Invest- 55 Assets That Grow Savings and Earn Passive Income Invest 55 Assets That Grow Savings and Earn Passive Income Invest i Ojijo Invest- 55 Assets That Grow Savings and Earn Passive Income …to those who do not want to work for their money to those who want their money to work for them! Invest ii Invest- 55 Assets That Grow Savings and Earn Passive Income Book Title: Invest: Invest- 55 Assets That Grow Savings and Earn Passive Income FIRST EDITION, 2012 ISBN: 978-9966-123-09-1 Copyright © 2012, Ojijo. All rights reserved. This work is copyrighted by the author. No parts of this publication maybe reproduced, stored in a retrieval system, or transmitted in any form, without permission of the publisher. ojijobooks.com Tirupati Mazima Mall, Nsambya, Ggaba-Road, Plot 2530, P. O. Box 34416. Kampala, Uganda. Tel: +256 41 4696004/31 251 7908 Email: info@ojijobooks.com Website: www.ojijobooks.com (256) 0776 1000 59 * (256) 0701 1000 59 Invest iii Invest- 55 Assets That Grow Savings and Earn Passive Income Investors’ Holy Book This book is for me who wants to become rich through investing, through applying my savings to earn me passive income. The first part of the book discusses investing and the need to invest, stating that the only way to become rich or maintain the riches that I have already acquired is through investing, that is, making the assets I already have to acquire more assets for me. This part also covers the basic and fundamental principles of investing. The second part of the book takes me through the various investment products; the markets where I can buy and sell such products and the market players, including regulators, associations and brokers. The book concludes by introducing a prospective investor fundamental principles of economics and economic institutions. to Invest iv Invest- 55 Assets That Grow OSavings Earn Passive Income JIJO ’ S 55and BOOKS 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. F INANCIAL L ITERACY BOOKS Be Bold, Sell Something –Ojijo’s Guide For Entrepreneurs, Entrepreneurship Trainers, and Business Coaches Managing Business Cashflow (Ojijo’s Guide to Raising, Protecting and Growing Business Finances) Invest- 55 Assets That Grow Savings and Earn Passive Income Successful Saccos - Managers' Guide to Acquire, Retain and Grow Membership, Savings and Assets Making Money Together: Ojijo’s Investment Club Manual Making My Child Financially Intelligent: Money Lessons by Age Group (from 3-13yrs) Retire Happy: 21 Questions to Plan My Retirement 69 Ways to Earn Extra Money While Keeping My Day Job What Can I Sell? 101 Business Ideas for Youth in Africa Why Is My Business Dying? What To Do About It? I Am A Network Marketer - Ojijo's Network Marketing Guide 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. PERSONAL BRANDING BOOKS Stupid Writers: Ojijo’s Guide to Writing Articles, Reports, Plans, Profiles & Proposals People Buy People - 23 Ways To Use Networking Skills To Sell Myself and My Products Talanta: Ojijo’s Guide to Identifying, Developing & Selling My Talent This Is How To Treat A Man (Fathers, Husbands, Lovers, Sons, Brothers) Soft Sweet Words: Romantic Whispers to My Woman Cause Action: Ojijo’s Public Speaking Handbook The Formula Of Getting Rich! Seventy-7 Moves of a Sexy Woman Self-Discipline - What, Why & How 99 Ways to Make People Laugh 22. 23. 24. 25. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. L AW BOOKS Business Transactions & Contracts Law Handbook Family Law Handbook Intellectual Property Law Handbook Alternative Dispute Resolution Law Handbook Real Estate Law Handbook Civil Litigation Law Handbook Energy Law Handbook Labour Relations Law Handbook Administrative Law Handbook Environmental Law Handbook Criminal Litigation Law Handbook Ojijo’s Financial Services Law Rich Lawyers, Poor Lawyers : Law Firm Management Handbook African Jurisprudence, Luo Jurisprudence: Theories, Institutions and Procedures of Law and Justice (Introduction to Law) Legal Rhetoric: Ojijo’s Guide to Legal Writing, Legal Arguments & Legal Interpretation Policy & Legal Issues in E-Commerce & E-Governance (ICT Law) 38. 39. 40. 41. 42. 43. 44. POLITICS AND RELIGION Why Did Hitler Kill The Jews? Politics of Poverty: The Odinga Curse to the Luos Open Religion: My Religion is the Best Religion Garveyism: The Philosophy of Marcus Garvey 100 Upright Men: World’s Greatest Revolutionary Politicians The Mungiki: Terrorists, Victims, Saints: Three Sides of the Same Coin! This Is How To Manipulate Voters: Ojijo's Guide for Campaign Managers, Politicians and Aspiring Politicians! 45. 46. 47. 48. 49. 50. 51. 52. 53. 54. 55. OTHER BOOKS Fireplace Stories: Ojijo’s Performance Poems Killing The Luo The Half Story of My Life: Follow Your Heart, Live Your Dream I Speak Luo: Conversational Phrases of Luo Language The Luo Nation: History & Culture of Joluo (The Luo People Of Kenya) Luo Traditional Medicine : Curative and Preventive Plant, Animal and Mineral Extracts Tuongee Kiswahili: A Conversational Phrasebook With Audio CDs Eat Rich, Keep Fit-Foods & Exercises for Healthy Living This Is How To Improve School Performance-Responsibilities of Teachers, Students & Non Academic Staff Invest v I Am Sorry Father-A True Life Story of HIV-AIDS Teenager My Body: 100 Common Medical Symptoms, Causes, Possible Diseases, Treatment, Home Remedies & Prevention Invest- 55 Assets That Grow Savings and Earn Passive Income Investors’ Holy Book! INTRODUCTION TO INVESTING ...................................................................... - 1 ¥ What Is Investing? ............................................................................................. - 1 ¥ Why Bother Investing? ..................................................................................... - 3 ¥ The Two Types of Investors ............................................................................ - 6 ¥ The Ojijo 9 (The Nine Fundamental Principles of Investing).................. - 7 ¥ The Ojijo 3 Classes of Investment Vehicles ............................................. - 25 CLASS 1 VEHICLES: PERSONAL DEVELOPMENT .......................................- 28 THE SCOPE OF PERSONAL DEVELOPMENT ....................................................................... - 28 6 (SIX) WAYS TO BRAND MYSELF (PERSONAL DEVELOPMENT STRATEGIES)! ......... - 29 ¥ Training: ............................................................................................................... - 29 ¥ Coaching: ............................................................................................................. - 29 ¥ Mentoring: ............................................................................................................ - 29 ¥ Instructing: ........................................................................................................... - 29 ¥ Consulting: ........................................................................................................... - 29 ¥ Counseling: ........................................................................................................... - 29 CLASS 2 VEHICLES: FINANCIAL INSTRUMENTS ........................................- 31 INTRODUCTION TO FINANCIAL INSTRUMENTS & INVESTMENTS ................................... - 31 ¥ What Is A Financial Instrument? ................................................................ - 31 ¥ What is Financial Investment? .................................................................... - 33 ¥ Professional Players (Individuals & Firms) .............................................. - 55 FINANCIAL INVESTMENT PRODUCTS.................................................................................... - 60 CASH ........................................................................................................................................... - 60 ¥ Bank Deposit Accounts .................................................................................. - 60 ¥ Money Market Account ................................................................................... - 62 STOCKS ....................................................................................................................................... - 64 ¥ Preferred Stock ................................................................................................. - 70 ¥ Common Stock .................................................................................................. - 75 BONDS ........................................................................................................................................ - 80 ¥ Municipal Bonds .............................................................................................. - 86 ¥ Corporate Bond ................................................................................................ - 88 ¥ Foreign Currency Bonds ................................................................................ - 97 ¥ Government Bonds/Treasuries, Treasury Bills .................................... - 102 ¥ Assets Backed Securities & Mortgage Backed Securities ABS/MBS ..... 111 ¥ Money Market Investment/Cash Market Instruments ....................... - 114 DERIVATIVES ........................................................................................................................... - 125 ¥ Futures/Forwards......................................................................................... - 127 ¥ Options.............................................................................................................. - 136 ¥ Swaps ............................................................................................................... - 140 CLASS 3 VEHICLES: ALTERNATIVE PRODUCTS ....................................... - 143 1. PROPERTY & REAL ESTATE INVESTMENT ........................................... - 146 Invest vi Invest- 55 Assets That Grow Savings and Earn Passive Income INTRODUCTION TO REAL ESTATE ...................................................................................... - 146 ¥ Property vis-a-vis Real Estate .................................................................... - 146 ¥ Non-Real Estate Property Investments .................................................... - 147 ¥ Real Estate Investment (Income- and Non-Income-Producing) ......... - 148 ¥ Real Estate Markets ..................................................................................... - 167 REAL ESTATE INVESTMENT PRODUCTS ........................................................................... - 169 ¥ Real Estate Investment Groups ................................................................. - 169 ¥ Rental ................................................................................................................ - 169 ¥ Real Estate Trading ...................................................................................... - 169 ¥ Real Estate Investment Trusts (REITs) .................................................... - 170 2. INSURANCE INVESTMENT ........................................................................ - 171 INTRODUCTION TO INSURANCE .......................................................................................... - 171 ¥ What is Insurance? ....................................................................................... - 171 ¥ What is Insurance Investment? ................................................................. - 171 ¥ Insurance Markets ........................................................................................ - 171 ¥ How to Invest in Insurance ......................................................................... - 173 INSURANCE INVESTMENT PRODUCTS ................................................................................ - 175 ¥ Insurance Bond/Investment Bond ........................................................... - 175 ¥ Endowment Plans ......................................................................................... - 184 ¥ Child Education Plan .................................................................................... - 186 ¥ Personal Pension Plan .................................................................................. - 188 ¥ Provident Fund ............................................................................................... - 189 ¥ Annuity ............................................................................................................. - 194 3. FOREX INVESTMENT .............................................................................. - 198 INTRODUCTION TO FOREX ................................................................................................... - 198 ¥ What is Forex? ................................................................................................ - 198 ¥ What is Forex Investment? ......................................................................... - 198 ¥ Why Forex Investing ..................................................................................... - 200 ¥ Forex Markets ................................................................................................. - 201 ¥ Forex Trading: How Forex Works! ............................................................ - 202 FOREX INVESTMENT PRODUCTS ........................................................................................ - 204 ¥ Physical Delivery ........................................................................................... - 204 ¥ Currency Stocks ............................................................................................. - 204 ¥ Currency Funds, ETFs & ETCs ................................................................. - 204 ¥ Currency Futures ........................................................................................... - 204 4. COMMODITY INVESTMENT ...................................................................... - 206 INTRODUCTION TO COMMODITY ......................................................................................... - 206 ¥ What Is A Commodity? ................................................................................ - 206 ¥ What Is Commodity Investment? .............................................................. - 208 ¥ Why Invest In Commodities? ...................................................................... - 210 ¥ How to Invest In Commodities! (Farm-2-Fork) ...................................... - 213 ¥ Commodity Markets ...................................................................................... - 215 ¥ Trading in Commodities ............................................................................... - 216 COMMODITY INVESTMENT PRODUCTS .............................................................................. - 224 Invest vii Invest- 55 Assets That Grow Savings and Earn Passive Income HARD COMMODITIES (BASE, RARE EARTH & PRECIOUS METALS) .......................... - 224 ¥ Industrial/Base Metals (Copper, Aluminium, Zinc, Lead, & Iron/Steel) 226 ¥ Rare-Earth Metals (Lanthanum, Cerium, Praseodymium, etc) ......... - 228 ¥ Precious Metals (Gold, Diamond, Silver, Platinum, & Palladium) .... - 231 MEDIUM COMMODITIES (ENERGY & WATER) ................................................................ - 237 ¥ Electricity ......................................................................................................... - 237 ¥ Coal .................................................................................................................... - 239 ¥ Nuclear Energy ............................................................................................... - 241 ¥ Water ................................................................................................................. - 243 ¥ Green (Renewable) Energy ......................................................................... - 245 ¥ How To Invest in Oil & Gas: “soil-to-smoke” ......................................... - 246 SOFT COMMODITIES (PLANT & LIVESTOCK) ................................................................... - 256 ¥ Introduction to Soft Commodities Investing ........................................... - 256 ¥ How to Invest in Food Commodities: ‘field to fork’ .............................. - 258 ¥ Commercial Forestry ..................................................................................... - 261 5. PRIVATE EQUITY....................................................................................... - 262 INTRODUCTION TO PRIVATE EQUITY ................................................................................. - 262 ¥ What Is Private Equity? ............................................................................... - 262 ¥ What Is Private Equity Investment? ......................................................... - 262 ¥ Why Invest in Private Equity ...................................................................... - 263 PRIVATE EQUITY INVESTMENT PRODUCTS ...................................................................... - 264 ¥ Private Equity Funds (Venture Funds & Angel Funds) ...................... - 264 ¥ Distress Investments (Leveraged Buy Out, Mergers & Acquisitions) - 278 6. COLLECTORS ITEMS ............................................................................ - 287 INTRODUCTION TO COLLECTIBLES .................................................................................... - 287 ¥ What Is Collectibles? .................................................................................... - 287 ¥ How to Invest In Collectibles ...................................................................... - 293 COLLECTIBLES INVESTMENT PRODUCTS ......................................................................... - 295 ¥ Art and Photography .................................................................................... - 295 ¥ Books & Manuscripts ................................................................................... - 296 ¥ Classic Cars .................................................................................................... - 297 ¥ Memorabilia (Coins, Stamps, Militaria, etc) ........................................... - 298 ¥ Wine, Whisky & Cigars ................................................................................ - 302 7. COLLECTIVE INVESTMENT SCHEMES (FUNDS & CLUBS) ............. - 303 INTRODUCTION TO COLLECTIVE INVESTMENT SCHEMES (CISS)............................... - 303 ¥ What is Collective Investment Scheme .................................................... - 303 ¥ Why Collective Investment Scheme .......................................................... - 307 TYPES OF COLLECTIVE INVESTMENT SCHEMES ............................................................ - 308 ¥ Self-Directed Collective Investment Schemes (Investment Clubs & Cooperatives) ......................................................................................................... - 308 ¥ Professionally Managed Investment Schemes/Investment Companies . 310 Invest viii Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Closed-End Investment Funds .................................................................. - 311 ¥ Open-End Funds (Mutual Funds) .............................................................. - 314 APPENDIX ......................................................................................................... - 349 ¥ Investment Curriculum ................................................................................. - 349 ¥ Index of Investment Terms.......................................................................... - 353 - Invest ix Invest- 55 Assets That Grow Savings and Earn Passive Income INTRODUCTION TO INVESTING I am rich when I earn (at least) $100,000 a year in income; I am financially free when I own assets of not less than $ 1 million which earn me passive income of $100,000, that is, assuming a 10% rate of return per annum. -Ojijo ¥ What Is Investing? To invest is to acquire an asset. (Something that has value that will produce income or appreciate in value and when liquidated, will realize more than was spent in acquiring it). Investing is the commitment of money or capital to purchase assets in order to gain profitable returns in form of interest, income, or appreciation of the value of the asset. To invest is related to saving or deferring consumption, BUT with the aim of that money so saved is not consumed but used to bring more money. Investing is premised on the truism that whereas not all people can be entrepreneurs (some will be employees); whereas not all people can be career civil servants (some will be in civil society, and some will be in private sector); and whereas not all people can inherit money and live wealthy lifestyles (some are born in poor families, and some lose their money to become poor); ALL people can, and must invest. Indeed, even those who steal, rob, corrupt or plunder, must invest, otherwise, soon the money fizzles out. Investment, hence, is a mandatory undertaking, and all peoples, of all walks of life, professions, religion, and family backgrounds, must learn to invest; and must invest. Robert Kiyosaki taught, ‘to invest is to mind my own business.’ Investing is indeed a business. In the summation of The Intelligent Investor, Benjamin Graham wrote, “Investing is most intelligent when it is most businesslike.” Those are, says Buffett, “the nine most important words ever written about investing.” For Buffett, the activities of a common stock holder and a business owner are intimately connected. Both should look at ownership of a business in the same way. “I am a better investor because I am a businessman,” Buffett says, “and a better businessman because I am an investor.” -1- Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Investing Is Not Gambling Investing is not gambling. Gambling is putting money at risk by betting on an uncertain outcome with the hope that I might win money. True investing does not happen without some action on my part. A ‘real’ investor does not simply throw his or her money at any random investment; to be a real investor I must perform thorough analysis and commit capital only when there is a reasonable expectation of profit. Investing is confusing because it is a very large subject. Yes, there still is risk, and there are no guarantees, but investing is more than simply hoping Lady Luck is on my side. Investing is not a get-rich-quick scheme. Invest - 2 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Why Bother Investing? "It is okay to fail in class, and to fail in employment, and to fail in business, but I must not fail in investing." -Ojijo ‫ق‬ Investing Makes Me Rich People invest because they want to increase their personal freedom, sense of security and ability to afford the things they want in life. Investing allows me to take the money I have saved, and grow it, by creating my own financial portfolio. Investing is about making my money work for me. Robert Kiyosaki wrote, ‘The philosophy of the rich and the poor is this: the rich invest their money and spend what is left. The poor spend their money and invest what is left.’ When people invest, they spare money to offset the effect of inflation on idle cash as well as to benefit from an additional source of income and capital appreciation. Everybody wants more money. Investing allows me to take the money I have saved, and grow it, by creating my own financial portfolio. The only way to be rich is to invest and have assets. King Solomon knew it several millennia ago when he wrote, ‘the rich man’s strength is in his city’. The rich man’s city is his assets. Robert Kiyosaki says, “My poor dad always said, “Go to school and get good grades so you can find a safe, secure job with benefits.” Kiyosaki’s Rich Dad’s advice was, “If you want to be rich, you need to be a business owner and an investor.” An asset is any item, of value, usually purchased, or equivalently a deposit is made in a bank, in hopes of getting a future return or interest from it. An asset is expected to give returns without any work on the asset. The rich do not work for money. The rich work to build assets that will make money work for them. Riches protect the rich from pestilence of poverty. All rich people have assets. Whether they inherited it, married into it, won it, borrowed it, created it, or (God forbid) stole it, they all have assets. Assets leverage time and effort, so that money comes passively, even when the investor is not working. ‫ق‬ Investing Makes My Money Work For Me! To become rich and financially secure, I need to mind my own business; I need to invest. I need to have my own business. What we ultimately invest in is a business. Rich Dad’s rule was “My business buys my investments. Most people are not rich because they invest as individuals and not as owners of businesses.” Without my own business, I have no financial foundation. And without financial foundation, I will be poor, broke and miserable. Investing is the science of money making money. As Benjamin Franklin rightly noted, ‘Money makes Money, and the Money that Money makes, makes more Money.’ When I invest, Invest - 3 - Invest- 55 Assets That Grow Savings and Earn Passive Income I get personal, and financial freedom, then like Warren Buffet said, ‘I get to do what I like to do every single day of the year.’ Investing is about making my money work for me. Investing means putting my money to work for me. Essentially, it is a different way to think about how to make money. Growing up, most of us were taught that we can earn an income only by getting a job and working. And that is exactly what most of us do; but there is one big problem with this: if we want more money, we have to work more hours using more effort. However, there is a limit to how many hours a day we can work, not to mention the fact that having a bunch of money is no fun if we do not have the leisure time to enjoy it. As Robert Toru Kiyosaki, the author of the best-selling, Rich Dad, Poor Dad, wrote, ‘don’t work for money, let money work for you.’ It takes money to make money, but the money need not be mine; and shouldn’t. Indeed, when I invest, I earn what Kiyosaki calls, 20 percent money, which is money from capital gains or appreciation of stocks, bonds, and other assets like real estate. I am reminded by George Clason in his classical masterpiece, The Richest Man In Babylon, ‘make gold be your slave’. ‫ق‬ Investing Leverages Time and Effort Since I cannot create a duplicate of myself to increase my working time and effort; I need to send an extension of myself - my money (and hence time and effort) - to work for me. This is called investing, ‘putting my money to work for me’. ’That way, while I am putting in hours for my employer, or even mowing my lawn, sleeping, reading the paper or socializing with friends, I am becoming rich because my money is making more money for me elsewhere. Quite simply, making my money work for me maximizes my earning potential whether or not I receive a raise, decide to work overtime or look for a higherpaying job. This leverages my time and effort, giving me more hours and effort I would have had alone. And John D. Rockefeller agrees when he asked thus: ‘Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.’ Said rich dad. “Investing is simply a plan, made up of formulas and strategies, a system for getting rich . . .almost guaranteed.” ‫ق‬ Taking Control of My Finances Taking control of my personal finances will take work, and, yes, there will be a learning curve. But the rewards will far outweigh the required effort. Contrary to popular belief, I do not have to allow banks, bosses or investment professionals to push my money in directions that I do not understand. After all, no one is in a better position than I am to know what is best for me and my money. Investing is one of the major 'missing pieces' in many financial education programs. I am taught about saving but not about investing in assets that will Invest - 4 - Invest- 55 Assets That Grow Savings and Earn Passive Income produce passive income for me. Saving to purchase an item I really want is not as difficult as it may seem at first if I use a system, and it feels great when I do reach my savings goals. I will always have money for continued education. I am less likely to develop the habit of feeling guilty for spending my own money; an emotion many adults suffer from. However, I will remind myself that it is not a competition. As Rich Dad said, “Investing is not a race. You are not in competition with anyone else. People who compete usually have huge ups and downs in their financial life. You are not here to try to finish first. All you need to do to make more money is simply focus on becoming a better investor. If you focus on improving your experience and education as an investor, you will gain tremendous wealth. If all you want to do is to get rich quickly, or have more money than others, then the chances are you will be the big loser. It’s OK to compare and compete a little, but the real objective of this process is for you to become a better and more educated investor. Anything other than that is foolish and risky.” Invest - 5 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ The Two Types of Investors There are two broad types of investing and investors: There are two basic types and broadest forms of investing. Investors can be loaners or owners. It is either an equity investment or a debt investment. € Loaners invest in debt instruments. A debt investment is where I loan my money to someone else for an amount called interest. These may take the form of a bank savings account, a certificate of deposit, Treasury notes or corporate bonds among others. A debt investment is unique in that the borrower is obligated to the debtor to pay the money back. Debt investments give me a lower return than equity investments. € Owners invest in equity instruments. An equity investment is where I loan my money to someone else for a share of the profits he receives from the way he uses the money. These investments involve ownership of all or part of tangible or intangible assets such as real estate, intellectual property or stock in a company. An equity investment differs from a debt investment in that there is no obligation on the part of the debtor to pay me back. Debt investments are also lower in terms of risk than similar equity investments. Invest - 6 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ The Ojijo 9 (The Nine Fundamental Principles of Investing) “Investing is one of those skills that take just a week to learn but a lifetime to perfect.” -Ojijo Investing is guided by certain core principles which when followed, will lead to successful investing and becoming rich and financially independent. The principles herein referred to as The Ojijo 9 or The Nine Fundamental Principles of Investing, as below: ‫ق‬ Principle 1: Financial Goal Setting! $ What Is My Financial goal? A financial goal is a target I want to achieve. It is the ‘what I want to do or be’. My financial goal is the place I want to go to; the life I want to live; the career I want to practice; the money I want to earn; the health I want to have; and the adventure I want to experience. ‘It is not enough to do my best; me must KNOW what to do, and then do my best.’ said W. Edwards Deming, American statistician, professor, author, lecturer, and consultant. Today, I will define and describe my financial goals. $ Financial Goals To Be Smart! My financial goal must be smart. A SMART financial goal is one that is Specific, Measurable, Action orientated, Realistic and Time stamped. Specific – my objectives need to be specific, what exactly do me hope to achieve and why? Being rich for example is not a smart financial goal because it is not specific enough. I must know by how much: 1 million dollars? 200,000 dollars? Paul Nitze wrote, ‘One of the most dangerous forms of human error is forgetting what one is trying to achieve.’ People with clear financial goals, accomplish far more in a shorter period of time than people without. Measurable – My objectives need to be measurable. I need a way of measuring my progress to see whether I am target. This will allow me to tweak my action plan if needed, to get the desired results. When writing my financial goals, I will create benchmarks or milestones that I can use to measure my progress and know whether I am on track, off-track or not moving at all: stagnating. I will set financial goals and posts, so that when I move closer to it, I know, and when I move away from it, I will also know. With this, nobody can stop me, nobody can slow me down, and nobody can wear me out. Action orientated – I need an action plan. How am I going to achieve what I want? What are the necessary steps? What are my daily, weekly and monthly Invest - 7 - Invest- 55 Assets That Grow Savings and Earn Passive Income tasks? Financial goals + Actions = Results. I need to make a commitment towards implementing my action plan. My actions will ultimately determine my level of success. Steve Chandler said, ‘a financial goal without an action plan is a day financial dream.’ I will ask myself, ‘What can I do today to get one step, however small, closer to achieving my financial goals?’ I will then take daily action towards my financial goals and financial dreams. Mike Murdock was right, ‘my future is hidden in what I do daily’. I must make the first step to begin my journey of a thousand miles. Angelo D’Amico wrote, ‘I will accomplish my financial dream of tomorrow by acting today’. My success tomorrow will be the result of my actions today. My success is the sum of my past experiences. Without the foundation of my yesterday, my today would be pillared on nothingness; hopeless. ‘We are what we repeatedly do. Excellence, then, is not an act, but a habit.’ said Aristotle. I will work towards and achieve my financial goals gradually, but I must start today. The anonymous 13th century mystic must be quoted now, ‘I can only start the journey from where I am; and not where I am going’. In the future we will say one of the two things, ‘I wish I had’ or ‘I am glad I did,’ but we make that choice today’. I should make the choice today. NOW! Most people unfortunately just expect success to happen, what they fail to realise is that success comes to those who make it happen. Men of action are favoured by the goddess of good luck. ‘Financial goals allow me to control the direction of change in my favor.’ Brian Tracy said. It is proven that 95% of achieving anything in life is knowing what it is that we want. Realistic – Is my action plan and objective achievable? If not, I should go back and tweak it such that it is. I should ask myself, can I possibly sell goods worth 1 million dollars in two days? Can I possibly earn 200% return on my investment in six months? If the goal is not realistic, it is a wish, and will frustrate me. I need to set realistic goals. Big, but realistic. Time stamped – I will put a date on achieving my targets and ensure that I remain accountable. Napoleon Hill wrote, ‘A financial goal is a financial dream with a deadline’. By when do I want to earn my first 100,000 dollars? By when do I want to earn my first one million dollars? I must state the year, month, and date. I must time stamp my financial goal. Invest - 8 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Principle 2: Leveraging! “Leverage is the reason some people with money become rich, and others with money do not become rich.” -Ojijo There’s a saying: I need money to make more money. Every financial goal and result requires resources; from building a house, to investing, to starting a business, to attending school to get an education. After all, ‘there is no such thing as something for nothing’, Napoleon Hill reminds us. The Egyptians were right, ‘There grows no wheat where there is no grain.’ I to earn money, I must use money. To use fewer resources, and still achieve my financial goals, I need to work smart; I need to employ the concept of leverage. What resources am I going to need to help me achieve my desired outcome? The trick is to use fewer resources, and achieve more results. The trick is to work smart. The trick is to leverage. Leverage is the process of using less to achieve more. The root word for leverage – lever – comes from an old French word meaning “to make lighter,” which is an apt description of the power of leverage. Leverage allows people to work smarter, not harder. Even the Bible says in Proverbs, 23:4-5: ‘do not overwork to be rich.’ "Give me a lever long enough and a place to stand, and I can move the Earth." – Archimedes To lift a heavy object, I have a choice: use leverage or not. I can try to lift the object directly – risking injury and certain failure– or I can use a lever, such as a jack or a long plank of wood, to transfer some of the weight, and then lift the object that way. Leverage is about using other people’s resources to achieve my financial goals; other people’s STEM (skills, time, effort & money) to achieve my financial goals; leverage is about using less of my own, to achieve more. A smart financial goal is one that employs leverage. Leverage is borrowing money, which I use to make even more money. The moneymaking potential is always proportional to the total amount of money involved. Whether it is borrowed or not, it does not matter. As a common saying goes in Kenya, ‘money has no colour.’ Millions of people struggle financially because the power of debt leverage is used against them. Good debt makes me rich and bad debt makes me poor. Robert Kiyosaki said, “I retired young and rich because we were deeply in debt, deeply in debt with good debt, debt that made us rich and financially free.“ People without leverage work for those with leverage. Invest - 9 - Invest- 55 Assets That Grow Savings and Earn Passive Income Leverage is the use of various financial instruments or borrowed capital, such as margin trading, putting down lesser amount of money, and using it to control larger amount of money, hence, earning the margin. It is used in futures, forwards, options, as well as forex trading, re-purchase agreements, future contracts, and most forms of commodity trading. Leverage is making sure both my principal, as well as the interest it earns, earn me interest. This is the “The rule of 72,” also called the “doubling concept”, a mind-boggling wealth-building concept that the world’s top investment brokers teach their rich clients. The poor and middle class have a hard time getting rich because they try to use their own money to get rich. If I want to get rich, I need to know how to use other people’s money to get rich…not my own. I can read about how to leveraging time, leveraging skills, or leveraging effort in Ojijo’s 69 Ways to Make Extra Money While Keeping My Day Job! Invest - 10 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Principle 3: Saving-2-Invest! How do I start investing money? By saving! The key to investing is savings. An effective savings strategy coupled with a smart investing strategy will help me to meet my financial goals. ‘if you cannot save money, the seeds of greatness are not in you.’ wrote W. Clement Stone. Money should not just be saved; rather, it should be saved for investing. When it is just saved, it is kept, and it loses value due to inflation. However, when it is invested, it purchases assets, and sells those assets, at more money, called profit, or interest, or dividend. This is why money is called currency; it should be in constant state of motion, not static. Today, out of every amount of money I earn, I will save 10% and invest it. Saving what I earn is the first step to acquiring assets. In his masterpiece, The Richest Man in Babylon, George Clason, the soldier, businessman and writer, advises income earners thus; ‘pay yourself first.’ To save is to pay myself. Savings are used to create more money, not to pay bills. Benjamin Franklin, one of the Founding Fathers of the United States and a noted polymath, author, printer, satirist, political theorist, politician, scientist, inventor, civic activist, statesman, soldier, and diplomat was right, ‘A penny saved is a penny earned.’ This is one area where the Universal Law of Accumulation works. To save, I need to apply Ojijo three saving strategies. The three rules of saving; the three saving strategies are: 1) Put away 2) Put away small 3) Put away small regularly Saving in assets: the other method of saving is to directly purchase an asset, so that the money is saved in the asset. I can read extensively about the saving strategies in Making My Child Financially Intelligent - Money Lessons by Age Group (from 3-13 yrs). Further, in order to save-2-invest, I need a budget. Budgeting helps me to plan my finances. Budgeting lies at the foundation of every financial plan. Unlike what most people might believe, budgeting is not all about restricting what I spend money on and cutting out all the fun in my life.. Budgeting is understanding how much money I have, where it goes, and then planning how to best allocate the money. It does not matter if I am living paycheck to paycheck or earning six-figures a year, I need to know where my money is going if I want to have a handle on my finances. I will remember, ‘…money arrives like a tortoise, BUT departs like a hare!’ To create a budget, I will use The Ojijo 10% Budget Plan. The Ojijo 10% Budget Plan requires that I divide my revenue into TEN equal and separate areas, which all get 10% of the revenue allocation. The equality is premised on the fact that all parts of my daily living are equally important. Invest - 11 - Invest- 55 Assets That Grow Savings and Earn Passive Income The Ojijo 10% Budget plan is as below: 1. Giving to help the needy, whether directly or indirectly; as tithe or charity; or through the church, mosque, temple or Red Cross, etc.; 2. Rent & Utilities, including security & gardeners, mortgage, home insurance, lease, etc; 3. Saving-2-Invest in various assets, which will also include retirement plan payments as (old age) insurance; 4. Entertainment, including vacations, gifts, club membership fees, hobbies, etc; 5. Education, both personal and for children, including seminars, talent development programs and education insurance plan, etc; 6. Food & Drinks, excluding those taken as entertainment, e.g, alcohol, etc; 7. Transport & Communication, including fuel, repair and insurance; 8. Clothes & Personal Hygiene, including leg wear, sprays, jewellery and bathing items, etc; 9. Household & House Maintenance, including furniture & fixtures; kitchen appliances; and house help expenses, as well as property insurance; 10. Emergency & Insurance Fund. This covers my emergencies, including health insurance and life insurance premiums since, since disease can and will strike at anytime; and death, however certain, is always an emergency. The rule of thumb is that any excess money that remains from any of the categories will be added to category 3 and invested to make me financially independent. I can read extensively about budgeting in Making My Child Financially Intelligent Money Lessons by Age Group (from 3-13 yrs). Invest - 12 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Principle 4: Long Term Investing! Many people want to get rich, or invest in the investments the rich invest in, but most are not willing to invest the time. Almost anyone can easily become a millionaire if they simply follows a long-term plan. But again, most people are not willing to invest the time, they want to get rich NOW. Instead they say things like ‘investing is risky’ or ‘it takes money to make money’ or ‘I don’t have the time to learn to invest. I’m too busy working and I have bills to pay,’” Robert Kiyosaki says, “Their ideas about money and investing cause their money problems.” All they have to do is change a few words, a few ideas, and their financial world will change like magic. But most people are too busy working and they do not have the time. ‘Always invest in the long-term’, Warren Buffet advises. I need to invest long term. I should not be influenced by short-term fluctuations. These are inevitable in all economies as well as businesses experience the boom and bust cycle. I should not try to time the market. I need to get in and stay in. I should review my plan periodically, and whenever my needs or circumstances change. If I am not confident that my plan makes sense, I will talk to an investment advisor or someone I trust. A long-term view helps me to safely invest in 'riskier' investments, such as stocks, which the market rewards in general. This requires patience and discipline, but it increases returns. This approach reduces my choices to two: stocks and stock mutual funds. In the long run, they are the winners. The additional risk is worth it due to the power of compounding. 10% a year for 20 years is 570%, but 7% a year for 20 years is only 280%. I should not procrastinate. Research shows that since 1960’s, five year and above investment in the stock market always brings positive return on investment. Warren Buffett advises thus: ‘The rich invest in time, the poor invest in money.’ Most investors lack control or are out of control. rich dad used, “There is risk driving a car. But driving the car with your hands off the steering wheel is really risky.” He then said, “When it comes to investing, most people are driving with their hands off the steering wheel.” If I didn’t have a plan, a little discipline, and some determination, the other investor controls would not mean much. I should begin now because an early start can make all the difference. An early start provides a long time horizon for compounding to show its true benefit for the investor. For average people, investing is not so much a helpful tool as the only way they can retire and maintain their present lifestyle. By investing long term, I am planning ahead. By planning ahead I can ensure financial stability during my retirement. ‘It never was my thinking that made the big money for me. It was always my sitting. My sitting tight!’ said Edwin Lefevre. This blunt Invest - 13 - Invest- 55 Assets That Grow Savings and Earn Passive Income warning is treated by many financial advisers like the Holy Bible. Once I arrange my assets into my ideal allocation, I should not tinker. Warren Buffett again advises me, ‘I never attempt to make money on the stock market. I buy on assumption they could close the market the next day and not re-open it for five years.’ I will rebalance once a year to keep my mix on track, but otherwise, I will listen to Livermore and sit tight. Henry Ross Perot, the American billionaire noted, ‘Most people give up just when they are about to achieve success. They quit on one yard line. They give up the at last minute of the game one foot from a winning touch down.’ I will remember that even if the market tanks it always recovers for long term investors, and when it is low I will snatch up a lot of shares at bargain prices. As long as I am dollar-cost averaging I will always be buying shares at a cheaper price. The market can remain irrational longer than I can remain solvent. Bubbles occur. However, investors should never attempt to short them because, while bubbles eventually burst, they can grow larger and last longer than investor resources. This requires patience and discipline, but it increases returns. The additional risk is worth it due to the power of compounding. To invest long term, I should not procrastinate. I should begin now because an early start makes all the difference. An early start provides a long time horizon for compounding to show its true benefit for the investor. Further, I should invest long term since the liquidation value (if I said, ' give me my money back'), I will often get less than my original capital contributions during the first two years. That is to say, investing in the stock market is a long-term proposition, and I may only see my contribution increase in value after the second year or so of investing. Invest - 14 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Principle 5: Portfolio Diversification! “Only a fool tests the water’s depth with both feet. “ (Ghanaian Proverb) Portfolio diversification is the golden rule of successful investment: This simple strategy is overlooked by 85% of investors. Diversification is a fundamental aspect of financial planning. In a nutshell, it is the old adage to not put all my eggs in one basket. If I have all my eggs in one basket and something happens to the basket then I am in big trouble. But instead, let me say I keep some of my eggs in the refrigerator. Then if something happens to the eggs in the basket I still have the ones in the refrigerator. The practice of diversification says that I should have a little in each of these to diversify myself against risk of the stock market and whatever else might happen in life. There are two main methods of diversifying ones portfolio: $ THE AGE METHOD: One of the most popular formulas designed to provide a stage of life allocation - the age method - is to subtract your age from 100 to determine my share percentage, put 10% in cash and the remainder in bonds. $ TIME HORIZON METHOD: The next method that can be used is the resource / financial goal method. Here I would need to determine my time horizon. The longer the period (time) the greater the share allocation. Money that is needed in the short term should not be invested into shares I will diversify - by company, by industry, by company size and by geography. In stocks and bonds, there is safety in numbers. No matter how careful I am, I can neither predict nor control the future. So I must diversify. ‘In stocks and bonds, as in much else, there is safety in numbers.’ If I own the right number of stocks, bonds and funds and they are allocated across several categories, industries and geographies, I can substantially lower the risk of losses to our portfolio and increase returns at the same time. If I diversify properly; I can lower risk AND improve returns at the same time, making this a no-brainer. Diversification is the process of finding the investing sweet spot where I can optimize risk vs. return. Woody Allen stated the general idea when he said: “The advantage of being bisexual is that it doubles your chances for a date on Saturday night.” Diversification is about mixing: Another critical piece is the diversification mix. I want to invest in a wide variety of industries, categories and geographies to ensure that when one specific area goes south, it does not tank my whole portfolio. My portfolio should be spread across a wide variety of categories and geographies, most of which will not correlate at all with anything going on in Invest - 15 - Invest- 55 Assets That Grow Savings and Earn Passive Income telecom, some may even be inversely correlated (meaning they do well when telecoms do poorly). To diversity, I need a portfolio. PORTFOLIO: A combination of different investment assets mixed and matched for the purpose of achieving an investor's financial goal(s). For example, if I own a telecom and suddenly the industry is getting bad press due to invasion of privacy lawsuits, the rest of our portfolio can cover the losses of that stock. Why? If we're diversified, that is probably our only telecom investments, the rest are in unrelated industries and will not be directly affected by these lawsuits. Diversification reduces risk: Diversification is important. If I spread my investments across various types of assets and markets, I will reduce the risk of catastrophic financial losses. Diversifying investments in a portfolio helps to manage risk. The safest port in a sea of uncertainty is diversification. As most successful investors will tell me, diversification is king. A diversified portfolio not only reduces unwanted risk, but also contributes to a winning portfolio. And having a well-diversified portfolio does not necessarily mean just buying more than one stock; branching out into other areas of investment could be a viable alternative. The strategy to get rich is entirely different than the strategy to stay rich. One gets rich through inheritance or by taking risk. One stays rich by minimizing risk, diversifying and not spending too much. Items that are considered a part of my portfolio can range from real items such as art and real estate, to equities, fixed-income instruments and their cash and equivalents. There is not just one strategy that can be used to invest successfully. Ideally an investment portfolio should have both equity and debt instruments. Using this guideline I can allocate my money as best fits my personal situation. This strategy does not even rely on my ability to pick stocks. It relies on the principle of diversification. I should divide my money between these types of investments. Invest - 16 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Principle 6: Dollar Cost Averaging! Dollar cost averaging is buying at intervals: Dollar cost averaging is a technique by which an investor divides the given investment over a period of time and invests that amount on a regular basis as opposed to buying in all at once. When I buy the same stock or mutual fund at regular intervals and with a fixed amount, I am said to be using the dollar cost averaging method. If the market price of the selected stock or mutual fund declines, the investor will buy a greater number of shares. On the other hand, when the market price of the selected stock or mutual fund increases, the investor will buy lesser number of shares. Dollar cost averaging reduces risk of price fluctuations: By putting in, say, $100 each month (rather than a large amount once a year), I sometimes buy when the prices of the units of the fund are higher, and sometimes when prices are lower. In the end, the purchase prices average out. I can hence reduce some of the risk that poor timing and potentially adverse price fluctuations will have on my investment decisions. Just about any fund company or bank will let me invest like this with an automatic payment plan. However, dollar cost averaging will not protect me in a steadily declining market. Further, if I discontinue with a dollar cost averaging plan, I will lose money when the market value is less than cost of the shares. Invest - 17 - Invest- 55 Assets That Grow Savings and Earn Passive Income Month January February March April May June July August September October November December Total Dollars Invested 100 100 100 100 100 100 100 100 100 100 100 100 1,200 Price per share 12.76 13.25 15.25 18.76 20.26 18.85 15.62 17.85 16.62 13.26 14.5 16.76 193.74 No. of shares purchased 7.84 7.55 6.56 5.33 4.94 5.31 6.40 5.60 6.02 7.54 6.90 5.97 75.94 Average price per share = 193.74/12 = $ 16.15 Average cost per share = 1,200/75.94 = $ 15.80 Dollar cost averaging encourages automatic savings: The best thing about dollar cost averaging is that it gets me into the habit of saving every single month. Dollar cost averaging permits systematic contributions to an investment portfolio periodically, hence encouraging savings Dollar-averaging (continuing to invest the same amount of money every month) really works. This investing strategy will, over a period of time, result in the investor buying the selected stock or mutual fund at an average cost per share that will be less than the average price per share. For example, assuming that a person invests $100 per month for 12 months in a Mutual Fund; as can be seen from the below table, the average cost per share is lower than the average price per share. Invest - 18 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Principle 7: Risk Tolerance! “risk is the other side of investing” -Ojijo Risk is a necessary element of life. There is always the chance that something will not work out for me and this chance is called risk. There is a risk in everything I choose to do in life including my financial life. The broad range of investment opportunities represents varied levels of risks and rewards. History unequivocally supports this ‘no free lunch’ principle. Stocks (high risk) have paid more than government bonds (medium risk), which in turn have beaten low-risk Treasury bills. Among many, many other things, this law suggests that to earn returns high enough to build true wealth, I have to put some of my money in risky assets like stocks-the only investment to handily beat inflation over time. As Rich Dad said, “What good is making a lot of money if you wind up losing it all?” The greater the risk I take, the greater the reward I will receive. This applies to investments but also to life decisions. In the financial world this is illustrated when I choose to invest in a stock over a safer investment. The extra risk I take is rewarded in terms of the stocks growth. In our personal world this is illustrated in a decision to attend college. Attending college is essentially a case of one assuming a risk. I am foregoing years of income for the chance that the increased education will pay off for me in more income in the long run. This is actually a pretty safe investment that usually works. Bill Gates was right, ‘To win big, you sometimes have to take big risks.’ If I want to invest with very low risk and high returns, I have to pay the price. And the price involves study, lots of study. I need to study the basics of business. So to be a rich investor, “I have to be a good business owner, or know a business owner.” $ Types of Risk Depending on the nature of the investment, the type of 'investment' risk will vary. The risk can be caused by market changes, interest rates fluctuation, management imprudence, liquidity rates, industry practices, political issues, etc. $ Risk Reduction Strategies Since there is imminent risk in entrepreneurship, every entrepreneur should take risk reduction measures. I can do this by applying various strategies: Experimenting: The first strategy is to experiment. This involves taking action through a series of low cost events and projects before committing a great deal of resources (time, energy, skills and money). Invest - 19 - Invest- 55 Assets That Grow Savings and Earn Passive Income Risk Sharing: Risk sharing by partnership with individuals or corporations that have complementary skills will increase the chance of success while reducing the risk in terms of time, skills, money and energy that is required. Risk Should Be Proportional To Available Disposable Income: The golden rule surrounding all investing is: I should not spend more than I can afford to lose. This is the absolute truth. As a general rule in risk taking, I should not take more risk than ability, willingness or need dictates. I should take risk with money I can afford to lose. Risk Should Depend On My Investment Objectives: The two main investment objectives are income generation and capital appreciation. Capital appreciation will require high risk, high return investments like equities, while income generation require low risk, fixed securities, like bonds. Risk Should Be Based On My Financial Position: As multi-millionaire, in an effort to increase my profit for the year; I may have no problem putting down $100,000 in a speculative real estate investment. Risk Should Be Based On My Age: A 75-year-old widow living off of her retirement portfolio needs income from her investments to survive, she cannot risk losing her investment, and takes a passive investment strategy. A 35 year old young executive, on the other hand, has time on his or her side, and hence, takes an aggressive investment strategy. Diversification Mitigates Risk: Whatever my personality type, putting my eggs in different baskets protects me from a failure in one industry sector, or one company. Knowledge Mitigates Risk: The more extensive my knowledge of what has been done, the greater will be my power of knowing what (not) to do. ‘As a general rule, the most successful man in life is the man who has the best information.’ said Benjamin Disraeli. I should build my knowledge base to help me in achieving financial independence. Whether it takes a week, a month or a year to become thoroughly knowledgeable, it does not matter. I should start learning immediately, today. Investing is a big bet on an unknowable future. I should accept I need to learn, and then learn. This will reduce the risk of venturing into this unknowable future. Think about how much information I have! Too little increases risk. Warren Buffett said, ‘Risk comes from not knowing what you are doing.’ Invest - 20 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Principle 8: Knowledge-Based Investing! To be a great investor, I need have a great financial IQ. Financial literacy is one of the most important investor basics, especially if I want to be a safe investor, an inside investor, and a rich investor. Kiyosaki said, “Anyone who is not financially literate cannot see into an investment.” Improving my financial literacy ultimately reduces my risk and improves my investment returns. I don’t need to be an expert in order to achieve satisfactory investment returns. But I must recognize my limitations. It’s vital, however, that I recognize the perimeter of my “circle of competence” and stay well inside of it. I will focus on the future productivity of the asset I am considering. No one has the ability to evaluate every investment possibility, but I need to forecast for five years to ten years, at the least. If I lack the ability to estimate future earnings, I should move on to other prospects. If I don’t feel comfortable making a rough estimate of the asset’s future earnings, I will forget it and move on. I need to be an informed investor. Investing is the key to building wealth, but investing in and of itself is not enough. If I have to invest, I need to invest wisely! I do not need to be a financial expert to invest, but I do need to learn some basic terminology and concepts so that I am better equipped to make informed decisions. This is what this guide is all about. Investment is not speculation. Investment is informed speculation. My financial goal is to be informed enough to understand and analyze what I hear. Then I can decide what fits with my investing personality. When asked how he managed to become a rich investor, Warren Buffet said, ‘we read hundreds and hundreds of reports every year.’ Investors are willing to pay for knowledge. They read books, journals and magazines ranging from investing to personal development. They attend seminars to improve themselves. They are voracious. Successful investors know that their cup of knowledge must never be full so they always keep their minds open; ever ready to learn. Robert Kiyosaki reminds investors that investment is all about being an insider. To be an insider today, I will be informed. As Kiyosaki says, “knowledge is the new money”. I make the most money as an investor by being financially literate as well as knowing internal strengths and weaknesses of the investment. I find the best investment opportunities from understanding accounting, the tax code, business law, and corporate law. The more I read financial statements, annual reports, and prospectuses, the more my financial intelligence, or financial vision, increases. Over time I will begin to see things that the average investor never sees. It is in these invisible realms where the real investors shop for the Invest - 21 - Invest- 55 Assets That Grow Savings and Earn Passive Income biggest investment bargains. As Warren Buffet says, “the income statement and balance sheet the magic carpet of investing.” Learning to read financial statements is a tedious process, especially when I first begin to learn. The good news is that it gets easier and faster as I practice. But not only does it get easier, but I can also review many more investment opportunities almost automatically without thinking, just like riding a bike, or driving a car. The reason most people suffer financially is because they purchase liabilities and list them under assets. If I want to be rich for generations, I must know the difference between an asset and a liability. I must know the difference between something of value and something that reduces value. I will always remember that my expense is someone else’s income, and my liabilities are someone else’s asset. When I am out of control of my cash flow, I make the people who are in control of their cash flow rich. I need to understand the financial ratios, mainly the return on equity, return on assets, and return on capital, which all analyse how the transforms capital into profit for investors. The other ratios are debt to equity ratios, or leverage ratios, which indicate what percentage of the company is funded by debt, and hence, how much more debt the company can absorb before it becomes fully leveraged. Warren Buffett never invests in businesses he cannot understand or that are outside his “Circle of Competence.” All investors can, over time, obtain and intensify their “Circle of Competence” in an industry where they are professionally involved or in some sector of business they enjoy researching. Buffett’s logic is compelling: “If you own a company (either fully or some of its shares) in an industry you do not understand, it is impossible to accurately interpret developments and therefore impossible to make wise decisions.” There is a great investing saying thus, ‘Invest in things you know.’ Peter Lynch said it best when he said, ‘Never invest in an idea I cannot illustrate with a crayon.’ Invest - 22 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Principle 9: Re-Investing & Compounding! Reinvesting means plaughing back what I earn as profit into purchasing more assets, hence, investing it. When I am investing, I should not be a hungry investor. If I make a profit, at least 50% should be ploughed back in investments. Compounding is the most important principle in saving and investing. It has been called the eighth wonder of the world. It is the key concept of any saving and investing plan. Albert Einstein called compound interest ‘the greatest mathematical discovery of all time’. This is true partly because, unlike the trigonometry or calculus I studied back in high school, compounding can be applied to everyday life, and in finance, it applies to amplify the growth of my working money. Whereas investing maximizes my earning potential, compounding maximizes the earning potential of my investments. Compounding makes money make more money: The wonder of compounding (‘compound interest’) transforms my working money into a state-of-the-art, highly powerful income-generating tool. Compounding is the process of generating earnings on an asset's reinvested earnings. To work, it requires two things: re-investment of earnings and time. The more time I give my investments, the more I am able to accelerate the income potential of my original investment, which takes the pressure off of me. Compounding is premised on the doctrine of the Time Value of Money. (TVM). Time Value of Money (TVM) is the idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. This core principle of finance holds, provided money can earn interest, any amount of money is worth more the sooner it is received. The time value of money demonstrates, all things being equal, it is better to have money now rather than later. I need to start investment now, today. I need to start investing now, today. By giving my investment more time to grow, I earn myself more money. Investments start to grow slowly and then accelerate. The invested money accumulates interest, and the accumulated interest is itself accruing more interest. Everyone knows that money deposited in a savings account will earn interest. Because of this universal fact, I would prefer to receive money today rather than the same amount in the future. The earlier I put money to work, the longer it works for the members, and the more wealth is generated. It makes a lot of sense. Wealth is generated via production. The longer my money works in good companies, the more time it has to produce further profit; profit which I also get to share. Reinvesting earnings allows me to take advantage of compounding. I must keep hands off the principal and earned interest. Compounding is realized by reinvesting the earned income or interest. Reinvesting is the investment of both principal and income from principal rather than distributing it as dividends or profits. Reinvestment of resources is a useful strategy that all Invest - 23 - Invest- 55 Assets That Grow Savings and Earn Passive Income entrepreneurs regularly employ. As long as I do not need the income (from dividend payouts), It is generally a good idea to reinvest. Reinvestment dovetails with the investing maxim of ‘dollar cost averaging,’ which holds that investors do well to consistently invest small amounts of money. The return I receive on an investment is interest. If I invest $20,000 and it returns a modest 10% a year then I will have earned $2,000 in interest. Compounding interest is the escalating effect of interest. As an example, if my $20,000 investment was returning 10% per year after 10 years I would expect to receive $20,000 in interest. Actually it is much more than that. Compounding interest ensures the amount I earn is more. After Year 1 I receive $2,000 which makes my investment $22,000. For Year 2, 10% of $22,000 is $2,200. This is because I reinvested that $2,000; it works together with the original investment. This means the amount of interest I receive in year 2 is greater than year 1. This interest I am earning is compounding. Every year, my investment compounds more and more. After 5 years my investment of $20,000 has gone up to $32,210. That is interest of $12,210 not $10,000 as I first thought. This little bit extra may seem like peanuts, but I did not have to lift a finger to earn that $2,210. More importantly, this $2,210 also starts to earn interest. At the end of 10 years my investment is worth $51,875. I have returned $31,875 and not $20,000. Dividend Reinvestment: When I am paid a dividend, I typically can choose to receive it in cash or reinvest it and purchase additional stock. Dividend reinvestment is a systematic method of accumulating shares of a stock that pays a dividend. Many investors use dividend reinvestment as part of a longterm buy-and-hold investment program. This will happen even as I send voluntary contributions to purchase additional shares. Further, putting dividend reinvestment stocks in a retirement account can shelter the dividends from current tax liability. If I choose to reinvest our dividends, in effect, we're taking the dividend payment in stock instead of cash. Reinvesting dividend income is an important part of the overall return on our investment as a club. It is similar to compounding interest, with the principal of our investment constantly growing and theoretically paying higher dividends each quarter. The process takes time, but reinvesting our dividends can increase our total return in the long run. The cool thing is that I can put all of my profit back to work, and effectively have more money generating more profit. This process can keep iterating so long as I do not withdraw my money. Script dividend:, capitalisation issue or bonus issue A scrip issue, also known as capitalisation issue or bonus issue, is a form of secondary issue where a company's cash reserves are converted into new shares and given to existing shareholders, or an issue of additional shares to shareholders in proportion to the shares already held. Invest - 24 - Invest- 55 Assets That Grow Savings and Earn Passive Income The Ojijo 3 Classes of Investment Vehicles ¥ Investment is the science of money making money. To invest, I exchange the money I have already acquired for an asset, and then I let the asset increase in value, either through value addition, or holding it for a period of time. I have various options of making my money to make more money for me. These options are referred to as ‘investment vehicles,’ or ‘investment products’, which is just another way of saying ‘a way to invest.’ Each of these investments is something I purchase or place my money into in return for the earnings (capital gains, dividends or interest) that is generated over time and paid back to me. There are many different investment products, or vehicles, because there are many different people with many different needs. Investing is a plan to get me there. And one is not necessarily better than the other. These vehicles are grouped according to the type of asset invested in, and Ojijo, in his classical and all time best-seller, Making My Child Financially Intelligent: Money Lessons by Age Group (from 3-13yrs), classifies the investment vehicles into three broad categories, namely, Personal Branding or Self-Help; Traditional Assets or Financial Instruments; and Alternative Assets or Alternative Investment Products: 1. Personal Branding or Self-Help, which is the greatest form of investment, involves engaging in activities which enable me to identify and develop my talents and skills to realize my potential; and set goals and achieve my dreams and aspirations so as to enhance the quality of my life and contribute to my community. In addition to other excellent books written on the subject, I can also read Ojijo’s The Gift of E11even Moves to Make Me Wealthy, which teaches me the eleven areas that I need to develop to enjoy the complete and wealthy lifestyle, namely health, relationships, riches/money, career, adventure, happiness, dreams & goals, positive attitude, controlling the day, helping people and being peaceful). I can also read Talanta: Ojijo’s Guide to Identify, Develop and Commercialize My Talent & Career Skills, which has practical exercises to help me identify, develop and commercialize my talents and skills, through training, mentoring, coaching, consulting, instructing and or counseling. Invest - 25 - Invest- 55 Assets That Grow Savings and Earn Passive Income 2. Traditional Assets or Financial Instruments, also called securities, are a real (hard copy) or virtual (electronic) documents representing a legal agreement/contract involving a monetary value. They can indicate that someone owes me specific pre-agreed money amount/interest (Debt Instruments/Bonds and Bank Deposit Accounts-term and fixed deposits); or that I own part of some business process (Equity Instruments/Shares); or a cash investment, whose values are determined directly by the market (Bank Savings Accounts). Further, financial instruments can be securities whose value is determined by fluctuations in the underlying asset and are used for speculation or risk management, also refered to as derivatives. (Options, Futures, Forwards and Swaps). A practical book to read for further knowledge in investing in financial instruments is Invest: Ojijo’s Guide to Financial Instruments & Alternative Investment Products. 3. Alternative Assets are assets other than traditional investments (stocks, bonds or cash or their derivatives). Alternative assets include Property/Fixed Assets, Insurance, Forex, Private Equity, Collective Investment Schemes, Collectibles and Commodities. A practical book to read for further knowledge on investing in alternative assets is Invest: Ojijo’s Guide to Financial Instruments & Alternative Investment Products. In detail they are; $ Collective Investment Scheme (CIS) is a pool of money from various investors for investing in various assets. It can be a professional scheme, managed by a fund manager, group, bank, or company, called Investment Company. Such professionally managed schemes can either be closed-ended (limited number of shares issued once) or open ended/mutual funds (open for new investors to buy shares). Collective Investment Schemes can also be self-managed by the members. Such are called investment clubs, which allow members to also learn and network. A practical book to read for further knowledge in forming, joining and running an investment club is Making Money Together: Ojijo’s Investments Clubs Manual; $ Property/Fixed Assets includes long-term tangible/physical assets (such as machinery, land, buildings, equipments, vehicles), or intangible/technological assets, can be a tool, technique, craft, system or method of organization in order to solve a problem or serve some purpose. Assets in software/ computer application form are called Information Technology/IT Assets (commonly referred to as software); Invest - 26 - Invest- 55 Assets That Grow Savings and Earn Passive Income $ Collectibles are objects regarded as being of value or interest, either because they are old/antiques, or they are specially manufactured to be collectibles, including art, antiques, coins and stamps; $ Commodities are naturally occurring/raw/primary products, and are divided into three (3) categories of hard, medium and soft commodities. Soft Commodities include (plant- soya, grains, vegetables, etc & livestock- pork, beef, chicken, etc); Medium Commodities (energy- oil, gas, electricity, etc & water); and Hard Commodities (base/industrial metalscopper, aluminum, iron, etc & precious minerals- gold, silver, diamond, uranium, palladium and platinum); $ Private Equity involves injecting working capital to start-up or operating private companies; and owning equity/shares for a period until returns are collected. It is done by venture capital firms, private equity funds or angel investors through leveraged buyouts, venture capital, growth capital, distressed investments and/or mezzanine capital; $ Insurance Assets are insurance products that have both a protection as well as an investment component such as endowment plans (education), pension plans and annuities (retirement), investment bonds/insurance bonds and endowment plans (life insurance); and $ Forex Investments involving the purchase and sale of currencies against each other. The foreign exchange market, which is usually known as ‘forex’ or ‘FX,’ is the largest financial market in the world. It does not matter which method I choose for investing my money, the goal is always to put my money to work so it earns me an additional profit. Even though this is a simple idea; it is the most important concept for me to understand. Too many so-called investors get attached to one investment product and one investment procedure. For example, a person may invest only in stocks or a person may invest only in real estate. The person becomes attached to the vehicle and then fails to see all the other investment vehicles and procedures available. Kiyosaki said, “A true investor does not become attached to the vehicles or the procedures. A true investor has a plan and has multiple options as to investment vehicles and procedures.” Invest - 27 - Invest- 55 Assets That Grow Savings and Earn Passive Income CLASS 1 VEHICLES: PERSONAL DEVELOPMENT THE SCOPE OF PERSONAL DEVELOPMENT Personal Branding or Self-Help, Personal Branding is the greatest form of investment I can ever make. It involves engaging in activities which enable me to identify and develop my talents and skills to realize my potential; and set and achieve my goals and dreams so as to enhance the quality of my life and contribute to my people and my community. The full scope of Personal Branding covers the identification and development of my talent and careers. The first step in Personal Branding is to acquire knowledge, either through the people I meet, or the books I read. However, just as the Holy Bible warns, ‘bad company spoils good morals’, so is reading and not applying counterproductive. Indeed, just as the Holy Quran advises, ‘next to knowledge must come action,’ the positive results will only come from daily application of the lessons and strategies learned. As I read books, I will focus on applying what I have learned in the books I have already read. The Buddhists are right, ‘to know, and not to use, is not yet to know’. In addition to other excellent books written on the subject, I can also read Ojijo’s The Gift of E11even Moves to Make Me Wealthy, which teaches me the eleven areas that I need to develop to enjoy the complete and wealthy lifestyle, namely health, relationships, riches/money, career, adventure, happiness, dreams & goals, positive attitude, controlling the day, helping people and being peaceful). I can also read Talanta: Ojijo’s Guide to Identifying, Developing and Selling My Talent & Career Skills, which has practical exercises to help me identify, develop and sell my talents and skills. Invest - 28 - Invest- 55 Assets That Grow Savings and Earn Passive Income 6 (SIX) WAYS TO BRAND MYSELF (PERSONAL DEVELOPMENT STRATEGIES)! Branding Approaches: The process of personal branding, that is, engaging in activities which enable me to identify and develop my talents and skills to realize my potential; and set and achieve my goals and dreams so as to enhance the quality of my life and contribute to my people and my community, can be done in 6 (six) ways namely: Training, Coaching, Mentoring. Instructing, Consulting, and Counseling. The differences in the above processes lie in the approach (methodology), purpose (why), and target (focus of the activity). ¥ Training: Training is the process of improving on my emotional, physical, spiritual and intellectual (four dimensions of the human being) fitness, by getting and applying relevant knowledge. I can do it by individually or in a team; and I can do it myself, or get assistance from an expert, or professional. As Samuel Johnson said, “Knowledge is of two kinds. We know a subject ourselves, or we know where we can find information on it.” ¥ Coaching: Coaching is the process through which I am taken through steps to achieve certain pre-determined goals in any area of my life, including financial, sports performance, career, project management, and or spiritual enlightenment. ¥ Mentoring: Mentoring is the process through which someone, the mentor, influences me to become better as an individual, and hence, ultimately, contribute more towards my projects. Mentoring is most of the time impassive, and the mentor hardly knows they are mentoring someone since they just live their life, and in so doing, they influence others to live better. ¥ Instructing: This is the process through which I am told exactly what to do, and how to do it, leaving little room for discussion. I will apply this where I need to execute a specific command, for instance, how to play Handel, or how to kick box, or how to march. ¥ Consulting: Consulting is the process where I seek professional advice on a pre-stated and specific challenge. The consultant will have clear terms of reference, and will seek to take me to where he is; in essence, a consultant pulls me to where he is, whereas in coaching, the coach pushes me to where I ought to be. ¥ Counseling: Counseling is the process of getting professional help with my psychological problems to restore my emotional balance when I am below normal (e.g. I Invest - 29 - Invest- 55 Assets That Grow Savings and Earn Passive Income have experienced the death of a loved one), or when I am above normal (e.g., I have won a lottery of hundreds of millions of dollars). Invest - 30 - Invest- 55 Assets That Grow Savings and Earn Passive Income CLASS 2 VEHICLES: FINANCIAL INSTRUMENTS INTRODUCTION TO FINANCIAL INSTRUMENTS & INVESTMENTS ¥ What Is A Financial Instrument? Financial instruments, also called securities, are a real (hard copy) or virtual (electronic) documents representing a legal agreement involving some sort of monetary value. The wide array of financial instruments in today's marketplace allows for the efficient flow of capital amongst the world's investors. ‫ق‬ Classification of Financial Instruments Financial instruments can be categorized by form depending on whether they are cash instruments or derivative instruments: ‫ ق‬Cash instruments are financial instruments whose value is determined directly by markets. They can be divided into securities, which are readily transferable, and other cash instruments such as loans and deposits, where both borrower and lender have to agree on a transfer. These financial instruments are recognized as cash that can be utilized for various transactions. Currency is the most easily identified of all cash instruments. ‫ ق‬Derivative instruments are financial instruments, which derive their value from the value and characteristics of one or more underlying assets. They can be divided into exchange-traded derivatives and over-the-counter (OTC) traded derivatives. This classification would include such instruments as futures, options, and swaps. Alternatively, financial instruments can be categorized by ‘asset class’ depending on whether they are equity based (reflecting ownership of the issuing entity) or debt based (reflecting a loan the investor has made to the issuing entity). Further, if it is debt, it can be further categorized into short term (less than one year) or long term. Foreign Exchange instruments and transactions are neither