still possibilities after principle 3 is applied. If the last traded price was between these prices, for example $10.95, then that would be the Match Price. If the last price had been $11.05, however, that would lie outside the range, so the closest of the possible prices, in this case $11.00, would be the Match Price.

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On 15 January the Johnson Report (“Australia as a Financial Centre”) was released, and it included recommendations concerning the specific steps that need to be taken to enable Islamic finance in Australia.

On 12 February Trade Minister Simon Crean launched the Australian Government’s first-ever comprehensive publication on Islamic finance. (“Islamic Finance” can be downloaded from http://www.austrade.gov.au)  The booklet provides a detailed explanation of the opportunities that Sharia compliant investment and banking offers Australia’s financial services sector.

On 27 April, Assistant Treasurer Nick Sherry gave an important speech in Qatar, in which he announced that he had directed the Board of Taxation “to undertake a comprehensive review of Australia’s tax laws to ensure that, wherever possible, they do not inhibit the expansion of Islamic finance, banking and insurance products.”

This follows on from movement elsewhere. Last year La Trobe University launched Australia’s first Masters Degree in Islamic Banking and Finance, and two Sharia compliant funds (the LM Australian Alif fund and the MCCA Income fund) were also launched.

Many of these initiatives are targeted at the large worldwide population of Muslims, which makes up almost a quarter of the global population. The most populous Muslim nation, Indonesia, is right on our doorstep, and with a rapidly growing middle class, it certainly represents a major opportunity for Australian financial services if we can develop sufficient expertise and infrastructure to take advantage of it. There are also around 340,000 Muslims living in Australia. Nearly 40% of these were born in here, almost 60% are under 30 years of age, and many of them would no doubt like to use financial planning services that align with their beliefs.

Of course the financial needs of Muslim clients are no different from those of any other clients. Like everyone else, Muslims need to earn a living, pay bills and taxes and worry about retirement. Like all of us, they face the risks of uncertain investment markets, unemployment, sickness, accident, mortality and longevity. The difference is that the solutions to these needs must comply with Sharia. All Muslims believe Sharia is God’s law, but there is a great deal of disagreement between the different schools of Islamic thought, cultures and geographic regions as to exactly what it entails.  Also, as with most religions, there is a great deal of variation in the degree of strictness with which the rules are observed.

The principles of Sharia are not overly complex and these are the main ones that bear on the provision of financial planning services. There are general prohibitions on riba (interest on monetary loans) and gharar (preventable ambiguity in contract essentials). Specific prohibitions apply to such things as alcohol and gambling, and so many businesses including breweries and casinos will not be suitable for investment, and many common financial products, including interest bearing investments and mortgages will not be compliant. Commercial insurance is problematical, as interest is earnint on reserves, and uncertainty and gambling aspects come into play. Nevertheless, mutual help and protection is a principle of Sharia (“takaful”) and so with careful design, compliant  insurance products can be created.

Apart from the prohibitions, there are some obligations, such as Zakat (sharing wealth with the poor) and Hajj (the pilgrimage to Mecca which must be undertaken at least once in the life of an able-bodied Muslim who can afford it.) These matters should be taken into consideration when planning.

Not every Muslim client will automatically want to pursue a purist approach that requires strictly compliant products and a client may be willing to consider conventional financial solutions where a suitable substitute is lacking or is uncompetitive. The important thing is to make enquiries about what is acceptable and to tailor the recommendations accordingly.

There will often be debate about what is or is not compliant. In many countries Islamic financial institutions have established structures and processes for ensuring Sharia compliance within the personal finance industry. Typically, the institution will have a board of religious scholars that issues religious rulings on whether a product or service complies or not. In Australia, however, not much infrastructure of this kind is in place, and there is a shortage of suitably qualified Islamic scholars equipped to do the work. There is no need for advisers or product providers to be experts in matters concerning Sharia, or to be Muslims. But realising the potential for Islamic finance will need the training of scholars that can advise on Sharia compliance regarding issues affecting personal financial planning.

Usman Hayat, director of Islamic finance and ESG at the CFA Institute in the UK has published widely on Islamic finance. He has identified five challenges that face a financial planning practice that plans to target and service Muslim clients This is what he says.

“First, the business model of a financial adviser may have Sharia-compliance issues of its own. If the financial adviser is employed by a conventional bank, the client seeking Sharia compliance may shy away from the bank’s advisory services because conventional financial institutions are deemed non-compliant with Sharia for reasons that include the prohibition on riba. Therefore, the adviser may choose to check the Sharia compliance of his or her business model and obtain a formal ruling from a scholar from whom clients may seek advice on Sharia-compliant products.

