Like many investors out there, you have decided to ‘start out in alternative investments’. You understand your risk tolerance and you have your objectives in place – if not, you obviously didn’t read the last section, please do!

Now it's time to work through how to get started. As we have mentioned more than a dozen times in this book, it is vital that you get advice first. Speaking to an expert in alternative investments is key to your success, when starting out in the world of alternative investments.

You may think that investing in a managed fund is the best path for you, or maybe a piece of artwork. But which fund? Which piece of artwork? Why?

This is where the experts come into action. They can provide you with factual data on the performance of their funds, of their investments, of what your money ‘could have looked like’ had you invested with them 1, 3, 5, 10 years ago. Often this is very compelling, but always remember, that past performance is not an accurate predictor of future returns!

It must be noted though, that in the wake of the Royal Commission into the Financial Services Sector, new laws require a financial adviser to recommend an investment strategy that best suits the client so the expert should be able to speak about more than just their own strategy or an MDA, but a range of financial products to best identify what will suit your particular needs.

As an investor that is new to alternative investments, it is often easy to get caught up in how well funds have performed, but you need to ask why? What market conditions lead to this?

Although you might feel like a ‘dummy’ before you put your hard-earned money into a fund, you need to understand everything about how it works, you have every right to ask why, what, when, where and how as many times as you need until you feel comfortable.

Should you be investing in a fund or a scheme, there will always be a prospectus or information memorandum for you to review. Take it to your financial planner and/or accountant and ask them to review it, again ask as many questions as you can.

The key is not being caught up in all the ‘smoke and mirrors’ that sometimes-unscrupulous fund operators have. For example, from a sleepy little town in Northern New South Wales, Kingscliff came Gold Sky, voted the #1 fund in a prestigious Hong Kong awards for fund innovations.

The fund claimed to use ‘big data’, ‘social media’ and ‘quantitative analysis’ to deliver returns well beyond market averages. Backed by big named sports stars, and holding lavish events with industries heavyweights such as Mark Bouris guest speaking, everything looked like gold for this little fund.

Then, it all came crashing down as the SEC and ASIC started peeling back the layers of the onion, looking into the director, his fund’s management experience and of course the company balance sheet and realised it was nothing but a Ponzi scheme, leaving investors over $12 million out of pocket.

By definition, the “key elements of Ponzi scheme are as follows: (1) using new investor funds to pay prior investors; (2) representing that the investor returns are generated from a purported business venture; and (3) employing artificial devices to disguise the lack of economic substance or defer the recognition of economic loss”.

In short, where money is involved, unfortunately, there are in many cases a large number of unscrupulous operators, doing a lot of things that are not only bad business but also illegal.

Before you step into investing, be sure to get independent advice from more than one person including your accountant, your financial advisor, and your lawyer. But if you don’t have any of those, maybe consider looking into getting one, as you want to make sure you are always protected.

Now, having reviewed the multitude of investment opportunities, both in traditional and alternative investments, you should have a grasp of what each investment avenue can provide and where you potentially fit in.

Odds are, as this is a beginner’s guide, then you will be starting your journey into investing. If, however, you are reading this section of this e-book, then you have started your journey in the right way. Getting information and a basic understanding of the different types of investments - both alternative and traditional – is paramount before you start anything.

Once you have finished this book, sign up and attend a few seminars, take a workshop or two, even log in and start trading on a simulator – such as the ASX Game – which allows you to trade in live conditions, but with money that is not your own. Therefore you limit any losses entirely, but unfortunately, you don’t make any gains.

So, now to the million-dollar question, what type of investor are you? The key is to understand first what your objectives are? Are you looking for the thrill of trade, buying and selling quickly and taking risks, or are you looking to invest for the long term, maybe to support or fund your retirement?

Like you would a business plan, firstly, set yourself a series of key goals or objectives. These can include setting up a residual income stream in 5-10 years or turning $10,000 into $100,000 in ten years. Ensure you are being SMART or, Specific, Measurable, Achievable, Relevant and Timely.

For example, by 2025, I want to have a diversified portfolio of shares with a value of $60,000. So, even if you have to put in $12,000 per year, or $1,000 per month into your portfolio and you make no capital gains through the shares, this is achievable.

Once you have 5+ objectives in place, now it is time to understand your risk tolerance. Can you afford to lose everything you are putting in? If the answer is no, then shares, cash and property through the ‘traditional’ investment channels are right for you. Potentially being part of a managed fund, even investing in some art could be of benefit.

On the other hand, if you have come into some money – through inheritance or otherwise – maybe you own your own home, and you are looking to invest money and make a higher return – with little to no consequence to your livelihood or the roof over your head, then potentially looking at investing in a fund, ETFs or even CFDs could be an option.

We will always put a warning in place, that these alternative investment channels are used by experts, as when people with a little knowledge play in this space, they are often taken advantage of and can lose a lot more than you thought you were investing – as mentioned above.

So, the key is to get advice, seek experts to guide you. For example, many MDAs – such as the MDAs at Walker Capital – provide minimum investments of $10,000, and their returns – which you can see for yourself on our website – often buck the trends in the marketplace. It must be noted that the investment strategy used by Walker Capital as part of the MDA includes investing in highly risky and speculative products.

While investing is often seen as a long term strategy to future wealth and sustaining your lifestyle, there is no question that when you put your own money in, you become very interested in reading about company information, market movements and looking for the next play for your portfolio. Stay informed, read the financial papers, websites and blogs from ‘real’ authority figures – and NEVER invest more than you can afford to lose.

So, you could be a risk-averse investor, putting your money only into ‘blue-chip stocks’ such as BHP and the banks, while ensuring that you have your mortgage paid and your kids school fees paid. On the other side of the coin, you may have a high-risk tolerance, happy to risk $1,000, $10,000, $100,000 even $1,000,000 if the payoff is worth it.