debt nor equity based and comprise a third, unique type of instrument. Different subcategories of each instrument type exist, with their own unique characteristics and structures. Invest - 31 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Why Financial Instruments? Financial instruments are the best bet for investing because my money will work for me to make more money, leaving me with time to do other things, unlike investing in fixed assets where I have to worry about rent, refurbishments, inventory, employees coming late, or overhead costs like stationery, utilities, etc. Financial investments have some protection through insurance in the event of a bankruptcy or malpractice and I am entitled to receiving something back from a liquidation of assets if that were to occur. This is not the case with my private businesses. I must insure my business and assets in business if I have to be safe and protected. In doing the above, I have my money definitely being put to work, and I become part owner of the biggest companies in the country and internationally. Further, with no additional work on my end, I can reinvest all the money that gets paid out in dividends, which allows me to see the benefits of compounding over time, even more so if I set this fund up in a retirement plan that allows my investment to grow without being taxed immediately. It is easy! It fits my preference to avoid the work of picking stocks. Invest - 32 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ What is Financial Investment? Financial investment is the commitment of money by buying financial instruments, commonly called securities or in buying fairly liquid real assets, such as gold or collectibles. ‫ق‬ How Is Financial Investment Made? Financial investments are typically made indirectly via intermediaries such as banks, insurance companies, mutual funds, pension funds, collective investment schemes and investment clubs. An intermediary generally makes investments using the money from many individuals. I can also invest directly by walking into the individual company or institution selling the financial instrument and purchasing the same through broker. Investing wisely requires a combination of astuteness, knowledge of the market, and timing. There are different types of methods to analyze the market and the market conditions and make investment decisions. The two common methods are: £ TECHNICAL ANALYSIS: This method of analysis is used by a ‘momentum’ investor. Technical analysis looks at the price fluctuations that occur in the stock market. The investor bases the decision to invest on what he feels the price will do next. £ FUNDAMENTAL ANALYSIS: This analysis is used by the ‘growth investor’, also called, ‘value investor’. This investor looks at the company’s current value, and determines if it is undervalued, meaning, it has an intrinsic higher value than the current stock price, and hence, it has a high growth potential. The investor determines value after weighing all the known information about a company’s business, management, and financial traits. Price and value are not necessarily equal. In finance, intrinsic value refers to the value of a company, stock, currency or product determined through fundamental analysis without reference to its market value. It is also frequently called fundamental value. It is ordinarily calculated by summing the discounted future income generated by the asset to obtain the present value. In valuing equity, securities analysts may use fundamental analysis—as opposed to technical analysis—to estimate the intrinsic value of a company. Here the "intrinsic" characteristic considered is the expected cash flow production of the company in question. Intrinsic value is therefore defined to be the present value of all expected future net cash flows to the company; it is calculated via discounted cash flow valuation. Invest - 33 - Invest- 55 Assets That Grow Savings and Earn Passive Income Prominent investors like Benjamin Graham and Warren Buffett made some of their greatest profits by purchasing fundamentally-sound, well-run companies when their market value was running at a substantial discount to their intrinsic value. They were able to look past the near-term problems and bad news affecting the firms and realize that once ephemeral issues were taken care of, they would be viable, profitable enterprises. Fundamental analysis includes:  Economic analysis  Industry analysis  Company analysis On the basis of these three analyses the intrinsic value of the shares are determined. This is considered as the true value of the share. If the intrinsic value is higher than the market price it is recommended to buy the share . If it is equal to market price hold the share and if it is less than the market price sell the shares. An alternative, though related approach, is to view intrinsic value as the value of a business' ongoing operations, as opposed to its accounting based book value, or break-up value. Warren Buffett is known for his ability to calculate the intrinsic value of a business, and then buy that business when its price is at a discount to its intrinsic value. Benjamin Graham adage is right: “Price is what you pay, value is what you get.” In valuing real estate, a similar approach may be used. The "intrinsic value" of real estate is therefore defined as the net present value of all future net cash flows which are foregone by buying a piece of real estate instead of renting it in perpetuity. These cash flows would include rent, inflation, maintenance and property taxes. One way to look at it is that the market capitalization is the price (i.e. what investors are willing to pay for the company) and intrinsic value is the value (i.e. what the company is really worth). The market value, or book value, or capitalization, of a security is what anyone is willing to pay for it in the open market. Depending on broader market conditions and the popular opinion of investors at any given time, a company's market value can either be much higher or lower than its fundamental and intrinsic value. Most stock investors use the fundamental method of analysis to make most of their investing decisions. They find companies that are listed on the stock market that show good growth, profit, and earnings but that are still cheap to buy and have not yet reached their potential. The investors hence buy this stock and hold on to it for several years so long as the fundamentals, as listed previously, continue to hold strong. This type of investment strategy is called ‘buy and hold’. Invest - 34 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ What Are Financial Markets? To invest successfully in financial instruments, I need to know the financial markets; and better still, I need to know the definition, and roles of markets. In economics, typically, the term market means the aggregate of possible buyers and sellers of a certain good or service and the transactions between them. The term "market" is sometimes used for what are more strictly exchanges, organizations that facilitate the trade in financial securities, e.g., a stock exchange or commodity exchange. This may be a physical location (like the NYSE, BSE, NSE) or an electronic system (like NASDAQ). Much trading of stocks takes place on an exchange; still, corporate actions (merger, spinoff) are outside an exchange, while any two companies or people, for whatever reason, may agree to sell stock from the one to the other without using an exchange. Trading of currencies and bonds is largely on a bilateral basis, although some bonds trade on a stock exchange, and people are building electronic systems for these as well, similar to stock exchanges. Rich dad said. “Most people are trying to make money by what they think is investing. But trading is not investing.” Trading is a procedure or technique. A person trading stocks is not much different than a person who buys a house, fixes it up, and sells it for a higher profit. One trades stocks; the other trades real estate. It’s still trading. Financial markets can be domestic or they can be international. Financial market is a mechanism that allows people to buy and sell (trade) financial instruments/securities (such as stocks and bonds), commodities (such as precious metals or agricultural goods), and other fungible items of value at low transaction costs. Financial markets, just like the normal flea markets, work by placing many interested buyers and sellers in one ‘place’, thus making it easier for them to find each other. Without financial markets, borrowers would have difficulty finding lenders themselves. Intermediaries such as banks, brokers and financial advisers help in this process. Banks take deposits from those who have money to save. They can then lend money from this pool of deposited money to those who seek to borrow money in the form of loans and mortgages. However, more complex transactions than a simple bank deposit require markets where lenders and their agents can meet borrowers and their agents, and Invest - 35 - Invest- 55 Assets That Grow Savings and Earn Passive Income where existing borrowing or lending commitments can be sold on to other parties. A good example of a financial market is a stock exchange. In the stock exchange, a company can raise money by selling shares to investors and its existing shares can be bought or sold. Typically a borrower issues a receipt to the lender promising to pay back the capital. These receipts are securities which may be freely bought or sold. In return for lending money to the borrower, the lender will expect some compensation in the form of interest or dividends. Trading is based on an open cry system or bids and offers can be matched electronically or direct sales can be made between brokers. OPEN OUTCRY is a method of trading used at stock and commodity exchanges that involves calling out the specific details of a Investors order, so that the information is available to all traders. The information is then usually written on boards so all traders can see it. Open outcry has largely been replaced by automated trading systems. These are cheaper, globally accessible, disseminate information perfectly and match orders perfectly. ‫ق‬ Functions of Financial Markets Capital markets have a special role in the economy, inter alia; $ intermediary functions of financial markets The intermediary functions of a financial markets include the following: ‫و‬ Transfer of Resources: Financial market facilitate the transfer of real economic resources from lenders to ultimate borrowers. ‫و‬ Enhancing income: Financial markets allow lenders to earn interest or dividend on their surplus invisible funds, thus contributing to the enhancement of the individual and the national income. ‫و‬ Productive usage: Financial market allow for the productive use of the funds borrowed. The enhancing the income and the gross national production. ‫و‬ Capital Formation: Financial market provide a channel through which new savings flow to aid capital formation of a country. ‫و‬ Price determination: Financial markets allow for the determination of price of the traded financial assets through the interaction of buyers and sellers. They provide a sign for the allocation of funds in the economy based on the demand and supply through the mechanism called price discovery process. ‫و‬ Sale Mechanism: Financial markers provide a mechanism for selling of a financial asset by an investor so as to offer the benefit of marketability and liquidity of such assets. Invest - 36 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫و‬ 'Price determinants: Financial market allow for the determination of price of the traded financial asset through the interaction of buyers and sellers. They provide a signal for the allocation of funds in the economy, based on the demand and supply through the mechanism called price discovery process. ‫و‬ Sale mechanism: Financial markets provide a mechanism for selling of a financial asset by an investor so as to offer the benefits of marketability and liquidity, of such assets. ‫و‬ Information: The activities of the participants in the financial market result in the generation and the consequent dissemination of information to the various segments of the market. So as to reduce the cost of transaction of financial assets. $ financial functions of financial markets ‫ق‬ ‫و‬ Providing the borrower with funds so as to enable them to carry out their investment plans. ‫و‬ Providing the lenders with earning assets so as to enable them to earn wealth by deploying the assets in production debentures. ‫و‬ Providing liquidity in the market so as to facilitate trading of funds. Four (4) Parties In Financial Markets Financial markets are composed of two parties, and two intermediaries. The two parties are lenders and borrowers, and the two intermediaries are the markets, and the financial intermediaries. $ Lenders Who have enough money to lend or to give someone money from own pocket at the condition of getting back the principal amount or with some interest or charge, is the lender. They can be companies, individuals, or groups of individuals. Many individuals are not aware that they are lenders, but almost everybody does lend money in many ways. A person lends money when I:      puts money in a savings account at a bank; contributes to a pension plan; pays premiums to an insurance company; invests in government bonds; or invests in company shares. Companies generally tend to be borrowers of capital. But when companies have surplus cash that is not needed for a short period of time, they may seek to make money from their cash surplus by lending it via short term markets called money markets. There are a few companies that have very strong cash flows. These companies tend to be lenders rather than borrowers. Such Invest - 37 - Invest- 55 Assets That Grow Savings and Earn Passive Income companies may decide to return cash to lenders (e.g. via a share buyback.) Alternatively, they may seek to make more money on their cash by lending it (e.g. investing in bonds and stocks). $ Borrowers Individuals borrow money via bankers' loans for short term needs or longer