Monthly Review - November 2010

November was a month of solid if unspectacular financial progress. Equities and commodities appreciated but those gains were partly offset by small losses on the ETFs and adverse FX movements as the AUD/NZD fell against the USD. Cash flow on the properties was negative(although still a positive contribution to net worth) due to a combination of repair bills and a two vacancies. Savings were average.

Here are the details:

1. my Hong Kong equity portfolio appreciated. There were no transactions this month;

2. my ETFs were mixed in line with their respective markets (Hong Kong, Russia, Taiwan, India and China) for a small net decline in value;

3. my commodities appreciated for a modest gain (with gains in the basket ETF, silver and HOGS offsetting a fall in NICK);

4. two of my properties were vacant but the portfolio is still making a positive contribution to my net worth. However, I have been hit hard with multiple repairs which were either paid in October or will be paid in November. This means that we had a negative cash flow in November. That said, as the biggest component of the monthly payments is principal on the mortgages, the properties remained profitable even with a vacancy and the bills. The situation will be better in December with one of the vacant units now let at a substantially higher rent;

5. currency movements were mildly unfavourable, as the AUD, NZD and RMB appreciated against the USD;

6. savings were positive in spite of income being low and expenses being slightly high. Net savings were average.

My cash position remains modest. Cash on hand and deposits now represent about ten months' worth of expenses.

For the month, net worth increased 1.53%. The year to date increase is 24.89%.

My target retirement window remains sometime between early 2012 and the end of 2013. Every passing month brings me closer to my retirement goal.

One vacancy down, one to go

One of our two vacant apartments was rented today. We have repainted and done some minor repairs, all of which were overdue, for a total cost of less than half a month's rent. We have also agreed to remove some of the loose furniture not wanted by the incoming tenant. Anything we can't sell before the tenant moves in will be donated to a local charity.

While the six week vacancy was longer than I had hoped we did manage to avoid having the property vacant over the Christmas-New Year period when it is traditionally hard to find tenants.

The really good news is that we secured a 22.6% increase in the monthly rent - a very meaningful increase that will provide a nice boost to the monthly cash flow. Even with one vacancy, we will now be back to a positive monthly cash flow. Given that the biggest outgoing every month is the principal component on the mortgage payments, the properties are providing a nice addition to our net worth each month.

I am less optimistic about the other vacant unit (which has been on the market since 1 November) rented before Christmas.

Owning a private business is not for me

Prompted by this post on Seven Million in Seven Years and Adrian's response to my comment on stocks and real estate being my preferred investment choices for retirement, here are my reasons for not wanting to own or manage a private business post retirement:

1. I don't have the skill set for it. I have spent my entire working career in the professional services industry (apart from a brief stint in the finance industry). I have zero experience in running a business. It would be stupid to place my retirement at risk by investing in something that is outside my skill set. At best I could look to investing in a business with minimal capital requirements;

2. It's too risky. Most private businesses need a reasonable amount of capital. Most private businesses fail. A private business is not liquid. A private business is not a diversified investment. Cutting your losses usually means shutting the business down before the creditors do and writing off most, if not all, of your investment. I've seen enough failures and the hardships they have created not to want to risk taking myself and my family down that road;

3. It's hard work. Most private businesses require a lot of work. A lot of hard work. Signing up for a lot of hard work is not part of my retirement plan. There is a very long list of things to do once I say goodbye to my professional life. Working as hard as ever on an uncertain proposition which may or may not place my retirement plans in jeopardy strikes me as a very strange form of retirement.

I used the word "most" a lot in this post. Sure there are businesses which (i) don't require much capital (ii) do succeed and (iii) don't require a lot of hard work. If I find or think of such a business I'll be tempted to give it a go - but I'll be keeping it to myself. Given my lack of experience in business ownership and management, I simply don't think it's for me. If I wanted to continue working my butt off I could just continue doing what I'm doing now - I'm very well paid and am not placing (much) of my own capital at risk.

Real estate and stocks may not have the same upside as owning your own business, but they are less risky and less time consuming. That works for me.