The key is to set your objectives, set your limits, get expert advice and stick to your line – the moment you start deviating, getting carried away or ‘straying from your strategy’ this is where mistakes can be made and losses incurred.

Art

Investing in art has moved from the stuffy collections of the wealthy elite, into the mainstream as investors around the world seek to diversify their portfolios, hedge against risk and collect some beautiful talking pieces for their office or home walls along the way.

In 2019 the Art Basel UBS Art Market Report contended that the global art market was worth close to $US67 billion. Now to many investors, this may seem like something too good to miss out on, however, although the market value increased vs. 2018, the net gain over 10 years is 8.7 per cent, which is lower than the Australian rate of inflation! 

With over 40 million transactions in the global art market, there is an underlying assumption of ‘liquidity’ in the market, as could be assumed with the trading of shares, bonds or other financial instruments. However, this is not the case for all art, the market certainly is a ‘buyer beware’ scenario.

Like with other financial instruments, without prior experience or knowledge an investor wouldn’t simply walk in and buy any art piece off the shelf – unless they had the means to do so and like the work.

There are indeed intermediaries, galleries, and buyers’ agents providing services from simply the buying and selling of the works, through to providing services such as ‘buyers agents’ as you would find in real estate, who scout out particular works or artists. In addition, there are art investment specialists that work directly with clients to purchase high growth prospect works from rising or established artists.

It is often said that beauty is in the eye of the beholder, and no industry is this more apparent than the art world. What some people may see as an eyesore, could fetch astronomical prices at auction; it is simply about investing in the right works at the right time, and like any asset class, knowing the right time to move them.

Transparency and markets are often an issue with art

It is no secret that there are forgeries and many cowboys trading art around the world, and not merely in a Jack Ryan or James Bond thriller. Artworks, especially those considered ‘fine art’ can be sold for millions, tens of millions, even hundreds of millions of dollars, so it is no wonder there are forgeries and fakes circulating out in the marketplace.

The art market as a whole is largely unregulated, leading to a wide range of issues in itself. In addition, the trade in fine art is unpredictable because it depends not just on supply and demand but also on the unmeasurable factor of taste.

Although this is starting to evolve and change, with many art registers and auction houses around the world implementing blockchain technology for the purpose of cataloguing and tracking the movement of art from galleries, through to storage to stamp out forgery.

Like all investments, for those who are entering the market for the first time, or potentially looking to step their investment up a level, seeking expert, certified & professional advice is always the best course of action. As previously mentioned, there is a wide range of experts around the world that specialise in particular art types or even investment art pieces.

These are pieces that are in high demand by private and corporate houses, that seek to lease the asset, providing ongoing and incremental returns, while the owner also enjoys the asset value appreciation. Through the right investment strategy, there are significant opportunities and ROI that can be realised, not only for a capital gain but also for portfolio hedging.

Antiquities

Like art, antiquities have grown significantly in appeal for portfolio diversification in the past few decades. However, before such time, antiquities have been the source of much conflicts, such as the crusades in which the knight’s templar plundered much of the middle east in the quest for the holy grail, said to be the cup that Christ passed around at the last supper.

All that aside, antiquities have a large potential capital appreciation, and many of us don’t even know what we may have in the cupboard. From dinner sets, glassware, pottery, vases, furniture that has been created by famous artists, or production houses – such as Royal Doulton – have huge potential for capital growth.

Wine                 

If you were lucky enough to get your hands on a bottle of 1951 Penfolds Grange Hermitage from your grandparent’s cellar from back in the day, you would be doing ok. Individual bottles of the 1951 vintage are still held by collectors; one sold at auction in 2004 for just over $50,000.

The global wine industry was valued at approximately USD 302.02 billion in 2017 and is expected to generate revenue of around USD, 423.59 billion by the end of 2023, growing at a CAGR of around 5.8% between 2017 and 2023.

Investment in wine most certainly is not a new idea, however with high levels of transparency, accountability and liquidity – unlike say cryptocurrencies – there are huge opportunities to be made at all levels of the spectrum. It should be remembered that we are not suggesting you head down and get a case of 2019 cleanskins from your local bottle shop as an investment.

The fact of the matter is “less than 1% of all wine produced worldwide may be considered investment grade, with the market traditionally preoccupied with the prestigious chateaux of Bordeaux. The finite quantities produced, ever-decreasing through consumption generally ensure predictable growth in the long-term with a perfectly inverse supply curve”.

But in saying that, as new and emerging markets – such as the Chinese & South East Asian middle-class rise in numbers and appreciation of wines, the markets are certainly being challenged in terms of their supply/demand curve.

Like investing in stocks, art or maybe a fund, it is important to not just go it alone. Also remembering that just because you may like a particular wine, it doesn’t make it valuable. There are many wine shows around the capital cities and wine regions of Australia, as well as auction houses – such as Langton’s in Melbourne and Christie's Auction House in Sydney – that run specific wine investment courses, auctions and of course events.

Not only could you make a good investment by attending such a course, but also you will learn a lot and have a great time while doing it.

Other alternative investments

These include Private Equity Infrastructure, Private Equity Real Estate and Private Equity Debt Funds; these are very selectively used and are most certainly not available to any investor off the street.

The investments outlined are highly complex financial instruments that are used by only ‘institutional investors and extremely wealthy individuals.

That being said, it is still very important as you move through your investment journey, especially that into alternative investment opportunities, to understand them – if even from a basic level. As such, we have provided a brief synopsis of each to give you an understanding.

Private Equity Infrastructure

Investing in Private Equity (PE) infrastructure is an investment in utilities, transport, social infrastructure: such as hospitals and schools and of course energy assets. Unlike ‘private equity’, PE Infrastructure is treated differently due to its low volatility and strong cash yield. In addition, infrastructure assets performance is often implicitly or explicitly linked to macro indicators such as inflation, GDP, population growth, and has a very low correlation with other asset classes.