Second, the Sharia compliance of products branded Sharia compliant by their providers may not be foolproof, and sometimes such compliance may only be a change in form rather than a change in substance of a conventional product. On more than one occasion, Islamic finance has experienced situations where products approved by the Sharia supervisory board of an Islamic financial institution were later criticized for lacking such compliance. Recently, Sukuks (compliant securitised assets that behave in a similar way to interest bearing investments) came under intense criticism when prominent scholars condemned some instruments for being dangerously close to conventional bonds. A financial adviser need not take positions on issues of Sharia compliance but should explain to the client that there is room for a difference of opinion on Sharia compliance and that some of the common practices in the Islamic finance industry are not without their critics.

Third, the position of Sharia on a given issue, as stated by a Sharia scholar, may come in conflict with the law of the land. For instance, transfer of wealth under Sharia could come into conflict with civil law, particularly where the client dies without a will. Clearly, financial advisers cannot assist clients in violating the law. They may, however, simply state the facts and confine their advice to solutions that comply with the law.

Fourth, given the emphasis on risk–reward sharing in Islamic finance and the prohibition on interest-bearing monetary loans, advisers may have difficulty meeting the suitability criteria of the client who seeks Sharia compliance but displays high risk aversion or a low ability to withstand risk coupled with vulnerability to inflation. In such situations, the adviser may need to explain to the client that given the general lack of Sharia compliance of conventional fixed-income instruments, the client needs to understand the potential trade-offs between Sharia compliance and risk avoidance.

Fifth, the need to educate the client while remaining sensitive to his or her emotions is likely to be greater than in conventional financial planning. The client may have only a vague understanding of the scope and implications of Sharia compliance. Because these matters concern the client’s religion, he may feel embarrassed that he neither understands such matters nor finds confining himself to Sharia-compliant choices easy. This challenge, however, is not one that most advisers would find difficult to overcome because their profession trains them to deal with it.”

It does seem that the Australian Government is serious about boosting Australia’s capacity to service Muslim consumers of financial services, and given the amounts of money involved, that seems to be a sensible thing to do. Although Australia is short of capacity, the international system is well organised. Among other things, an Islamic Financial Services Board (IFSB) headquartered in Malaysia has been in place since 2002 and The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), based in Bahrain, has been in place since 1990.

The IFSB has issued 12 prudential standards and other publications covering  risk management, capital adequacy, corporate governance, supervisory review processes, transparency and market discipline, ratings, money markets, governance for collective investment schemes and governance for Takaful (quasi insurance) operations. This is a substantial body, with almost 200 members, including The World Bank and the International Monetary Fund.

The  AAOIFI  issues accounting and auditing standards within the Islamic finance sector which attempt to align with local Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).

The introduction of Sharia-complaint financial planning into an existing financial advisory business is possible because the financial needs of Muslim investors are the same as those of any other investors. However, while the usual financial planning process can be applied with little amendment, the design of fully compliant solutions will have its challenges.

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Review of Wills

Despite the best efforts of financial planners, around 40% of Australians do not have a valid will. Intestacy results from a failure to write a will, but also occurs if a will is not valid (perhaps because it has not been signed and witnessed according to the law, the testator did not have mental capacity to make a will or the will has been badly drafted) or if a valid will has been made but all the beneficiaries have died. Partial intestacy occurs when a valid will exists but it does not dispose of the whole of the estate.

A will is revoked by making another will, deliberately destroying the old one, or by marrying. A will may be open to challenge, and may be invalid, if it does not adequately take into account any change of marital status including de facto arrangements, an addition of children, the death of a child or significant changes in financial circumstances.

Dying intestate

When a person dies intestate, the law of the jurisdiction in which the person is domiciled at the date of their death will determine how the estate is administered and the assets distributed.

If  there are no surviving spouses or relatives, the assets of the estate may pass to the Government of the State or Territory.

The new laws applying in NSW from March 1 make the provisions listed below. Note that the term “de facto spouse” has been replaced with “domestic partner”. Domestic partners are included in the definition of “spouse”, and they may be of the same or opposite sex. Under this definition, it is clear that a person may have more than one spouse.