Avoiding the new stamp duty is not that easy

The SCMP carried an article by Jake van der Kamp pointing out that property speculators could avoid the new stamp duty imposed on property owners who sell within two years by buying through a company rather than in their own names. In theory this is true. In practice it's not that simple because:

1. assumption of liabilities: when you buy a company, you will take the company subject to all of its assets and liabilities. A buyer will want to know exactly what those are before proceeding. Put differently, would you buy something which had the potential to contain undisclosed liabilities? I wouldn't, but if I did proceed, I'd want a discount for the additional risk and an indemnity from a credit worthy seller to compensate for the risk involved. Bear in mind that there will be at least one risk which you won't be able to pass back to the seller of the company - the stamp duty liability that would arise if the company sold the property within the two year period;

2. due diligence: for the reason mentioned above, you will want to do due diligence on the company before buying. You won't be able to rely on the audited accounts - even if any exist (which is unlikely for a new company), they only cover you up to the relevant balance date and, in any event, are not a guarantee. Assuming you (i) have the skill set needed to do the due diligence and (ii) can get the confirmations needed, why would you spend the time doing the extra work unless you are going to be compensated for it;

3. running costs: it costs money and time to run a company. Accounts have to be prepared. They have to audited. There are a bunch of forms to be completed each year. the annual costs will be in the vicinity of HKD10,000 pa (+/- a bit). For the average buyer of a self use flat that's a cost which is both meaningful and avoidable, unless the seller is going to compensate you for it;

4. selling: if you want to sell, you'll either have to sell the property or persuade someone else to accept the same risks and costs which you did when you brought the company. If you want to sell the company, you'll be competing against people selling properties directly which are not tainted by the issues associated with selling a company. If you want to sell the property not only are you then left holding an empty company which you must pay to wind down but you will also face the possibility that if the company's original acquisition was deemed to be a business activity, then any gain on sale will be treated as a taxable profit (which issue seldom arises when it is an individual who does the selling). If a gain on sale is treated as a taxable profit, bear in mind that the profit is calculated based on the original purchase price paid by the company - not the implied price you paid when you purchased the company - and you could end up in a situation where you are paying profits tax when you have actually made a loss.

Personally, if I have a choice between buying a property or buying a company which owns a property, I will take the property every time. I would need a lot of assurance/protection and compensation before I would take on the risks, expenses and work involved in buying someone else's company.

Another way of looking at this is to ask why most transactions involving properties are not already structured so that people buy and sell companies which own the properties. You would think that if it was that easy to dodge the stamp duty (which was already up to 4% payable by the buyer before last Friday's changes), everybody would be doing it and buyers would be happy to do so in order to avoid a hefty stamp duty cost. They don't. Outside the realm of high end commercial real estate it is very very unusual for someone to buy a company which owns a property rather than the property itself - for the reasons given above.

I'm sure a lot of creative thinking will be spent trying to avoid the new stamp duty, but I don't see it being as easy to avoid as Mr van der Kamp suggests.

Cooling the Hong Kong property market (2)

Following on from the Hong Kong government's latest measures to cool the local property market, I gave some thought to other measures the government could take should the market continue upwards. Here's what I came up with:

1. foreign ownership restrictions: I have issues with this one. Hong Kong has almost not foreign ownership restrictions and our whole economy is based on free movement of capital in and out of Hong Kong;

2. increase the supply further: given the lengthy lead time between making land available for development and new properties being ready for occupation, this is a difficult one to get right. Memories of the serious policy mistakes of 1997/8 are still fresh in people's minds;

3. increase interest rates: while the HKD:USD prevents the government from controlling interest rates directly, it could impose a levy on loans used to finance property purchases. This would have the effect of making property ownership more expensive;

4. remove the interest deductability for investment properties and owner occupied homes;

5. cancel the rates concession;

6. increase the deposit requirement again or, alternatively, increase it only for non-owner occupied properties;

7. change the immigration scheme to exclude residential property from the list of eligible assets.

Any others?

The main issue with items 3, 4, 5 and 6 is that they will impact lower and middle income groups the most. These are the very people the government is supposed to be helping. Guessing whether these (or any other) measures will or will be adopted is a matter of speculation and will depend largely on what happens to the market in response to the measures announced last Friday. One thing that is clear though is that the government has both the tools and the political will to take steps to cool the market further should the need arise.