So, why can’t I jump on this asset I hear you say? Well, often the buy-in for such an investment is in the Millions, even hundreds of. Not only that, but they are highly complex in their structure and done through the big end of town. So although it would be great to put your $10,000 savings into, unfortunately, this is not for you.

Private Equity Real Estate

Typically for private equity real estate, the minimum rate of investment is often starting from $250,000. This is often a barrier to many investors.

Private equity real estate is an asset class composed of pooled private and public investments in the property markets. Investing in this asset class involves the acquisition, financing, and ownership (either direct or indirect) of property or properties via a pooled vehicle.

Although very risky – due to the fluctuations in property prices, supply, demand and other both micro & macro-economic factors – the return on investment is not uncommon to realise 8%, 10% even 20% depending on the countries and regions you are investing in, and the types of real estate assets – i.e. hotel, commercial, mixed-use and residential developments.

Private Equity Debt Funds

Created, raised and managed by professional investment firms and managers, a private equity debt fund is used for making investments in various ‘debt’ securities according to one of the investment strategies associated with private equity. At inception, institutional investors make an unfunded commitment to the limited partnership, which is then drawn over the term of the fund.

Similar to other funds, there are passive and active funds, depending on their level of management, however, as a general rule, they offer less attractive returns for investors. “A debt fund may invest in short-term or long-term bonds, securitised products, money market instruments or floating rate debt. On average, the fee ratios on debt funds are lower than those attached to equity funds because the overall management costs are lower”.

Often seen as a contentious issue within the Australian domestic & political arena, a private equity buyout is “A situation in which the shares of a public company are bought in order to make it into a private company”.

Throughout Australia’s robust investment history, there have been a wide array of positive and negative news stories when it comes to ‘private equity buyouts. These include the saviour of some companies and the complete and utter failure of others.

There is a wide variety of rationale for private equity buyouts, for both investors and shareholders alike. Private Equity allows the company to be taken out, presumably by a more skilled operator and then essentially take their business underground. Meaning that they can restructure, reorganise and remarket themselves as a ‘new and improved’ business.

How are private equity buyouts funded and how can you invest in them?

Often seen as ‘corporate raiders’ Private Equity Buyouts are undertaken usually through funds, that as previously discussed are created for the purpose of purchasing, getting, restricting and spinning off – selling the whole or the best parts – of the company in the short to medium term.

Other Private Equity Buyouts are done through a fund, but with the long-term play at hand, looking to buy, build and grow the assets, with fund unit holders realising their returns from the successful implementation of this strategy.

So, like an investment in a managed fund, a private equity buyout fund will have a prospectus or information memorandum that is available for investors to review and apply to invest in should they meet the investment criteria.

With these sorts of investments, they can often be risky depending on the nature of the business and the financial and operational state it is currently operating under. As such, they are usually restricted to institutional and sophisticated investors – such as your industry superannuation fund or Gina Rinehart.

An example of these sorts of Private Equity Buyouts are those undertaken by Quadrant Private Equity in Australia, who have a range of funds and portfolios with an asset mix to diversify the risk and provide the best possible returns for shareholders.

Why are Private Equity Buyouts so important to Australian business?

In 2019, “Pacific Equity Partners’ data on the number of deals greater than $200 million suggests activity was relatively stable, with 17 deals done in 2019, up from a five-year average of 15 deals”. “While as a whole, in 2018 private equity registered $28 billion for 72 buyouts, rising 85.2 per cent from the year before with $15.1 billion covering 67 deals”.

As can be seen, the sheer volume and value of these transitions are huge for the business owners and investors of Australia. In addition, being part of a buyout fund is equally important.

In Australia, we have a long list of high-profile casualties, the most recent of which are well-known retailers such as Harris Scarfe and Dick Smith Electronics. However, often, Private Equity Buyouts have significant upsides, and it isn’t just brands or companies in trouble that are being acquired, with the 2019 buyout of Arnott’s Biscuits being purchased for $3.2billion AUD!

What do Private Equity Firms do with companies once they have acquired them?

There are several key reasons private equity firms purchase companies, or they acquire large stakes within companies.

Purchasing distressed assets to build back up is a key reason for a private equity firm’s existence. That is, where the original management has either mismanaged or doesn’t have the skills or capabilities to take the business through the transition it needs to take to become a great company with long term prospects.

As such often, there are ‘fire sales’ in which investors seek to exit the market in a hurry to minimise their losses (through the share market), or are offered a price for their shares – often pennies on the dollar of what they originally paid – to sell their shares to the private equity firm.

The goal is then, for the private equity firms to bring in management consulting companies, administrates and install their own management teams to bring the company up from the brink of collapse – or even long term losses – to being a successful entity in their own right.

Purchasing companies to pull them apart and spin-off

One of the more aggressive strategies is that of private equity firms valuing particular assets or departments within companies, which are able to be cut out of the business and sold off.

Similar to a car wrecking yard - in which the value of the individual parts of a car are sold off, far outweigh the value of the car sold as a whole – the companies are acquired, consultants are brought in to strategically manage the process, and the company is literally carved up and sold off for profit.

This can be most successful when companies have a range of core and secondary offerings, such as an airline that may have a frequent flyer program, the airline operations, the ground staff, catering and more divisions, that can essentially be picked apart and sold off as individual entities.

Strategic purchases companies to gain a competitive advantage

Many companies rely on their supply chain to operate an effective business model. Often, be it a physical asset such as a railroad, port or manufacturing facility; or a technical asset such as Intellectual property, technology or employee skills, a competitor or upstream/downstream company within the supply chain will often look to acquire companies through private equity deals.

