Financial Journalist

FT Mandate 21 May 2001

Could convertibles push equities into the shade if understanding of them was more widespread? Examples of convertibles currently on the market show they can provide more security than equities, says Gerry O’Kane

“They simply will not see the opportunities available to them in the convertible market,” says Jeremy Howard, head of Deutsche’s global convertible research, referring to what he contends is the stubborn refusal of equity fund managers focus seriously on an investment instrument that combines the security of fixed income with the potential upside of an equity holding.

Any investor in equity funds should pay attention because, while the global convertible market has reached a market capitalisation of US$460bn, Mr Howard describes equity funds as “also-rans” in their use of them. As shares have plummeted in the past months, his argument for their use is a strong one: low downside risk while retaining exposure to the equity and usually receiving a higher yield.

The basics
Mr Howard is convinced that a failure to understand the basics of convertibles has been the reason and it disappoints him. While there may be complex issues involved in the market, certainly in the way hedge funds utilise them, they are easy instruments for an investor to understand. So much so that banks in Luxembourg pushed their customers to buy them in large numbers last year.

In their simplest form convertible securities are part debt and part equity.

The holder has the right (but not obligation) to exchange the bond for the underlying share. At maturity the holder can either get back their cash, having had the benefit of a yield over the convertible’s life, or convert to the underlying share, whichever option affords them the most value. There are exceptions to this basic model but essentially anything else is a variation on this theme.

“I would consider non-genuine convertibles to be securities structured by institutions which are linked to equities, an index or even oil prices which carry some form of financial guarantee,” says Mr Howard.

He is adamant that investors should be careful with related instruments called reversible convertibles. “They give you what looks to be very high yield, perhaps 13%, but the downside is that the redemption amount is linked to the stock price on the way down.” And with the current bear market, investors who are holding reversibles are suffering.

The Colt Telecom story
A look at several convertibles currently on the market can clarify what investors, retail, fixed income or equity should look out for.

Colt #3, issued in December 1999, was the third convertible Colt Telecom had released. It pays a coupon of 2% with a final redemption date in 2006.

Had an investor bought at issue in 1999, they would have paid Euros1000 for the right to either get back his E1000 in 2006 or to take 17�6065 shares (the conversion ratio). He would also have been paid an annual coupon of 2%. The pricing of the bond meant the investor was paying a 30% over the prevailing stock price (E56.80 versus E43.69)

Why might an equity fund manager have bought the convertible over the equity?

On the upside, although the premium of 30% meant the convertible did miss a little of the initial upside, the bond did capture a significant amount of the upside. The bond rose 30% to 130, while the stock rose 44%.

But over this short period the convertible was yielding slightly more. Almost 70% of the upside was a decent participation, considering the downside protection that was inherent in the convertible; downside protection that was to prove massively useful in the coming months.

By late March 2000, Colt shares were doing very well, with parity (the value of the shares underlying the convertibles) hitting approximately 120% (E1,200 per bond). This was an increase of about 40% in the share price. The convertible rose as well, by 30%. Not quite all the upside, but a good performance.

As the TMT wreck gathered pace through 2000, Colt Telecom stock was destroyed. Equity fund managers who sat on their stock saw their investment plummet 86% to the low in March 2001.

But the convertible’s performance was a different story. Although the creditworthiness of the company did suffer in the bear market, the fixed redemption price of the convertible effectively gave holders a put option on Colt Telecom stock. The convertible therefore, never traded below 72, a decline of only 44.6%.

So the pay-off profile was 70% of the upside but only 52% of the downside, a risk adjusted out-performance, and all the time the holder was receiving a higher yield. “So in a bear market the convertible lowers the downside risk, while retaining exposure,” says Mr Howard.

On a wider portfolio basis, such risk-adjusted performance is hugely useful in improving returns.

Credit quality lesson
There is also a lesson to be learned from the Colt 3 convertible and this is the bond element of the instrument.

“The credit quality of the issuer is important,” warns Howard. He says that, as with any bond, the amount of debt outstanding is important. In lower credit quality companies such as Colt Telecom, if the share price falls precipitously the riskiness of the company’s debt increases and the bond floor (that is value of the convertible as a straight bond) falls. This is what happened to some extent in the Colt example.

The Siemens/Infineon story
An example of a convertible that has avoided Colt’s problems with credit spread expansion, is Siemens/Infineon. This was what is known as an exchangeable bond. The only difference with an exchangeable it that it is issued by one company but converts or exchanges into the shares of a different company (usually one in which the first company has a cross-holding).