Cooling the Hong Kong property market (1)

Last Friday the Hong Kong government announced three measures to cool the overheated Hong Kong property market:

1. reduced the maximum loan to value ratios for mid-range flats. The new LTV ratios will be 60% for properties priced between HK$8 million and HK$12 million. For properties priced at above HK$12 million the maximum LTV will be 50%. This has two effects. The first is that buyers need to come up with much larger deposits. While this will not be an issue for the majority of investors from the PRC who (anecdotally at least) are largely paying cash, it is an issue for those attempting to get on the property ladder for the first time or who are hoping to upgrade their homes. The second effect is that a higher deposit results in a smaller mortgage -both the level of indebtedness and the monthly commitments will fall resulting in reduced risk to both households and banks;

2. a new special stamp duty on properties which are sold within two years of the date of purchase - 15% if sold within 6 months, 10% if sold within 6-18 months and 5% if sold within 18-24 months. Historically, taxes on short term sales have have only one effect - by forcing people to hold for a longer time period, supply falls and prices go up;

3. plans to stabilise the supply of new units at around 20,000 p.a. These are only plans and it remains to be seen whether this is the right number.

The initial reactions have been mixed. Reports of sellers cutting prices and buyers holding off "until the picture becomes clearer" have been widespread. My own take is that the higher deposit requirement will have some impact on mid-range properties as there are reasonable numbers of buyers who will have to save more to pay the higher deposit deposit. A the top end of the market, there should be relatively little impact (if any). The higher stamp duty will obviously make buying and selling within two years unrealistic and reduce both demand and supply.

As a long term real estate investor, I am largely indifferent to the new measures. I don't want to see a bubble occur (because of the inevitable crash and other consequences which follow including an adverse impact on the rental market). Even more, I do not want to see a repeat of the serious policy issues of 1997/8 when the government attempted to significantly increase the supply of new properties and crashed the real estate market.

If the market comes down far enough, I'll consider adding to the portfolio. How much is enough? Good question and one that I don't have a ready answer to.

Also to be considered - if the market does not cool down sufficiently, what other measures can the government take?

Is the CPI an appropriate basis for retirement planning?

With the risk of deflation likely avoided, more attention is now being given to the level of inflation. A number of countries have already started taking measures to curb excessive inflation (e.g. China, Australia). In simple terms, for consumers, if we experience inflation this means that the nominal cost of living will be higher in the future than it is today. If one assumes that there will be an inflationary economic environment going forward, that will have an impact on retirement planning and investment management. In order to address the issue, it is necessary to hazard a guess as to the amount of future inflation. Given that professional economists routinely get their estimates of near term inflation wrong, my first working assumption is that there is very little chance of my being able to accurately estimate future inflation rates over a longer time period, so I'll be honest with myself and call it a guess.

How much will obviously depend on where you live and how you spend you money. As an example, a family with school aged children and without employer subsidised health care will (most likely) face a larger cost of living increases than individuals and couples without school aged children and with employer subsidised health care. A family living in a developing economy will be more vulnerable to food price inflation than a family in a developed market. Location and individual circumstances matter. My own spending habits will also change materially over time. Accordingly, my second working assumption is that, even if CPI is an accurate measure of inflation (see below), I cannot rely on it as a measure of my own personal expenditure inflation.

Many countries construct a consumer price index to measure changes in the price of a selected basket of goods and services which consumers buy. Each country has its own basket/methodology and will periodically revise both the components in its basket and the weightings given to each component. While it is unarguable that consumer spending habits will change over time and that the CPI construction must be revised from time to time, there will be lags between changes in spending habits and the CPI basket being updated. My third working assumption is that CPI is always at least slightly outdated and, even if accurately constructed, will never accurately reflect what is happening in the real economy. Historically, there have been times when the CPI has badly lagged the real world - the energy shocks of the early 1970s being a classic example.

CPI numbers are constructed by governments. Governments have considerable incentive to understate the true rate of inflation, both for political and economic reasons. It has often been said that the Fed's job is to manage inflation expectations and beliefs, not to manage inflation itself. The decision to stop publishing M3 data is often cited in support of these claims. There are many people who argue that the understatement is very significant. The evidence (both for and against) is somewhat mixed. My own personal cost of living as certainly been rising much quicker than CPI. My fourth working assumption is that even if I don't subscribe to conspiracy theories, there is a very real possibility (probability?) that CPI is biased to understate the true rate of inflation.