For example, a drinks company may be looking to sure up its supply chain and purchase a bottle making company and a small logistics company, to ensure it always has supplies available.

An example of this is Hancock Prospecting purchasing Atlas mining company in 2018, which held a strategic port that Hancock required for its mining expansion and movement of iron ore. As such, shareholders were offered a ‘buyout offer’ at a premium to the current share offering. This then required a minimum acceptance rate by shareholders, and Hancock was able to gain the strategic asset.

Activism investing

One other rationale for private equity buyouts is that of Activism investment. There are a wide number of activism investment firms and funds that seek to purchase outright or portions of companies that they feel require a new set of values.

This is most apparent in the banking sector, mining companies and anything essentially that has an adverse effect on people, the environment or is considered at the ‘behest’ of the community. It should be noted that these funds and companies often ‘bet against’ these companies, such as buying derivatives against them, to push the price down, but there are many instances where the private equity route is perused, and the company is purchased as a whole.

Although currencies can often be considered a ‘traditional investment’, Cryptocurrencies certainly don’t fall within this category. This is largely due to the fact they are volatile, they move against the market in many instances, and they are largely speculative.

Although this was not their original intention, which was to become an online currency through the use of blockchain technology, it was taken over by the money markets, a FOMO or fear of missing out ensued, derivatives were created, and the whole thing tumbled, so let’s take a look.

Cryptocurrencies such as Bitcoin, Ripple, Ethereum, Tron and literally hundreds more have been gracing the pages of the tech investment market updates and getting the motors running of many savvy investors around the globe.

Believed by many as the future of money, cryptocurrency has emerged over the past 10 years across the globe as a way to not only engage in eCommerce, but purchase items such as clothes, cars, houses, even meals at KFC!

What are cryptocurrencies?

Essentially cryptocurrencies are a form of electronic money. The money doesn’t physically exist but are held in the form of a ‘digital token’ created from code using an encrypted string of data blocks, known as a blockchain.

Bought and exchanged on exchange platforms using money, they can then be traded in marketplaces similar to trading shares online. Some popular exchanges include the Australian platform CoinSpot and other popular global platforms such as CoinBase, LinkCoin and Cex.io.

Of all the coins, the most popular and the largest in terms of market capitalisation is Bitcoin. In existence since 2009, its creation is shrouded in a great deal of secrecy and mystery.

Created by Satoshi Nakamoto, who posted the article Bitcoin: A Peer-To-Peer Electronic Cash System on a mailing list discussion on cryptocurrency in 2008, the cryptocurrency was created to cut out the middleman in transactions – such as banks. The cryptocurrency does this using blockchain technology, which makes the transaction not only safe, but if you don’t have the exact ten-digit code required – you can’t get your money back.

In 2010, the first cryptocurrency trade took place with an investor deciding to sell their Bitcoin for the first time – swapping 10,000 of them for two pizzas. If the buyer had hung onto those Bitcoins until December 2017 they would be worth more than $56,336,600 Australian dollars!

Since the early days of Bitcoin, the market has grown to include new currencies and global awareness of the features (ie. advantages and benefits of owning your own piece of digital currency) has grown. Interestingly, one of the core benefits of cryptocurrency is that you don't need to own a whole coin, just a part of one to be in on the action.

The rise and fall of Bitcoin

Bitcoin is the largest of all the coins and valued at $5633.66 per coin as of the 17th of March 2019, in a market that is valued at $97,196,079,818.08 Australian dollars!

The market took a massive turn in 2017 as the mainstream jumped at the chance to make some money and the rising tide of FOMO (fear of missing out) with the cryptocurrency starting the year at $1381.40 per coin on the 2nd of January 2017, hitting its peak at $26,802 on the 17th of December 2017!

People couldn’t believe their luck, as people were turning into overnight millionaires, but this was assuming that they had all the required codes to sell their coins and that they sold when the time was right.

With many expert investors such as Warren Buffet saying that Bitcoin was 'probably rat poison squared', there were many sceptics that couldn’t believe the prices were sustainable – and they were right!

By February 2018, the price had crashed down to $10,188.99 per coin hitting its lowest point on the 10th of December 2018 of $4646.25.

So, what happened?

There were a number of straws that broke Bitcoin’s back. Firstly, a number of countries banned trading – such as South Korea – many of who had a massive love of the cryptocurrency up until that point. This was due to serious concerns about regulation, tax implications and the fact the money could be traded with virtually no oversight.

Secondly, the price rise in 2017 was driven by a bubble, as more and more people heard about the cryptocurrency and jumped on in a case of fear of missing out (FOMO), thus the rules of demand & supply came to fruition, more people wanted the cryptocurrency and people holding them wanted more of them.

Finally, the Chicago Board Options Exchange and Chicago Mercantile Exchanges listed Bitcoin Futures, which allowed sophisticated speculators to short the coin on a large scale – effectively crashing the price.

There are other currencies aren’t there?

Absolutely, there are hundreds if not thousands of cryptocurrencies – 2112 according to Coinmarketcap.com as of March 17 2019 - which should have all been operating as their own markets shouldn’t they?

Although the cryptocurrency market was not supposed to be a derivative market, it most certainly became one. Not only thanks to the shorting of the cryptocurrency that was occurring on the Chicago exchanges, but also when Bitcoin crashed, it took the entire market with it.

By the end of the first quarter of 2018, the entire cryptocurrency market fell by 54 per cent, with losses in the market topping $500 billion!

Currency or speculative instrument?

There are a number of shortcomings of cryptocurrency, firstly they were set up as an ‘alternative currency’, and in the initial outset, early adopters were using it to purchase anything from pizzas to islands (at the market peak).

As a currency, it failed. Bitcoin has morphed into an asset whose only purpose is speculation. Imagine walking into a store and purchasing a meal, only to find out it went from costing you $50 to $500 due to the movement in the price!