• To receive a benefit in an intestate estate in NSW a relative must survive the intestate by 30 days (this is a new rule: previously a relative only had to survive the intestate)

• If a person dies leaving a spouse or spouses the spouse or spouses inherit the whole intestate estate.  This applies whether or not there are any children from the spouse or spouses, but It does not apply if there are children from other relationships involved.
• If there are children from a relationship other than the spouse/s (perhaps from an ex-spouse), the estate is divided according to a formula between the spouse/s and the children. When this formula is applied, children from both the current spouse/s and from the other relationship(s) are included.It works like this. The spouse will receive (or multiple spouses will share between them) a legacy of $350,000 as adjusted by the Consumer Price Index in accordance with a formula set out in the intestacy laws. (Under the previous intestacy laws the legacy was only $200,000 and only one spouse or one de facto spouse was entitled.) The spouse(s) will also receive the intestate’s personal effects and one-half of the remainder of the intestate’s estate.All children, including those of the other relationship and of the spouse/s, share the remaining part of the estate.
• Where multiple spouses survive the intestate their entitlement is shared in accordance with a written agreement they make between themselves and submit to the administrator of the estate or in accordance with an order of the Supreme Court. If no agreement or court order exists, they share equally between them.
• The legislation has created a new right for a spouse to acquire any of the property that belonged to the deceased. It must be paid for, either from the spouse’s entitlement in the intestate estate or, if that is insufficient, from his/her own resources.  The property includes any real estate or personal estate such as a car, boat or shares. Previously the spouse or de facto partner could elect only to take the matrimonial home. Note that this provision does not apply where there are multiple spouses.
• If no spouse exists, but only issue, then the issue share the estate equally. Note that “issue” includes all generations of descendants: children, grandchildren, great grandchildren and so on.
• If the intestate dies with neither spouse nor issue then the distribution goes, in order, to parents, siblings (there is no longer a distinction between siblings of the whole and half blood), grandparents, aunts and uncles (there is no longer a distinction between whole and half blood) and, finally, first cousins.  Cousins were previously not entitled. Note that if one or more of the siblings has died then their share will pass to their issue.
  

  Dangers of Intestacy

The NSW Trustee and Guardian (a NSW Government body which includes what was formerly known as the Public Trustee) has further information on its web-site on these changes at http://www.tag.nsw.gov.au/Intestacy/default.aspx. That site also includes the following real life examples of how things can go wrong when a valid will is not in place.

• A man died without a will. It could not be established that his birth was ever registered and therefore next of kin could not be established. His estate worth $180,000 passed to the Government.
• A reclusive woman decided to write her own will. The only relative with whom she had contact was a niece. However, after writing her own will, she asked the niece’s husband to sign the will as her witness. On her death she left an estate worth $400,000, but unfortunately the niece was not able to inherit the estate due to the fact her husband had signed the will as a witness. The will fell into intestacy as a spouse of a beneficiary should not be a witness. The estate was distributed to entitled next of kin.
• A woman decided to write her own will and one of the terms was “I want my house sold and the money from the sale placed into my investments”. On her death, it was noticed the woman had 2 investments, one which passed to her husband and the other which passed to her infant son. The issue was who was entitled to the proceeds of the sale of the house?
• A woman drafted her own will and she used a number of terms such as “balance”, “remainder” and “residue”. The whole will was confused and conflicting. Action was taken in court to rectify the terms of the will and the cost was $13,000, and took 2 years to complete. The value of the estate was $78,000.
• An eighteen year old man had been living with his girlfriend for only 6 months when he died without a will. The court decided that his girlfriend was his legal de facto spouse, and she received his entire, substantial estate. The man’s parent’s received nothing.
• A will provided for the income from a very expensive property to be paid to a person during her lifetime and after her death the property was to go to “Crown Street Women’s Hospital”. By the time the lady died that hospital had closed down and a lot of legal costs were spent in an application to the Court to decide which Charities were to receive the property. This could have been avoided by a carefully drafted will.
• John Thomas was a wealthy and educated man. He left a will in Australia to cover his Australian assets and a will in England to cover his U.K. assets. Unfortunately his Hong Kong assets were not covered by either will and were administered according to the Laws of Intestacy of Hong Kong.
• Jim had looked after his uncle Wayne for many years and had been assured that he was included in the will. When Wayne died Jim, searched the house for a will but to no avail. He checked all the local solicitors, banks and anyone else who might have dealings with his uncle. There was no evidence of a will anywhere or anything to suggest Wayne ever made a will. Under the Laws of Intestacy, Jim shared his uncle’s estate with several other nieces and nephews who barely knew their uncle and never attended to any of his needs.
• A 21 year old girl with no will was killed in a motor vehicle accident during the course of her employment. There was $200,000 accident cover. The estate passed to mother and father equally on intestacy but the father had deserted family weeks before she was born. He had had no contact since but was entitled to $100,000.
• A ‘family’ consisting of 3 step children fought for 3 years over the division of old ‘antique’ furniture which was valued at $6,000. Legal costs incurred by the children amounted to $55,000.
• Husband filled in a ‘do-it –yourself’ will form – intending to leave the whole estate to his wife. He inserted his wife’s name in the section of the form appointing her the executrix but forgot to insert her name in the section for nominating a beneficiary – in effect, he left the whole estate to nobody.