My own personal basket of expenditures is heavily weighted to (i) housing (ii) education and (iii) travel. Post retirement, I will need to add (iv) health care to the list. My personal weighting far exceed the weightings given in the Hong Kong CPI basket. All of these items have historically increased at rates exceeding the general CPI. My fifth working assumption is that I should expect to experience a personal rate of inflation which is higher than the general rate of inflation.

Conclusions

The implications of my five working assumptions are sobering:

1. I need to assume that the real level of inflation I need to protect myself against will be higher than any official CPI data;

2. the required return on investments needs to be adjusted upwards to compensate for the expected level of inflation;

3. while my own personal rate of inflation is totally irrelevant to the pricing of assets in the marketplace, if inflation generally is understated, it follows that asset pricing and asset allocation needs to be revisited.

In short, CPI is not an appropriate surrogate for inflation in retirement planning. For me at least, I have to assume a higher rate of future increases in the cost of living.

Footnote: strictly speaking, inflation is a measure of the change in the money supply, not changes in the nominal prices of goods and services.

Book Review: The Flaw of Averages

Statistical uncertainties. A topic which the non-mathematician in me found rather daunting. As someone who prefers to do my own retirement planning and investment management, the reality is that I have to deal with a wide range of uncertainties on a daily basis. Getting away from that fact is not possible so I need to have at least some understanding of the basics.

Sam Savage's "The Flaw of Averages" was exactly what I needed to get my mind around some of the key issues. Written in terms that even a layperson can easily understand (and with plenty of humour), this book made for an educational and entertaining read.

Some key takeaways:

1. replacing uncertain future outcomes with a single average and then relying on that single average to plan for the future is a systemic error which explains why forecasts are always wrong (this is known as the "flaw of averages";

2. there is an important distinction between "risk" and "uncertainty" (uncertainty being an objective feature of the universe while risk is a more personal construct;

3. techniques for reducing uncertainty;

4. average inputs do not always deal produce average results;

5. the Seven Deadly Sins of Averaging (actually 12 of them);

6. some practical examples from the world of personal finance. Of these the most important is that a retirement portfolio which is adequate if a single average rate of return is achieved over the life of the portfolio is as likely to fail as to succeed.

Highly recommended for anyone with an interest in personal finance or investment management.

Why you don't need an adviser

In my previous post, I had a mini-rant against financial advisers who charge high fees without offering any value added services. My view is that you do not need to pay for a financial adviser if you are willing to do a small amount of homework, do a small amount of work and accept responsibility for your decisions.

Financial advisers cost money. Most charge either a percentage of assets under management or get a commission from anything you invest on or both. There are usually a few other costs thrown in. So what do they offer in exchange for these services? The list may include:

1. basic investment advice: for the most part you don't need this. Even if you want to spend as little time as possible on your investments, reading a few books like The Boogleheads Guide to Investing will be enough to tell you to (i) keep the costs low (ii) go with an equity/bond/cash allocation that suits your age profile, risk tolerance etc. (iii) avoid chasing performance and so on. You don't need an adviser to tell you to do this

2. selecting investments that will outperform: most advisers fail to beat an appropriate benchmark before fees. Even fewer do it after their fees. Past out performance is not a basis for determining future performance. Predicting which advisers will "outperform" is a guessing game with the odds firmly stacked against you. If you want to try and do better than a basic investment investment plan (see #1 above), you need to accept (i) that more work will be involved (ii) the odds are stacked against you (iii) you have a better chance of outperforming if you aren't handicapped by the adviser's fees

3. access to investment products: in the bad old days, there were no ETFs listed in HK, there were no low cost index funds available to the public and it was an exercise in futility trying to access products like Vanguard. Your options were largely (i) buy shares directly or (ii) pay a hefty front end load and a hefty management fee to buy into actively managed funds. Front end loads of up to 5.75% and MERs in excess of 3% pa were not uncommon. And people wondered why the fund penetration rate in Hong Kong was so low. That started to change in November 1999 with the listing of the HK Tracker fund - the first ETF to be listed in Hong Kong. Now there is a wide range of ETFs listed on the HKSE. You pay no front end load on these (only brokerage and other transaction costs which are quite low) and while the typical MER is higher than Vanguard it is still only a fraction of what you would pay for an actively managed fund. It is also easy enough to buy ETFs listed on overseas exchanges if there is something you want but can't find locally. You don't need an adviser to access these - only a broker and a willingness to read the offering document and watch the bid ask spread before you buy