Block chain – where do they fit in?

Used by many cryptocurrencies and an original feature of the Bitcoin cryptocurrency, blockchain technology was an important innovation that has already changed and will undoubtedly change a range of industries and transactions in the future.

A blockchain is the structure of data that represents a financial ledger entry, or a record of a transaction. Each transaction is digitally signed to ensure its authenticity and to ensure no one tampers with it, so the ledger itself and the existing transactions within it are assumed to be of high integrity.

These digital ledger entries are distributed among a deployment or infrastructure serving the purpose of providing a consensus about the state of a transaction at any given second.

Blockchain provides a high level of security when it comes to the management of ledgers or databases of information. The whole idea was a ‘peer to peer’ system, rather than trading through a third party, such as a bank.

Other uses for blockchain technology could be to create a permanent, public, transparent ledger system for compiling data on sales, tracking digital use and payments to content creators, such as wireless users.

There have been applications across the ownership and trading of assets, such as artwork, whereby investors can purchase a ‘piece’ or percentage of the artwork and trade it on a platform as they choose utilising the blockchain technology.

So, what does the future of cryptocurrency hold?

Although the market has seen a performance that can only be described as a rollercoaster, the cryptocurrency market provides a high number of tradeable speculative instruments for account holders.

Companies such as Ripple with their XRP currency have contracts that are being explored by the likes of Santander and CIMB for future transactions and may even replace Swift payments for cross-border transactions which provides huge scope outside of the speculative instrument that many cryptocurrencies have become.

The perception of traditional financial institutions around cryptocurrency is changing. Moving forward, stakeholders can expect to see an increased inflow of funds from Wall Street into the crypto market as crypto funds, ETFs, and other investment vehicles debut. However, the inflow of Wall Street will also require increased transparency, accountability, and regulation.

It needs to be remembered that although cryptocurrency has experienced massive spikes and drops in price, it is also in its ‘early adoption’ phase. As such, there may be market volatility such as what was experienced in 2017/2018 until mass-market momentum steps in.

The market for cryptocurrency has come a long way and fast, and now institutional investors, global corporations and governments are looking at how they can utilise, incorporate and regulate the cryptocurrencies themselves, as well as the technology that underpins them.

Although cryptocurrency may have failed in its initial attempt to create an ‘alternative peer-to-peer’ currency, it has instead created a speculative instrument and is far from being dead and gone.

Cryptocurrencies have the hallmarks of being excellent trading instruments for people who want to take the time to learn and trade the market, but their future could be a highly lucrative, albeit highly speculative path.

In today's ever-present and ever-expanding financial markets, there are many forms of trading undertaken by individuals and institutions to gain an advantageous position or financial outcome.

One of those forms of trading is known as proprietary trading, or "prop trading," which occurs when a trading desk at a financial institution, brokerage firm, investment bank, hedge fund or other liquidity source uses the firm's capital and balance sheet to conduct self-promoting financial transactions.

How is propriety trading different to regular trading?

Unlike regular traders at your financial institution, brokerage firm, investment bank, hedge fund or an associated institution, the propriety-trading desk is run independently to that which the client’s institution serves, and is set up to benefit the institution first and foremost.

Traders traditionally make their money through a range of fees from clients, primarily a ‘brokerage fee’ which is for the service of the institution facilitating the trade on behalf of the client. The second is what is known as the “spread”.

In stock trading, this is the difference between the current bid and ask prices for a stock (the bid/ask or bid/offer spread). In futures trading, this is the price difference between delivery months for the same commodity or asset. In bond trading, it is the difference between yields of bonds with similar quality and different maturities, or of different quality and the same maturity. In underwriting, it is the difference between what the issuer receives from the underwriter and what the underwriter receives from the public (underwriting spread).

Therefore, as the above definition from the Financial Times suggests, it is the difference between whatever financial instrument costs to acquire for the broker or institution and what they on-sell it to the client for.

Proprietary trading differs in that it uses the internal, institutional cash to profit from opportunities in the marketplace, without clients being involved.

Are there any benefits to clients of institutions who conduct proprietary trading?

Although proprietary or “prop” trading is primarily focused on the institution itself and profiteering from the skills and expertise of the proprietary trading desk traders, it also has several key underlying benefits for the retail clients of the firms that undertake proprietary trading.

However, it must be noted before we move too far forward into the benefits of proprietary trading, that it is seen as a risky form of trading, albeit one of the most profitable operations of a commercial or investment bank. During the financial crisis of 2008, prop traders and hedge funds were among the firms that were scrutinized for causing the crisis in the first place.

When it comes to the specific benefits for the clients of the institutions that engage in proprietary trading, there are a number of key qualities in favour of this style of trading which are outlined below:

Firstly, the institution can increase its liquidity due to the fact that 100% of the profits made through proprietary trading are kept in-house, not distributed to clients. Increasing liquidity allows the company to grow, employ more and better systems, analysts and traders while also the services offered to retail customers.

Secondly, the institution can stockpile a pool or inventory of securities & other financial assets. This assists clients as an inventory allows the institution to offer an unexpected advantage to clients.

Thirdly, it helps these institutions prepare for down or illiquid markets when it becomes harder to purchase or sell securities on the open market, thus making them available for their clients to access – not the general market.

Proprietary trading allows a financial institution to become an influential market maker by providing liquidity on specific security or group of securities.

In reality, the client benefits are that the banks and institutions that conduct proprietary trading in theory should be more liquid, and have access to assets in potential markets which don’t favour their client’s position. This means that the trader can be in a state to assist them buy or sell the asset as they require, not to mention being a market ‘maker’ or influencer’ which could further assist their client’s position.

It is no secret that proprietary trading has the primary goal of making money for its institution.