While this article is mainly concerned with the new laws in NSW, the broad principles, dangers, expense and inconvenience of intestacy apply equally in other States and countries. The job of drawing up a will falls to legal advisers, but a good planner will include questions about changes that may affect the currency of a will at every review, and will do everything possible to motivate clients to keep their wills, powers of attorney and beneficiary nominations current.

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Distinction between Warrants and Options

Option contracts are standardised, but there is a wide range of warrant types. Offerings from the different issuers vary significantly, and each warrant has its own distinct terms and conditions. The issuers of warrants must produce a disclosure document (PDS) for each warrant it offers. It is essential for investors to read and fully understand these documents before investing. Of course it is equally important for an adviser to do the same before advising a client to acquire any particular security, to satisfy the “know your product” requirement.

Warrants may be either call warrants, where the holder has the right to buy an asset at a predetermined price by or at a predetermined date, or put warrants where the holder has the right to sell an asset. Unlike options, investors are unable to write (short sell) warrants.

Underlying Assets

Warrants are issued over a variety of underlying assets. These include:

• individual shares
• baskets of shares
• share market indices
• commodities
• currencies

Trading and Investment Warrants

Warrants are generally classified as either “trading warrants”, designed for investors with shorter term investment horizons, or “investment warrants” for investors looking to gain longer term exposure to an underlying asset. Trading warrants tend to be higher risk/return than investment warrants. The distinction between the two categories is not always clear-cut, and some warrants may have features of both types.

Trading warrants include:

• equity put and call warrants
• equity barrier warrants
• currency warrants
• index warrants
• commodity warrants

Investment warrants include:

• instalments
• capped warrants
• basket warrants
• endowments
• structured investment products (ALPS, YIELDS)
• premium income warrants (PIES)

The diversity of structures, underlying assets and payoff profiles is one of the features of warrants that make them attractive to investors. However, as a result of this diversity they also present a fairly complex mix of risk/return profiles and strengths and weaknesses. Whether a particular warrant instrument is appropriate for a particular investor will depend upon the structure and terms of the instrument and the profile and investment goals of the investor.

Warrant Terms and Pricing Variables

Unlike options, warrants do not have standardised contract terms. However, depending on the type of warrant, the warrant price is influenced by many of the factors that affect option premiums, including:

• spot price of the underlying instrument
• strike price
• volatility of the underlying investment
• interest rates
• dividends

These variables may have different effects on different warrant types. For example, some warrants, such as instalments, entitle the holder to the dividends paid on the underlying investment. A dividend payment will therefore affect an instalment differently from a trading warrant, where the holder is not entitled to the dividend.

Other Warrant Variables

While the variables listed above are common to both options and warrants, there are a number of others that may be unique to warrants. These include:

• settlement terms—warrants may be deliverable by transfer of the underlying instrument or they may be cash settled
• conversion ratio—the number of warrants that must be exercised to enable delivery of one unit of the underlying instrument. All else being equal, the higher the conversion ratio, the lower the warrant price. To calculate the warrant price on a per share basis, multiply the price by the conversion ratio. For example, a warrant with a conversion ratio of 4:1, that is trading at $0.10, is worth $0.40 on a per share basis
• covering—a covered warrant is one offered by an issuer who holds the underlying instrument in a legal structure on behalf of the holder. The existence of physical cover reduces the counterparty risk faced by the investor
• index multiplier—this is applied in the case of index warrants to determine the amount to be paid to the investor at expiry
• cap levels—this refers to the upside cap placed on some warrant series that limit the investor’s return. Essentially, this represents an option written back to the issuer by the investor that is embedded in the structure. All else being equal, a capped warrant will trade at a lower price than an uncapped warrant
• barrier levels—these are defined levels, the breach of which causes some event to occur. Some barriers may cause a warrant to terminate before the original expiry date while others may cause an adjustment to the exercise price
• assessed value payment (AVP)—unlike options where the failure to exercise an in-the-money option at expiry results in the complete loss of the option’s value, the warrant issuer will make a payment to the holder if an in-the-money warrant expires unexercised. If the warrant is deliverable, the issuer must pay the holder an AVP, which is the warrant’s intrinsic value less reasonable costs. If the warrant is cash-settled, 100 percent of the intrinsic value must be paid to the holder.