In this case Siemens was holding shares in Infineon following its partial IPO, and was releasing an exchangeable was a way of disposing of a further stake. What makes this product so attractive is that issues such as credit worthiness do not relate to the underlying stock but to the issuer, in this case Siemens. Any decline in the Infineon share price does not affect the credit of Siemens.

Mr Howard says, “Brought to market in 2000, the convertible offers a 1% coupon and, with an issue size of E2.5 billion, should also ensure good liquidity. The effect of having such a large firm guarantee the convertible is reflected clearly in the convertibles price performance, especially when compared to Colt.

“The convertible was issued at 100 and has never fallen below 90, a downside of less than 10% despite the huge fall in Infineon’s share price. Had you been holding Infinion shares over the same period you would have lost well over 50% yet had neither an annual coupon nor guaranteed repayment of your original capital.”

Flexibility on offer
“It should be remembered that convertibles are used for different reasons by different investors,” says Howard.

“At one end you have the Belgian dentist investing for income with a guaranteed repayment and the possibility of huge upside if the share performs well.

“At the other end of the spectrum sit some of the most sophisticated hedge funds in the world. They also use convertibles as arbitrage vehicles, performing a number of complex transactions to unlock theoretical undervaluation,” he says.

“While the use of convertibles in hedge funds is a complex story involving deltas, gammas and swaps, it is hedge funds that now keep the market efficient, by ensuring that convertibles trade close to their theoretical value in the secondary market. This is good news for all investors.

“When we are pricing convertibles, the valuation of the equity option component is very important for us,” says Mr Howard.

But away from the hedge fund community, his rules for investing in his asset class are simple: “Always pick an underlying stock that you like, this is the most important rule. Check that the credit quality is as high as possible and that the bond is not too close to maturity or an issuer call, and you will usually have an instrument that will perform well in all weathers.”

convertible bonds, equity funds

Benchmark Third Quarter 1999

Even a dart-throwing chimpanzee can select a portfolio that performs as well as one chosen by the experts.”That devastating indictment of the performance of managed equity funds was written by Princeton finance professor Burton Malklet in his book, A Random Walk Down Wall Street. That comment also acted as a catalyst in the creation of what are now known as index funds. Financial houses came under increasing pressure to justify the huge salaries and research budgets of their Investment teams that were underperforming the dart-throwing chimpanzees. Here, our London-based correspondent Gerry O’Kane finds out why index funds are becoming as popular in the US and the UK as traditionally managed funds.

To a great extent Asian investors have been left out in the cold when it comes to having access to index funds, as much a reflection of the under-developed Asian funds market. Elsewhere they have found much favour and in the US the country’s second largest fund company, Vanguard, specialises in such offerings.

In the US and Europe there has been a growing love affair with the concept of “buying the market”, the foundation of index funds. Personal investment advisors are seeing them as a way to complement actively managed funds for long-term growth. In brief, they offer diversification, the opportunity to increase foreign exposure, returns consistent with market performance but also low annual management expenses, usually less than one percent.

It is important for Asian investors to realise that while there may be a limited number of funds available that are licensed through the various regulatory authorities, they are available if they ask personal investment advisors to purchase them. However, a lack of knowledge has certainly hampered any growth in this market.

Matching the Index
Stock index funds seek to match the returns of a specified stock benchmark or index, for example the S&P 500 index in the US or the FT 100 index in the UK. It tries to match “the market” by buying representative amounts of each stock in the index. This differs to the normal managed fund which pays a manager to take positions on individual stocks, sectors, or investment strategies. An index is a basket of stocks constructed to represent the whole market or a subset of it, for example, a property index. It does not take much skill to create an index fund. One just buys the stocks in the index in proportion to their weight in the index.

A more advanced method of producing index funds is through derivatives, achieving a similar exposure to foreign equity markets. By their nature, derivatives (such as futures contracts) require a much smaller initial investment than investing in stocks directly.

Index funds do not attempt to beat the equities market but try to equal it. For investors the major attraction is their extremely low expenses - they charge low fees for providing the market’s returns.

It is worth noting that any difference between market performance and the return on an index fund is usually the result of management fees or fund expenses but unlike other funds the turnover of stock holdings are low.

But how do they compare to managed funds? Peter Lynch, Fidelity’s guru and former manager of its Magellan Fund, noted for his forthright views, stuck his neck out late last year by saying he believes managed funds will beat index funds over the next five years.