Understanding the Volcker Rule

It is hard to go into too much detail about proprietary trading without first discussing the Volcker Rule. Created in the aftermath of the 2008 Global Financial Crisis and named after former US Federal Reserve Chairman Paul Volcker, the Volcker Rule disallows short-term proprietary trading of securities, derivatives, commodity futures and options on these instruments for banks’ accounts under the premise that these activities do not benefit banks’ customers.

In other words, banks cannot use their own funds to make these types of investments to increase their profits. The purpose is to discourage banks from taking too much risk.

Although the Volcker Rule in relation to proprietary trading specifically is a US Federal law and not applicable within Australia, it sets the tone for regulation of the industry in not only the wake of the GFC, in which over $14 trillion was wiped from the global economy.

On a global level, it was realised that banks in many countries, not only the USA were not managing their levels of risk. In response, the Basel Committee on Banking Supervision revised its international framework of regulatory standards to improve the resilience of the global financial system. The revised framework increased capital requirements and introduced minimum liquidity standards.

In Australia, the 2014 Financial System Inquiry made a number of recommendations to strengthen the Australian financial system. In addition, APRA implemented a range of changes to the amount of capital and liquidity that a bank needed to hold. As a result the total capital ratio of the Australian banking system has risen to 3¾ percentage points since the start of 2008, and according to the RBA in June 2017 stood at 14¼ per cent.

By doing this, the changes meant that the banks are in a stronger position to weather any financial storm that may occur. Coupled with the Australian bank response to the 2018 Royal Commission into the Banking and Insurance sectors has now seen increases in liquidity but contractions in the retail finance offerings that receive approval in terms – particularly in terms of residential and small business loans.

For example, an analysis of more than 30,000 mortgages from online broker Lendi has found approval times have more than doubled for investors over the past 18 months while the wait time for owner-occupiers has increased by more than 50 per cent as the banks demand more information from borrowers.

The future of the sector has changed dramatically and is set for more change, largely in the name of protecting consumer’s interests.

A final word on propriety trading

Propriety trading is a highly profitable and internal way for firms to increase their market cap. Through trading in stocks, bonds, commodities, currencies, derivatives using a firm’s money rather than trading on behalf of clients, allows businesses to make profits for itself, providing financial firms with a strong financial advantage.

When trading with client’s money, in a fund or as part of a managed investment scheme, although the risks are minimised, in large part the profits (and losses) are enjoyed by the client, while the firm who has done the majority of the work, research and applied their expertise only enjoy their fee (eg. charged as commission or brokerage or as a spread margin) charged to the client.

Propriety trading allows firms to wave the fees, not apply the spread to the trade, whilst benefitting from all the in-house knowledge, skills and expertise to profiteer from and add to the bottom line.

There are the risks that institutions around the world, where the Volcker rule does not apply, will not apply sufficient rules and regulations around propriety trading which could, in theory – and in practice – collapse companies and economies around the world should they not be managed efficiently.

From the credit default swaps of the 2008 financial crisis, through to mortgage-backed securities of today, there is a range of financial instruments – especially derivatives - that promote a winner takes all mentality that banks simply should avoid to stave off a future global financial crisis.

Proprietary trading does not affect retail investors – unless for example the proprietary trading division causes the firm to file for bankruptcy as a result of incurring large losses - as it is the firm investing its own money. Only in the case of unethical behaviour in which a firm takes a position against that of a fund under their management – for reasons not as a hedge for a fund itself – or bets against the position taken by the fund should an investor be affected.

As an investor, it is important to understand about proprietary trading and its purpose, however, unless you are involved in fund management yourself, as a retail investor you will have little contact with the features, advantages and benefits of proprietary trading.

A managed discretionary account (MDA) is a facility – other than a registered managed investment scheme (registered scheme) or an interest in a registered scheme – in which an MDA client entrusts management of their portfolio of assets to an MDA provider.

Pursuant to ASIC Instrument (Managed Discretionary Account Services) Instrument 2016/968 an:

MDA provider means a person who holds an Australian financial services licence that authorises:

(a) dealing by way of issue in either or both of:

(i) interests in managed investment schemes that are limited to a right to receive MDA services; and

     (ii) miscellaneous financial investment products that are limited to a right to receive MDA services; and

(b) dealing in all the financial products that may be acquired with client portfolio assets under the MDA contract; and

(c) except where an external MDA adviser has contracted directly with each retail client to whom the MDA provider provides MDA services to provide financial product advice relating to the ASIC Corporations (Managed Discretionary Account Services) Instrument 2016/968 Part 1—Preliminary investment program—providing personal advice to people as retail clients in relation to the MDA; and

(d) except where an external MDA custodian has contracted directly with each retail client to whom the MDA provider provides MDA services to hold each client portfolio asset that is a financial product or a beneficial interest in a financial product—providing custodial or depository services, in relation to those client portfolio assets.

Managed Discretionary Accounts are essentially a portfolio management service in which investors provide funds to an investment manager to manage your portfolio in line with an agreed Investment Program and the client retains beneficial ownership of the assets.

By setting up a Managed Discretionary Account, you are able to remove the constant back and forward between you and the manager when it comes to the buying, selling or applying for investment in a wide range of investment products. So essentially, you are giving your money – or some of it – to someone else to look after.

The key benefits of a Managed Discretionary Account are that you are gaining access to a professional investment manager with extensive access to research and expert stock selection, which ultimately includes their active management of your account on a daily basis, responding proactively to market changes.

In addition, your Managed Discretionary Account can have a high degree of flexibility and tailoring to your specific investment strategy and or needs, including your risk tolerance rather than your money being merely thrown into a fund along with all the other investors pooled money.

In this way, Managed Discretionary Accounts are different from managed funds and provide greater transparency – through portals and individual correspondence - as to what the investors’ money is doing and when.