Advantages and Disadvantages

Advantages of using warrants include:

• convenient gearing—there is no need to arrange a credit facility
• a wide variety of instruments to meet a range of both speculative and longer term investment objectives
• depending on the terms set out by the issuer, a holder of a warrant may be entitled to receive dividends and franking credits
• the ability to extract cash from physical share portfolios by transferring them into instalment warrant instruments
• innovative structures that allow the targeting of high-income yields
• tradeable on ASX
• ASX oversight of market
• tax benefits, depending upon the type of warrant and the investor’s individual circumstances
• time to decide for the buyer of the warrant, until expiry, whether or not to take delivery of the underlying securities (or if cash settled, await expiry)

Disadvantages and risks of using warrants include:

• the diversity of non-standardised structures can make it difficult for investors to compare offerings over the same underlying assets
• some warrant structures are quite complicated and require a high level of investment sophistication to fully understand the payoffs and costs
• the absence of a central counterparty means that investors face higher credit risk than with other exchange-traded instruments
• depending upon the popularity of particular issues, liquidity may be quite low
• the inability of investors to write warrants may inhibit the arbitrage mechanism that generally acts to ensure fair pricing in derivatives markets
• warrants entail significant costs for issuers, including the maintenance of an investor register, client services function, regular issue of new instruments, provision of finance, compliance with ASX Market Rules and managing and hedging their market exposures. These costs must be passed on to investors and may make them expensive when compared to other structures
• limited life of warrants may mean that the expected price movement does not occur before expiry

Warrants versus Options

While options and warrants share many characteristics, there are significant differences. The following table sets out the main differences.

Note: The accreditation for this CPD article is no longer current. Please visit our CPD section for current CPD quizzes. 

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The change has brought de facto couples under the Commonwealth Family Law Act which has applied to married couples since 1975. Before this change, each State had separate and quite different laws covering property and maintenance matters for de facto couples, such as the Property (Relationships) Act 1984 in NSW. Where disputes needing the attention of a court involved both parenting and property issues, de facto couples often had to commence proceedings in two different jurisdictions; a Federal Court to deal with parenting and a State Court to deal with property and maintenance.  Now the Family Law Court deals with both issues for de facto as well as for married couples under the same Family Law Act.

To whom does the Family Law Act now apply?

The Family Law Act now applies both to couples who are married and to those in a de facto relationship. Note that same-sex relationships are included within the definition of ‘de facto couple’ in federal laws and that all de facto couples now have the same rights and obligations as married couples regarding maintenance and the distribution of property. Other legal changes throughout 2008 and 2009 put same sex couples in the same position as opposite sex de facto couples regarding taxation, superannuation, social security and aged care.

The term “de facto” is not closely defined. To meet the definition, couples must not be married to each other nor related by family, and must have lived together on a genuine domestic basis. What amounts to a genuine domestic basis will be decided by a court’s assessment of all the circumstances, but an application for a “de facto property settlement” under the new Family Law Act provisions can be made if any one or more of the following conditions apply.

• The de facto relationship lasted for at least two years in total.
• A child has been produced by the de facto couple.
• A partner has made a substantial contribution to the property or finances of the other.
• The relationship was registered under a State or Territory law.
• The partners resided for at least one-third of the relationship in a state to which the new laws apply (currently all Australian states and territories except South Australia and Western Australia).

If there is a dispute about whether two people were in a de facto relationship, the Court will consider matters such as:

• the length of the relationship  (a minimum of two years is usually required);

• the living arrangements, including whose name is on a lease, who pays the rent and so on;
• whether a sexual relationship exists;
• the degree of financial interdependence;
• whether property was jointly acquired, used and owned;
• whether the couple had or cared for children together;
• how the relationship was presented in public and
• the degree of mutual commitment to a shared life.