Bluntly put it is a view not supported by the facts. His own analysis argues that the developed stock markets increase in value eight-fold every 25 years and he also points out that managed funds outperformed index funds in the US between 1991 and 1993. But a broader analysis shows a different story.

Peter Macey of Macey Holland & Co., Investment Architects has done fascinating research on the performance of index funds against managed funds. While it is based on US markets, the conclusions reflect investment funds around the world. Using Morningstar, a US based provider of investment fund data, there were 198 US managed funds that met the criteria of using domestic equity, investing in the large stocks, with performance from 1985, through to December 1995 and not being index funds.

They were comparable to the S&P 500 which is dominated by the performance of large companies. Macey compared the performance of these 198 funds to the performance of the Vanguard S&P 500 Index fund for each calendar year from 1985 through 1995. Based on the principle that what one fund manager buys another sells, then at least half of the funds, about 99, should beat the index.

Nine out of Eleven Years - Index Funds Ahead
His analysis showed that the index fund beat the average manager in nine of the 11 years. On average only 36% of the managers beat the index fund in any year. The average annual return of the Vanguard index fund was 16% per year versus 14% for managed funds. This is pretty strong evidence that the average manager has not beaten the index.

For investors in the Asian market, Grand Pacific Securities Investment Trust Co., in Taiwan manages two index funds: the GP Taiwan Index fund and GP Taiwan Stock Index fund. Both aim to achieve an investment return in line with the performance of the Taiwan Stock Exchange index. The former is for expatriates, while the latter is for local Taiwanese.

Ironically interest in these funds has been limited. Jack Huang, the fund manager of the GP Taiwan Index fund says they are not popular for two reasons. “People here have a strong mentality of speculation. They don’t want to just have are turn in line with the index. They want to beat the index and have quick money,” he concludes. His second reason is highly pertinent to the general lack of index products for local investors. “There is not enough promotion of this kind of product and also not enough education here.” says Huang.

All in the Timing
But he also has a negative view on the principle of index funds. As an index fund requires an almost 100% holding of equity, he says this position makes it vulnerable to downside risk. His views however miss the point that managed funds underperform when the market rises if the manager is holding cash.

He argues that any investors putting their money in index funds should do so only for short-term investment, not as a long-term holding. a view quite contrary to views in other non-Asian markets. Again historical data shows that index funds held in excess of five years will nearly always show profit. Even in years of poor index performance, Huang’s view is unfair. In 1994, a bad year for the US market, the average equity fund lost 5.90 per cent compared with the S&P 500’s negative 3.12 per cent return.

Two index funds authorised for sale, in Hong Kong are the US$100 million Hang Seng Index Pooled fund, managed by Hang Seng Bank and the smaller Manulife Index Hong Kong fund, managed out of London. Both funds beat the average of their peers over all the time periods that BENCHMARK track, furthermore, over the past year the Hang Seng Index fund has returned 42.31% ranking it third out of 19 funds in the sector.

Our explanation for the strong performance is that most of the other 19 fund managers thought that the Hang Seng index would not recover as strongly as it has done and were therefore holding too much cash. Proof that with all the research in the world, you just can’t beat the market, and this is why index funds are worth some serious consideration.

Index Funds vs Managed, passive, asset managers

Benchmark — Investment Funds of Asia First Quarter 1999
By Gerry O’Kane

It is a financial instrument often mentioned but that few understand, including many of the professionals. This complex derivative is the instrument that destroyed Barings Bank.

That is the bad publicity. The reality is that futures and its sister, options, are frequently used by fund managers to hedge their positions; to protect themselves from the market doing something completely unexpected or as a way to trade more cheaply in an illiquid market. All that comes later.

What is a futures contract and how does it work? Put simply futures are an obligation to buy or sell something on a specific day for a preset price. A futures contract can be drawn up on a single stock, a commodity such as oil, or a basket of stocks, usually reflecting the composition of an index. Fund managers usually use futures contracts based on an index, although not always.

Options are the right to buy or sell an item for a preset price during a specified period of time.

Since the collapse of the Asian markets several index futures have come to market. On September 7, the SiMSCI futures contract was launched based on the Morgan Stanley Singapore index. Then on November 2, a new Dow Jones Thailand Stock Index (DJTI) future came to the Singapore International Monetary Exchange (SIMEX). Both contracts are theoretically a valuable tool for fund managers to hedge their equity positions in either Singapore or Thailand, either gaining or reducing their market exposure.