Who regulates Managed Discretionary Accounts?

With the spotlight placed firmly upon the financial services industry in the wake of the 2018 Royal Commission into the misconduct in banking, superannuation and the financial services industry, there is little doubt that investors are more aware of the need for accountability and transparency in their dealings with advisors in the sector.

Managed by ASIC under the Regulatory Guide 179: Managed Discretionary Accounts, there are strict rules and regulations that govern the setting up and running of these accounts for retail clients.

Therefore, providers of MDA Services must hold an Australian Financial Services (AFS) Licence with specific authorisations which allow them to issue MDA Services to clients. As a result of holding an AFS Licence they are governed by ASIC under the Corporations Act 2001.

Under an MDA Service you will receive personal advice from your financial adviser, who must hold the professional qualifications (or will be working towards holding the professional qualifications during the transitional period) as prescribed by The Financial Adviser Standards and Ethics Authority (FASEA) and meet, at all times whilst dealing with you, the principles and core values set under the Financial Planners and Adviser Code of Ethics.

Why use a Managed Discretionary Account?

The underlying benefit of Managed Discretionary Accounts is flexibility and transparency.

According to financial adviser and co-founder of Plenary Wealth Julian Nowland, “Using managed accounts has allowed us to switch the client communication on investments from being an admin and paperwork focus into a marketing and education strategy”.

Nowland continues, “instead of requesting information from clients to fill out forms or getting permission to buy this and sell that, we can focus on education, keeping clients updated on changes being made to the MDA, why it has happened and how that relates back to client’s lifestyle outcomes.”

By reducing the amount of paperwork and the authority to execute buys, sells and applications for financial instruments within the agreed guidelines, managers are provided with far more flexibility to act and capitalise upon opportunities as they arise – often in a time-critical manner.

If the account was ‘non-discretionary’, the advisor would require a range of authority from the client and paperwork to be completed by the client to transact the trade. This also assumes that the client was available at any given moment to speak with the advisor.

As such, Managed Discretionary Accounts are ideal for people who are busy or people that don’t have the time or skills to be involved in the ‘active portfolio management’, but rather prefer a balanced approach to their investment strategy having a long-term view.

In addition, should the client be travelling or on a different time zone, Managed Discretionary Accounts can provide solutions, which allows them to be essentially passive to their portfolio management, while their advisor makes their money work for them.

With usually a minimum $250,000 minimum investment requirement, they are suited to the sophisticated investor and those who meet the investment requirement.

What to look out for in a Managed Discretionary Account Manager?

When looking to invest money into a Managed Discretionary Account, there is a range of elements that you should always look for when assessing the viability of a manager for your account. Firstly, you want a manager who has knowledge around not just securities, but also a wide range of derivatives, managed investments, foreign exchange, margin lending and alternative investment strategies.

Having a Managed Discretionary Account manager who is well versed in a wide variety of investment options will provide you with the most holistic portfolio options and opportunities, which is always a benefit for any portfolio. In addition to this, ensure that your chosen financial advisor is on the Moneysmart Financial Advisors register and that they hold (or are working towards holding) the professional qualifications prescribed by FASEA.

Why are Managed Discretionary Accounts growing in popularity?

Like many industries, the financial services industry is being held to account for often out-dated practices due to technology driving innovation in the sector. As such, this technology is seen not only to increase efficiencies but also in transparency and accountability.

Growth in Managed Discretionary Accounts has been driven by several factors, including:

• An attempt to achieve greater practice efficiency among advisers
• A desire by advisers to deliver better, more precise client outcomes
• Technology developments that have enabled the systematic, model-based management of many portfolios
• A strategic trend for advice businesses to move towards wealth management, with different pricing models

Through Managed Discretionary Accounts, investors are able to be more connected to their investments thanks to technology and have more visibility and accountability, while the account managers have the authority and flexibility to act as the opportunities arise to maximise the growth potential of the portfolio.

Unlike many funds, in a Managed Discretionary Account, the investments and cash are all held in your name, on your HIN rather than on the managers or the fund itself. As the owner of the Managed Discretionary Account, you can always log in to review the exact composition and value of the portfolio at any time through online platforms, providing the ultimate in transparency.

In addition, Managed Discretionary Accounts are far simpler to manage come tax time, as all the investments are held by you, without other people moving in and out of the fund, potentially impacting your capital gains tax each financial year.

However, as with any financial service or investment, there are risks that need to be assessed and managed in line with your personal investment strategy, risk tolerance and desired outcomes.

The size, make-up and strategy you employ in your Managed Discretionary Accounts, like all investments, will be subject to market volatility, company, sector and industry risks. When dealing with overseas markets or currency, it should always be assumed that foreign exchange risks would apply and have a bearing on the gains/losses.

When using leveraged products, such as CFDs (contracts for difference) or leveraged loans or positions to amplify the position that the Managed Discretionary Account manager may employ or wish to hold, it should be noted that your position may require additional capital that exceeds the amount available in the fund, should the investment go against your position. Participation in leveraged products should be the part of your investment strategy which is taken with caution.

With all of the potential benefits that Managed Discretionary Accounts offer to investors, there are risks, but like any good hedge, they can be managed with due diligence and ensuring that your account manager is suitability qualified and experienced to meet the needs of your investment goals.

An ETF or exchange traded fund is a type of investment fund that can be bought and sold on a securities exchange market. They are often known as ‘passive investments’ and generally track in line with the value of the market or index they are tracking.

There are a range of reasons or rationales as to why people take out ETFs, from diversification of their portfolios, through to passive management and the low cost of management. Depending on an investor’s individual and personal investment goals and strategies, their reasons may vary.

