SPA3 and trading diversification

While many believe that diversification means to select stocks in various sectors and various markets, this tenet of modern portfolio theory (MPT) has its drawbacks.

1. This assumes that large portions of entire portfolios cannot be withdrawn from the market in a short time span (a few days).
2. Returns can be sub par as they will close match index performance
3. All stocks tend to have a high correlation during bear markets meaning that diversification is limited in reducing drawdown.
4. MPT does not allow for the scenario of creating a portfolio where entering and exiting positions in the market is done according to a consistent methodology and has integrated timing, risk management and money management rules.

This is why exposure to the stock market is best done with a trading system, either developed or purchased (SPA3).

When using a long only system to trade markets, it is inevitable that periods of drawdown will occur. The amount of drawdown you suffer will be based on how you manage risk in the market. If the market is dropping, the risk to enter long positions is HIGH meaning you can do a number of things:

• Close all positions until market returns to low risk
• Ignore market risk completely
• Sell 1/3 of all open positions immediately
• Sell 1/3 of open positions that are in overbought territory according to a momentum indicator of your choice
• Hold all Low Risk positions open and close all Medium and High risk positions

There are various approaches but the best (in terms of providing the smoothest equity curve overall) is to use a method of diversifying trading systems rather than to manage risk within the one market. Diversification for a trader means being able to switch systems on and off, or move various amounts of money between each to suit current market conditions.

Eg. Run long-only system on the ASX provided market is in low risk, and when market turns to high risk lighten all positions by 1/2. This then gives you back 1/2 of your money to use in a different system, such as a daily index system to trade the short side of a falling index. Once market risk returns to low this money can then be moved back into your long system and even leveraged to increase return.

This should reduce drawdown and mean that your equity curve is only being added to by systems that are trading with the predominant trend.

SPA3 research has shown that if you take a conservative risk profile and close all your positions immediately upon a high risk market, the overall returns are a lower than if you simply lighten and keep your money invested. This is true for bull markets (obviously) and even slightly sideways or negative markets, but not when the index drops 30-50% as it has done in 2008. During this time, a more conservative risk profile would have kept a trader in cash the whole year and saved them from serious drawdown.

Dealing with this in the future can be done in two ways. Either run diversified trading systems with a conservative risk profile in each to ensure that money is being used on the predominant trend, or to continue to trade long-only but with a hedge. There is an argument that a hedge simply retains the status quo and eats up brokerage, but if a trader has not developed more than one system to trade with any cannot rely on system diversification then hedging is a good way of keeping positions open but reducing drawdown.

Bank accounts for Trusts and Company Trustees

This is a copy of a post from invested.com.au which really helps me understand the relationship between a trust and company trustee. This is not legal or financial advice just an easy way to understand it.

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You need to understand that a trust isn’t a separate entity … it is what’s called a “legal fiction” (it only exists in the minds of lawyers ).

A trust requires a trustee to operate things on its behalf. This is usually either a company or an individual - in your case, you are looking at using a company for the trustee.

The trustee company is effectively just a shell company which does nothing more than act as a trustee. It holds no assets, it does not trade, and most importantly, it does not put itself at risk (if it did, the assets it looks after may also be at risk). As such, because the trustee company does nothing, it doesn’t need its own bank account (beyond that which it operates in its capacity as trustee).

The trust doesn’t have a bank account - the trust doesn’t exist. The trustee has a bank account which it operates “in trust” for the beneficiaries.

It takes a bit to get your head around … but remember, the trustee does all the work but doesn’t own anything itself - the trust does. The trust doesn’t exist, so it can’t do anything without the trustee - hence, the trust doesn’t actually do anything.

Come tax time you will get a tax return for the trust (!!!), and a set of financial reports for the trustee company (which don’t say anything, since it didn’t actually do anything).

It might help to think about it this way: trusts are only about ownership … a trust is used to designate who the beneficiaries of an asset is. The trustee company holds the assets in trust for those beneficiaries. In most situations you only deal with the trustee company - except when buying assets, at which time you designate that the asset is held in trust by the trustee company.

Of course, there is nothing stopping you from having the trustee company do it’s own thing like a normal company would … including running a business or owning assets, but it’s strongly not recommended … the trustee company should do nothing more than run the trust.

(PS. none of this is advice - I am not a solicitor or accountant, this is just my understanding based on what I’ve learned from my own accountants).

Depreciation allowances and tax-deferred income

Own units in a unit trust that owns a property?

One thing I couldn’t get my head around was depreciation allowances and they effect cash flow. I found this which should help:

People who hold investments in property, either directly or indirectly through listed property trusts or managed funds are able to benefit from depreciation allowances. These are of two types, being depreciation on buildings and depreciation on plant and equipment in buildings.

Depreciation allowances on buildings results in a part of the rental income being tax free to the investor. Depreciation allowances on plant and equipment results in tax deferred income. Tax deferred income is tax free at the time it is received, however when the property (or property trust or fund) is sold, the profit made on the sale is increased by the amount of tax deferred income that was previously received, resulting in a higher capital gains tax liability.

The reason the CGT is higher when you sell is because your cost base slides down towards zero as your tax-deferred income flows through to you over time, but the value of the property will (hopefully) increase which means the gap between them is BIGGER. You will therefore pay more CGT when you sell.

Questions to ask a mortgage broker

Tell me a bit about yourself and how you became a broker.
How long have you been in business? Do you take a long term view with the business?
Are you independent or do you prefer to deal with only certain lenders? Why is that so?
Do you disclose all your commissions?
Are you a lender yourself?
How many investors do you deal with?
Are you an investor yourself?
Do you deal with both residential and business loans?
Do you have any experiences buying through a trust/company trustee structure?
Are you a member of any professional mortgage associsations? (MFAA?)
Do you have professional indemnity insurance?
Do you have any references I could call?