Long or short?
Fund managers can either long a future (enter a contract to buy) or short a future (agreeing to sell). So how does the fund manager use the futures? Firstly, futures contracts initially cost only a small percent of the value of the underlying stocks. The seller of the future undertakes on the settlement date, usually around 30 days, to pay the cash value of the underlying stocks or provide the scrip for the stock. The future can be traded each day, its price moving with the market or expectations. Because of the higher risk with futures, the contract price is more volatile.

A fund manager may be holding stocks due to the fund’s principles of incorporation but he thinks the market is going to fall. He decides to short a futures contact. The fund is holding stock worth US$50 million. He shorts futures worth an equivalent value, the buyer expecting the index to appreciate. The portfolio falls in value by five per cent over the month, realising a paper loss of US$2.5 million. Because of the leveraged and volatile nature of futures, the contracts rise eight per cent. The fund manager is happy since the person who bought his futures contract is obliged to buy but despite a loss in his own stock values, he realises a profit of about US$1.5 million (US$4.0 million futures profit minus US$2.5 million stock loss.)

Trouble With Futures
The trouble with all of this is that despite efforts to reduce risk the use of futures can actually increase it if they are not implemented with pinpoint accuracy. As Salomons (an investment bank) reported, both the SiMSCI and the DJTI futures do not fully represent the underlying indices of Thailand or Singapore. There is some deviation so fund managers have to compute an even more complex method to fully cover themselves. Another problem is that the DJTI, for example, is valued in US dollars, not baht, so currency considerations have to be taken into account.

Options work in a similar yet converse way. A fund manager might be bullish on an index. He would buy a call option; that gives him the right to buy the contract at the strike price at any time during the period of the option. So the person selling may think the index will fall before the end of the month. The fund manager pays him 10% of the value of the contract and waits. The index might rise two points above the level of the seller’s options, if he exercises his option the seller has provide the underlying stock or the equivalent amount of cash. The benefit is a low outlay of cash but making a sizeable profit. Under this method, the buyer does not have to exercise his call but will lose the initial 10% charge.

As one can see, it is a complex and risky business and not for the feint-hearted. That’s why it’s probably best to let fund managers do the shouting. One way to play the market is throguh a specialist fund such as the ED&F Man AHL Diversified Futures fund. The minimum investment is US$30,000 and its track record is good. If you don’t have thirty grand to spend it would be worth going through a reputable financial advisor, they may deal you in with a smaller amount by clubbing your investment together through a nominee account.

Futures and Options

Benchmark Second Quarter 1998

In Heaven the Germans are the organisers, the French are the cooks, the British are the policemen and the Italians are the lovers. In hell, the Germans are the lovers, the French are the policemen, the British are the cooks and the Italians are the organisers. In the new “Euro”, they’re all one. This worries many people, not least investors in the ‘old continent’. Our feature writer, Gerry O’Kane, finds out what’s in store for the new currency that will be introduced in 1999 and asks what it means for Asian investors.

“Light blue touch paper and retire”. Those instructions should be added to any discussion of the Euro: bankers disagree, economists have themselves in a muddle over models, politicians have lost power over it and the poor man in the street is completely confused.

As for Asia, people have studiously ignored the topic of the single European Union currency. Some argue the region’s own currency woes are more important. Others believe it will have little impact on Asia. The reality is that the new unit will impact trade and should you invest in funds or stocks, there could be considerable implications. “Most Asian firms have not even thought about the Euro and that could be costly,” says Fan Qimiao, senior economist with UBS Securities.

On the positive side, money may be hedged against the Euro and profits could follow. On the down side, trade could be disrupted with its ripples causing further carnage in Asia as stock values in portfolios fall.

What is the Euro?
Before looking at implications it is necessary to understand how the new currency will work, at least in theory. By May 1998 the European Commission and the European Monetary Institute, the forerunner of the European Central Bank (ECB) will announce which countries have achieved the fiscal targets laid down for membership of the Euro. By January 1999 the Euro will be introduced and by 2002 it will become the day-to-day currency in most European Union countries.

By next year, forex traders, whether in Brussels or Bangkok, will be dealing in Euros, while Spanish pesetas, deutschemarks and French francs will become memories. Britain, Denmark, Sweden and Greece will opt out of joining the Euro, at least in the early stages. The powers that be in those countries object to it for a number of reasons primarily because they are not convinced the whole thing will work and also because they fear that real power, their nations’ sovereignty, will move to the European Union and the ECB

ECB Dictates Fiscal Policy
With the introduction of the Euro, a common currency across many countries, the ECB will dictate fiscal policy for the member nations. It will take on a job similar to that of the US Federal Reserve Bank or the Bundesbank in Germany. The right to dictate interest rates becomes its job.