A look inside an ETF

ETFs are funds in which investors can place money, which then uses those funds to purchase securities and, in turn, issues additional shares of the fund. When investors wish to redeem their mutual fund shares, they are returned to the mutual fund company in exchange for cash. Creating an ETF, however, does not involve cash.

As outlined by CommSec, ETFs trade at a unit price close to the net asset value of the underlying portfolio and each ETF has a unique ASX code, just like ordinary shares.

Features of ETFs:

• As ETFs have an open-ended structure, you can enter and exit an ETF as you choose (subject to liquidity).
• ETFs are a basket of securities created by issuers or fund managers
• Each ETF generally looks to replicate the returns of a specific index/benchmark
• Each ETF is allocated an ASX code and lists on the Australian Securities Exchange as one entity
• You trade and settle ETFs like ordinary shares, with a minimum investment of $500

Examples of ETFs are Vanguard Australian Shares Index (VAS), which is comprised of Australia’s 300 largest companies, seeking to provide a fund that mirrors the performance of the S&P/ASX 300. Another is the BetaShares U.S dollar ETF, which tracks the USD relative to the AUD.

ETFs vary in terms of the type of market, asset class or currency that they follow, but in real terms, they are created to track the performance providing hedging opportunities for investors.

Why do people invest in ETFs?

Diversification is the key reason people invest in ETFs. ETFs allow investment in a range of companies that wouldn’t be viable for an individual investor to achieve on their own, however, through the fund and the economies of scale it brings.

The second reason people invest in ETFs is for passive investing. Passive investing costs less than active investing, because you do not require a fund manager to buy and sell your portfolio’s assets, as you are relying on the long-term strategy of market growth. Passive strategies can outperform active strategies on the savings of the transaction & brokerage fees alone.

Thirdly, ETFs are simple to buy and sell. When the ASX or exchange that your specific ETF is listed upon opens, you can trade through an investment firm or online broker at any time at the market price.

When it comes to owning ETFs, the costs are low. As the performance is tracking with the market, you are not paying a broker or manager to actively manage your portfolio, thus reducing your costs.

Finally, the transparency & accountability of the ETFs is such that they are required for the most part to publish a list of their holdings on a daily basis. As an investor to the fund – or a potential investor – you can review their weighting in the fund on particular assets so you can ensure that your investment objectives are being aligned with by investing in the particular fund. Should you see a deviation of any type to your strategy or objectives, then you can sell out at the market price.

ETFs – An Example

When looking at a particular fund, we will turn to the example of Vanguard Australian Shares Index ETF (VAS). As per their fact sheet, the fund seeks to track the return of the S&P/ASX 300 Index before taking into account fees, expenses and tax.

As at January 31^st 2020, with a total fund size of $18,937.1 million in 298 holdings, the fund is heavily weighted in some of Australia’s most well known ASX listed companies including Commonwealth Bank, BHP, Westpac, CSL and ANZ Bank.

The sector allocation, as with the ASX300, is geared at 31.8% financials, 18.6% materials, 8.5% health care and 8.1% industrials as the top 5 largest segments, which stands to reason considering the state of the Australian economy.

In terms of allocation of the holding details by percentage and by company, all of the top ten companies span from 8.2% (CBA) down to 2.19% (Telstra), with anything outside the top ten (which in the case of the VAS fund lands at the Transurban Group) is invested at a rate lower that 2%.

This is representative of the Australian economy as a whole and ensures that as the nature of the fund is to track the performance of the ASX, the weighting in the fund should reflect that.

What are the risks with an ETF?

There is a lot to be gained from lower risk, solid, long term investment strategies for many investors. However, like all investments, there are risks with as many investors becoming increasingly concerned about how investments will fare when faced with an economic downturn, recession or even worse, another GFC.

But the fact is, that “investors who engage in mindless ETF strategies, believing diversification will save them, could face horrendous losses if markets tumble”.

The ETFs market is worth $60.24 billion in Australia, according to ETF Securities. There is a risk that investors become too reliant on ETFs and a market crash could send a large percentage of investors’ funds down, without alternative hedging mechanisms (such as a CFDs) in place to properly protect their portfolios.

While market risk is by far the largest concern as investors take a ‘passive mindset’ and ETFs providers start trying to out manoeuvre one another by offering no-fee options and options in ‘non-traditional markets’ such as crypto currencies, risk averse investors are being exposed to more risk than they once enjoyed, as issues scramble to cut costs.

As the number of investors looking to get into ETFs in Australia is set to expand, so are the number of funds that are set up. Although under the heavily regulated market of the ASX, there are still inherent risks of unscrupulous operators or funds that are operating in risky and underperforming sectors, not to mention the spread of performance by industry operators within the same sectors could weigh heavily on ETF investments.

Like cryptocurrency in 2017, ETFs are the ‘hot thing’ in financial markets – truth be told, many ‘traditional investors’ stayed well clear of cryptocurrency trading during that time and ETFs have an inherent risk of a similar occurrence.

As investors flock to take advantage of the ‘new ETF vehicles’ they may find they have limits on their liquidity, and if the money rushes out, the valuations could be harmed for existing investors.

Summary of ETFs

Like all financial products, ETFs have risk and should always be taken on only after you as the investor or your financial planner/broker has done the due diligence on the particular fund you are looking to become involved in.

Like any investment, should the fund begin to deviate from your investment strategy, you should review the appropriateness of the option for your portfolio, rather than staying in because “that is the way the market is going”.

As a long-term strategy, ETFs provide an opportunity for a certain percentage of your investment portfolio to effectively track with the chosen market, exchange, currency or commodity market that suits your investment needs, as provides a passive investment option.

For many investors, this provides security in the knowledge that even if their short-term strategy fails; their ETFs will be there to back them up. However, in the event of a market crash, recession or even a global financial crisis, not even ETFs are immune – and investments although passive, must always be informed and proactive when it comes to their investment portfolios.