4. domestic tax planning: if your only place of domicile is Hong Kong, you don't need tax advice to make your investments. Hong Kong's tax laws are that simple. Unless you are investing as part of a business, you do not pay taxes on capital gains, you do not pay taxes on dividends and you do not pay tax on interest. There is no estate duty under Hong Kong law. Stamp duties and a few other levies are payable on some investments, but unless you are dealing with very large transactions these cannot be avoided. I see no scope for a financial adviser to add any value here

5. international tax planning: if you are tax resident in another jurisdiction, have assets in another jurisdiction or are a citizen of another jurisdiction, you will probably need to have at least a basic understanding of the tax implications. For most countries the three main issues which need to be considered are (i) withholding taxes on income (ii) application of estate taxes and (iii) liability to pay income taxes. The first two can usually be found with relatively little effort using the Internet. The latter issue will usually require more work and may require the assistance of a professional tax adviser. As a general proposition, if the tax situation is sufficiently complicated that you need an adviser then you need a tax adviser and it would be risky to rely on a financial adviser

6. estate planning: there is no estate duty in Hong Kong. Assets held overseas may or may not be caught in an overseas estate tax regime. There are some legal restrictions on who you can and cannot leave your money to. Depending on circumstances, you may want or need to set up a trust (e.g. to benefit infant children). Advice on these areas is best given by a lawyer (not a financial adviser)

7. insurance: work out how much you need and shop around for the best deal. This applies to term life insurance, medical insurance and home and contents insurance. You don't need a financial adviser to do this for you

8. budgeting: for those having trouble saving and who can't be bothered to do a budget, the most basic solution is to set up an automatic investment plan. Many banks will offer monthly stock purchase plans which include ETFs. Decide how much to invest each month, which ETFs you want to buy and take 30 minutes to go to the bank and set it up. Do what you want with whatever is left in the bank account after those payments. It's not the best financial plan but it's much better than not saving at all. Anyone who can't be bothered to do even this probably does deserve to fall into the clutches of a financial adviser

Quite frankly, I fail to understand why any high cost financial advisers are still in business.

As a side note, I have yet to find a financial adviser in Hong Kong who only charges by the hour (or flat fee).

Investment services to be avoided

Like may professionals, I get more cold calls from financial advisers than I would like (the preferred number of calls is zero). While standards have improved (very) marginally over the years, most are from "independent" financial advisers selling high cost and inflexible insurance products or off the plan overseas real estate.

This week I received a cold call from a large financial institution, one that I did not have a relationship with. Curiosity got the better of me and I agreed to meet with them to see what they had to offer. I should have known better. I really should have. Their product had the following features:

1. front end load of "only" 2-3% depending on the amount invested;
2. annual management fee of 1.5-2% depending on the amount invested; and
3. annual platform fee of 0.3%.

The very neatly dressed and earnest "senior vice president" assured me that they were completely transparent, that there were no hidden fees or charges etc etc etc

And what did they offer to earn these "completely transparent" fees? Access to thousands of mutual funds, ETFs and individual stocks. Big deal. I can also access thousands of funds, ETFs, individual stocks and other investments without paying those fees.

He also waxed eloquently about the portability of the plan - if I leave Hong Kong, I can keep the same account wherever I live (except the US). Hmmm .... and I can't do that with any of my existing accounts?

He seemed surprised when I told him it was a very unattractive proposal.

I really don't understand why anyone would sign up for something as ridiculous as this.

QE II - the personal impact and USD debt instruments

There has been plenty of coverage on the impact of QEII on the economy, on currencies, on stocks, on bonds, on commodities and so on. At a more personal level, how does it affect me?