“Essentially the ECB will direct a monetary target for the Euro, as a whole - it will set a rate for the growth in money in the system,” explains Alex Skinner, an economist with Gerrard & National Inter Commodities, based in London. “The way the ECB will do that will be through. tweaking interest rates on the Euro.”

But before countries can become members of the new currency system they have to fulfill some basic economic requirements on debt, inflation and interest rates. Unfortunately these economic factors are regarded by most politicians as crucial to setting national political agendas, hence the touchiness of the subject,

The Requirements

• Nations must clurb debt to become a member of the club. The government’s deficit must be no more than three per cent of gross domestic product (GDP). National debt must be no more than 60% of GDP.
• The currency in question (the franc or lira) must have stayed within the Exchange Rate Mechanism (ERM) bands for two years. (This was the first move towards monetary union which saw member currencies valued to within 2.25% of the European Currency Unit. This backfired in 1992 when Britain was forced to pull out owing to domestic economic weakness. But since then the EU has kept more stable).
• A nation’s inflation rate and long-term interest rates must be within 1 .5-2 percentage points of the average among the states with lowest inflation. One reason for scepticism among non-Euro players is that for the whole thing to work all the countries must start from this level playing field. Analysts are arguing that governments are ‘massaging” their economic figures to fulfill the criteria and point to sales of gold reserves in Germany and re-structured debt on health services in Italy as evidence.

Practical Business Implications
What does all this mean when Europe starts to use the Euro? When it begins next year there will be no bank notes or coins stamped with ‘Euro’. That comes in 2002. Each country keeps its currency but each unit of currency is fixed at a rate to the Euro. Research by Union Bank of Switzerland indicates that one deutschemark will be 1.96 Euros, a French franc 6.57 and so on.

Of course, the Euro will be traded in the international market, against the Hong Kong dollar or the Thai baht. The difficulty for the ECB is convincing other nations outside the scheme that the Euro is worth being traded. “There are some benefits to using this system,” says Skinner. He points out that research indicates a lowering of transaction costs for those nations within the system. “Now goods going between Germany and France are registered as exports, after the Euro is introduced they will be seen as internal trade and research indicates this will have a beneficial economic impact of 0.5 per cent of extra GDP growth for some time.”

Pricing will also become transparent across the markets and classic economics argues this will force prices to lower levels.

The Downside
But there is the downside and for some British and German economists this is certainly the heavier side of the scales. “Right now Ireland and Spain are doing well, their economies are growing but there are indications that inflation will become higher and higher”, says Skinner.

Traditionally a country would fight inflation using interest rates or, in a worst case scenario, devalue the currency. Ireland and Spain will be unable to do this.

“The fact is that Germany is not concerned with inflation and likes current interest rate levels where they are. As a “core” country (the other being France) because of the size of its economy it will not increase interest rates.” All the national governments have left to toy with is taxation and that is a noted political loser.

For Asian Trade Only Questions
Should you be sitting in Asia it may seem like having little impact on you. Wrong. Without being able to trade in Euros, Asian businesses will lose business. IBM concluded in a recent study that it expects some European companies to go bankrupt. Some will be unable to operate efficiently, others which do not fully convert to using Euros in the early years (and this even includes regional state governments in Germany) will have to do double book-keeping, another expensive cost centre.

For Asian exporters they will be buying and selling in Euros. They will have to contend with double book-keeping and even opening Euro accounts. According to KPMG management consultants there are even problems in getting software to convert the currency because it uses a process of rounding and “triangulation” a conversion between two old currencies via the Euro. Buying and paying for goods, let alone forecasting will become an art in itself.

Naturally it doesn’t stop there. If companies begin having difficulties either picking up orders or sourcing goods, business will be hit. Stock prices will fall. That affects your European portfolio.

Apart from the fundamental effect on individual companies bottom-lines and their share price, it will have further effects on investment funds. Fund managers will no longer have hedging in 11 currencies and weighting currency risk is an element to asset management.

“The other thing is that the idea of national markets (indices) will disappear. Managers will be inclined to take a more sectoral approach to stocks as boundaries come down,” says Skinner. This makes it less clear for the investor where their money is being invested.

Either way, the Euro is thought to be as much an obstacle as an advantage. Investors in European funds should seek opinion from the resident ‘Euro expert’ at a fund house with millions at stake in these markets.

Euro introduction, triangulation, public borrowing