The sex of the partners is not relevant. The new laws explicitly apply equally to de facto couples of the same or opposite sexes. A de facto relationship can also exist even if one of the partners is legally married to another person at the time, so the “mistress” (or the male equivalent) may now have rights that did not exist prior to 1 March 2009 and which may impact on the property rights of a married spouse who is not having an affair. This aspect has not yet been fully tested in court.

Who can apply for a property settlement?

The new laws apply to de facto relationships that broke down on or after 1 March 2009, but earlier breakdowns can be considered if each partner agrees in writing to have the new laws apply.  Application must be made to the Family Court in relation to property and maintenance issues within two years of your relationship ending. Applications in relation to children can be made at any time.

How will property be divided?

Before the changes, the outcomes in property settlements often differed widely between de facto and married couples. For example, in NSW only the relative contributions (financial and non-financial) to the assets and liabilities of the relationship were taken into account when deciding on the post-split division. Crucially, the Family Court now also takes into account future needs, so that matters such as the provision of an adequate standard of housing post separation and low future earning capacity will be factored in. The member of the couple who is financially stronger is usually less favourably treated under the changed rules, and often more than 50% of the net asset pool is now awarded to the weaker party.

Consequently, the Family Court will consider these factors.

• The net value of current assets, including houses, investments, boats, caravans and superannuation.
• What each partner owned before the relationship and the contribution each person has made to the upkeep and improvement of any assets brought into the relationship.
• The direct financial contributions (eg wages, or payments for properties or improvements to properties), indirect financial contributions (eg gifts, inheritances or payment of household expenses) and non-financial contributions (eg do-it-yourself renovations, caring for children or domestic tasks) made by each person over the course of the relationship.
• Each person’s future needs, including considerations such as who will have the care of any children, relative earning capacities, and the financial resources available.

Once the court has decided on the split of the assets, it may make orders about how implementation will occur, such as:

• that assets such as the family home will be sold and the proceeds will be divided in a particular manner;
• that title to various assets will be transferred;
• that regular maintenance payments will be made; or
• that superannuation funds will be divided in specified proportions.

Will formal agreements between partners be effective?

The new laws do provide for de facto couples to make “binding financial agreements” about the way they will manage their assets together. This can be done before moving in together, during the relationship or after separation. Legal advice should be sought, because neither party can unilaterally change their mind at a later date and ask for a larger share of the assets. Also, certain formal requirements must be met if the agreement is to be binding, and it is usually a good idea to register agreements with the Family Courts in the form of Consent Orders.

Financial planners who have clients in same or opposite sex de facto relationships who they refer to solicitors for wills, powers of attorney and the like, should put binding financial agreements on the agenda for consideration.

Do the new laws provide recognition of parenthood for same-sex couples?

Many children born to or adopted by same-sex couples will be recognised by the law as children of both parents. This will include:

• children conceived through assisted or artificial methods to lesbian couples;
• children adopted by one or both members of a same-sex couple, as long as both consent; and
• children born under surrogacy arrangements recognised under a state or territory scheme. (NSW does not have such a scheme).

This recognition of legal parenthood applies to child support and parenting matters including decisions such as where the children will live, who they will spend time with, and who will make long-term decisions regarding education, religion and the like.

The Family Court has always heard matters in relation to children no matter what the relationship status was between the parents. Before the amendments same-sex parents could obtain parenting orders if they could demonstrate they were a person concerned with the care, welfare or development of the child but they can now apply to the Court for parenting orders in their own right as a parent. Court decisions continue to be made by considering what parenting arrangements would be in the best interest of the child.

Recognition of same-sex parents in some other matters, such as consent for medical treatment, fall under state laws.

Can the court make orders concerning maintenance and child support?

Either member of a separated de facto couple can make an application for the other party to pay maintenance to them for their financial support. The court will consider the relative financial position of each of the partners, and will make an order for maintenance if:

• applicants cannot adequately support themselves financially due to poor health, having the care of a child of the relationship or similar reasons beyond their control; and
• the  former partner of the applicant has the ability to provide financial support.

If a maintenance order is made, it will usually be for a fixed and limited period of time.

From 1 July 2009 child support laws have also applied to same-sex-parents, regardless of whether the children were adopted or born through assisted conception.

If a person’s name appears on the child’s birth certificate, or a court has made a finding, or a statutory declaration of parenthood has been signed, then it is likely that parenthood will have been established with attendant child support obligations. A parent can ask the Family Court for a declaration that child support is payable by their former partner.

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