The positives

1. the value of my investments went up: stocks appreciated, commodities appreciated

2. the risk of deflation (both longer term and shorter term) has been reduced. As the holder of a portfolio of risk assets, deflation would be a very bad thing for me

3. the decline in the USD and corresponding decline in the HKD (which is pegged to the USD) boosted the value of my non-USD/HKD denominated assets

4. the HKD peg to the USD is expected to create an influx of hot money. Combined with the continued low interest rates in the US, this means that it is likely that I will continue paying very low nominal interest rates and negative real interest rates for some time

The negatives

1. I am paid in USD: the decline in the USD amounts to a pay cut

2. the HKD peg to the USD means that there is an expectation of more money flowing into Hong Kong (among other places). Not only does this create the risk of an asset bubble, but it adds to inflationary pressures

3. some of our household spending is denominated in currencies other than the USD/HKD. QEII effectively means that the cost of overseas holidays, imported wine etc etc have increased. Not all of these costs are captured in general measures of inflation

4. the continued debasement of the USD (the world's largest currency) increases the risk of longer term inflation significantly

5. I am still accumulating assets. The increases in nominal prices of real estate, equities etc makes it more difficult to acquire assets at attractive prices

6. continued low nominal interest rates combined with increased inflationary expectations make bonds even less attractive going forward. Diversification across asset classes is now harder. This means that the risk to the private portfolio has also gone up

Conclusions

All in all, in the short term I am clearly a net beneficiary of QEII. However, over time the on-going effect of a pay cut and higher inflation (whether or not captured in CPI data) will erode those benefits. Also, the risks to my retirement have also changed - whether for better or worse being a complete guessing game.

Random thoughts on USD debt instruments

While there is no limit to the amount of money the Fed can create, there have to be limits to the amount of money investors are prepared to tolerate. Give (i) the ultra low interest rates for USD denominated debt instruments (ii) a Fed which is very publicly attempting to create inflation and (iii) the widespread belief that the US wants a weaker dollar, why anyone would want to buy USD debt instruments is totally beyond my understanding. The only justifications for buying that asset class in isolation are either a belief that the USD will strengthen or a belief that there will be a deflationary environment going forward.

Foster parents to a kitten

We recently acted as foster parents for a two month old kitten rescued by the SPCA. While our own cat (adopted from the SPCA in 2008) did not take kindly to the presence of the intruder or being denied access to part of our apartment, the experience was a good one. As expected, he spent most of his time hiding (either behind our bed or under a cabinet) and would bolt for cover whenever anyone came into the room. At night we could hear him running around, scratching furniture, unravelling the toilet paper, knocking things over and generally having fun. By the end of his stay it took very little effort to coax him out from hiding to play. I was tempted to keep him, but decided that it will take more work to get our own cat used to the idea of sharing her territory.

Yesterday I received a call from the SPCA to say that he had been adopted. Yeah!

Definitely an experience that was enjoyable and will be repeated.

RMB Bonds - revisited

As recently as September I asked myself whether RMB denominated bonds were a worthwhile investment . My conclusion was that while RMB bonds were fine for RMB which I already hold (which is not much), I could get better yields on equities so it didn't make a lot of sense to convert HKD into RMB in order to buy the bonds. I also felt that the China A50 Tracker fund was a better (although riskier) way to invest in the RMB. I purchased shares in some small caps and the China A50 Tracker fund last month - so far a good call, although the returns over a single month are not really that meaningful.

More recently, the market has rallied and (IMHO) the risk of investing in equities has gone up with the market. Also, with retirement getting closer, I need to start getting used to the idea that I need to have at least some of my money into low risk investments and accept the the correspondingly low returns.

The latest offering is from China Development Bank and offers a yield of 2.7% (which will get cut to around 2.5% after bank charges and FX conversion spreads) with a term of three years. It's not a great deal as the upside is limited, but it is better than leaving cash in the bank. Also, if I buy a series of these sorts of short dated investments with differing but generally short maturity dates (probably in a variety of currencies), this will form part of the cash/near cash asset allocation that I will need to have in place in retirement.

Accordingly, I have converted some more HKD to RMB (currently limited to a maximum of RMB20,000 per day) and made an application. I suspect that the application will be scaled back due to over subscriptions, but there will no doubt be no shortage of additional RMB bond issues.