term mortgages to help finance a house purchase. Companies also borrow money to aid short term or long term cash flows. They also borrow to fund modernization or future business expansion. Finally, governments often find their spending requirements exceed their tax revenues and to make up this difference, they need to borrow. Governments also borrow on behalf of nationalized industries, municipalities, local authorities and other public sector bodies. Governments borrow by issuing bonds. Government debt seems to be permanent. Indeed the debt seemingly expands rather than being paid off. One strategy used by governments to reduce the value of the debt is to influence inflation. Municipalities and local authorities may borrow in their own name as well as receiving funding from national governments. Public Corporations typically include nationalized industries. These may include the postal services, railway companies and utility companies. Many borrowers have difficulty raising money locally. They need to borrow internationally with the aid of Foreign exchange markets. Borrowers having similar needs can form into a group of borrowers. They can also take an organizational form like Mutual Funds. They can provide mortgage on weight basis. The main advantage is that this lowers the cost of their borrowings. $ Intermediaries These are the institutions that connect the owners of capital (lenders), to those who want to buy capital (borrowers). They include funds, insurance companies, pension houses, and banks. ‫ق‬ Types of Financial Markets The financial markets can be divided into different types: $ Capital Markets Invest - 38 - Invest- 55 Assets That Grow Savings and Earn Passive Income Capital Markets refers to the financial markets which provide long term capital for investment, as opposed to the Money Markets which refer to the short term aspect of the financial markets. The strength of capital markets is their ability to; mobilize long term savings, provide risk capital, encourage broader ownership of firms and efficiency of resource allocation through competitive pricing mechanism. The development of Capital markets within an economy therefore provides relevant signals for investment appraisal. In a capital market, money is provided for periods longer than a year. Capital Markets are of two types, the stock market (equity securities) and the bond market (debt). Financial regulators, such as the Financial Services Authorities (FSA), Capital Market Authorities (CMA) or the Securities and Exchange Commissions (SEC), oversee the capital markets in their designated jurisdictions to ensure that investors are protected against fraud, amongst other duties. The SEC /CMA is the watchdog. It is the agency that helps make—as well as enforce—the rules. It serves a very important role. Without it, there would be chaos. However, while it protects the public from the bad investments, it also keeps the public out of the best investments; the public end up investing in sanitized investments: which is one of the reasons the rich get richer. If a person is not aware, all deals—good and bad—look the same. It takes a great deal of education and experience to sort the more sophisticated investments into good and bad investments. And most people simply do not have that education and experience, but of course, the rich know their way, and so, because there are many more bad deals than good deals, SEC/CMA really serves to protect the poor and the middle class from themselves. People invest because they want to get rich. But because they’re not rich, they’re not allowed to invest in the investments that could make them rich. Only if I am rich can I invest in a rich person’s investments. And so the rich get richer. The SEC/CMA hence provides that the deals where people can get really rich are meant and left for the very few, called the accredited investors. An accredited investor is generally accepted to be someone who (according to the country): 1. has a net worth of $2 million or more (depends on the country); or 2. has had an annual income of $200,000 (10% return on net worth) or more in each of the most recent years (or $300,000 jointly with a spouse) and who has a reasonable expectation of reaching the same income level in the current year. (again, depends on the country)” Invest - 39 - Invest- 55 Assets That Grow Savings and Earn Passive Income The investment vehicles for accredited investors include: 1. 2. 3. 4. 5. 6. 7. Private placements Real estate syndication and limited partnerships Pre-initial public offerings (IPOs) Sub-prime financing Mergers and acquisitions Loans for startups Hedge funds The theory behind the “Accredited Investor” thing: if I have income or net worth above a certain point, I probably have a decent idea of how to manage money safely, so the government does not treat me like a child that needs protecting from itself. Further, that income and net worth also implies that I can afford to take a loss if the investment tanks. From the foregoing list, it is obvious that it is better to protect unqualified investors by restricting their access to these types of investments. $ Stock Exchanges The stock exchanges are markets for the trading of securities, namely, stocks and bonds. Countries with no stock exchanges raise their capitals from commercial banks only. Trading is by use of either the open outcry method or an automated trading platform. Some stock exchanges in a region can come together to form a regional exchanges association to create a wide market as well as increasing the liquidity levels within the region, while also integrating trading and clearing and settlement infrastructures to facilitate a faster trading system within the regional bloc. CLEARING AND SETTLEMENT: A comparison of the details of a transaction between brokers prior to settlement; final exchange of securities for cash on delivery. $ Over the Counter (OTC) Exchange Countries with less developed stock exchanges call their trading systems Over the Counter (OTC) Exchange (OTCE). € OVER-THE-COUNTER (OTC): Marketplace for securities that are not listed on an exchange. OTC securities are traded by many registered dealers rather than through an exchange specialist. Other OTC markets include those for government and municipal bonds. $ Money Markets Invest - 40 - Invest- 55 Assets That Grow Savings and Earn Passive Income Money Market is a segment of the financial market in which financial instruments with high liquidity and very short maturities are traded. The money market is used by participants as a means for borrowing and lending in the short term, from several days to just under a year. The Money Market is used by a wide array of participants, from a company raising money by selling commercial paper into the market to an investor purchasing CDs as a safe place to park money in the short term. The money market is typically seen as a safe place to put money due the highly liquid nature of the securities and short maturities, but there are risks in the market that any investor needs to be aware of including the risk of default on securities such as commercial paper. Money Markets provide short term debt financing and investment with original maturities of one year or shorter time frames, called ‘paper.’ This contrasts with the capital market for longer-term funding, which is supplied by bonds and equity. The money market consists of financial institutions and dealers in money or credit who wish to either borrow or lend. Trading in the money markets involves Treasury Bills, Commercial Paper, Bankers' Acceptances, Certificates of Deposit, Central government Funds, and Short-Lived MortgageBacked and Asset-Backed Securities. The money market provides liquidity funding for the global financial system. The Common money market instruments include the following; ¥ Certificate of deposit – Time/term deposits, commonly offered to consumers by banks, thrift institutions, and credit unions. ¥ Repurchase agreements - Short-term loans, normally for less than two weeks and frequently for one day, arranged by selling securities to an investor with an agreement to repurchase them at a fixed price on a fixed date. ¥ Commercial paper - Unsecured promissory notes with a fixed maturity of one to 270 days; usually sold at a discount from face value. ¥ Treasury bills - Short-term debt obligations of a national government that are issued to mature in three to twelve months. ¥ Money funds - Pooled short maturity, high quality investments which buy money market securities on behalf of retail or institutional investors. ¥ Foreign Exchange Swaps - Exchanging a set of currencies in spot date and the reversal of the exchange of currencies at a predetermined time in the future. ¥ Backed securities- Short-lived mortgage and asset-backed securities € Stock Markets Stock Markets or equity markets provide financing through the issuance of shares/stock, and enable the subsequent trading thereof. The stock market is one of the most important sources for companies to raise money. It allows Invest - 41 - Invest- 55 Assets That Grow Savings and Earn Passive Income businesses to be publicly traded, or raise additional capital for expansion by selling shares of ownership of the company in a public market. This is an attractive feature of investing in stocks, compared to other less liquid investments such as real estate. When I buy stocks, I own a part of the company’s assets. If the company does well, I may receive periodic dividends and/or be able to sell my stock at a profit. The stocks are listed and traded on stock exchanges. The financial instruments traded in Stock Markets are common shares, preferred shares, voting shares and registered shares. € Bond Markets The bond market (also known as the debt, credit, or fixed income market) is a financial market where participants buy and sell debt securities, usually in the form of bonds. Bond markets provide financing through the issuance of bonds, and enable the subsequent trading thereof. € BOND is a certificate of debt issued by the bond issuer with a promise to pay a specified sum of money at a future date and carries interest at a fixed rate. There are different types of bonds depending on the jurisdiction (country) and the issuer. The following products trade in this market: $ $ $ $ Corporate bonds Government bonds Municipal bonds Mortgage backed, asset backed, and collateralized debt obligation securities Because of the specificity of individual bond issues, and the lack of liquidity in many smaller issues, the majority of outstanding bonds are held by institutions like pension funds, banks and mutual funds. Further, the capital markets consist of primary markets and secondary markets. € Primary Market In primary markets, new stock or bond issues are sold to investors via a mechanism known as underwriting. € UNDERWRITING is the process that a large financial service provider (bank, insurer, investment house) uses to assess the eligibility of a customer to receive their products (equity capital, insurance, mortgage, or credit). The primary market is the market for new issuers or where new capital is raised. It is the market where securities are sold for the first time through an Initial Invest - 42 - Invest- 55 Assets That Grow Savings and Earn Passive Income Public Offer (IPO). At the primary market sale proceeds of the securities offered flow directly from the buyers or investors to the issuers of the securities. € € Initial Public Offer (IPO): The first sale of stock by a private company to the public. IPOs are often issued by smaller, younger companies seeking the capital to expand, but can also be done by large privately owned companies looking to become publicly traded. In an IPO, the issuer obtains the assistance of an underwriting firm, which helps it determine what type of security to issue (common or preferred), the best offering price and the time to bring it to market. IPOs can be a risky investment. For the individual investor, it is tough to predict what the stock will do on its initial day of trading and in the near future because there is often little historical data with which to analyze the company. To invest in the IPO, I must fill a Share Application Form (SAF), which I accompany with the money to buy shares, and I deliver to my dealer/broker dealer, who takes it to the lead broker who allocates the shares. In case the offer is over subscribed, the shares available are divided amongst the applicants and I will receive a refund of the shares paid for but not allocated. Secondary Market In the secondary markets, existing securities are sold and bought among investors or traders, usually on a securities exchange, over-the-counter, or elsewhere. The secondary market is the market for trading securities that have been sold or issued in the primary market and already in the hands of the public. The secondary market, provide a very important complement to the primary market. An active secondary market makes it easier for corporate entities and Governments to raise fresh capital through the primary market. Invest - 43 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Financial Markets Transaction (Trading) Process Trading is conducted through a multiple processes, depending on the type of exchange. If it is an over the counter exchange, then a member is allowed to invest directly to clients in their offices. Equally members are allowed to transact with other members either face to face or through the telephone throughout the working hours of the normal working days. Further, depending on level of technology sophistication (or lack thereof), some exchanges employ trading through an open outcry trading session is conducted at the trading floor. Other exchanges use an Automated Trading System (ATS), which matches bids and offers electronically. Brokers converge at the trading room and post their orders in the ATS. Matched orders are displayed on the computer terminal in the trading room as well as being projected in the public gallery. Some exchanges have the ATS operating on a local area network (LAN), while others have it on a wide area network (WAN) which can be accessed by brokers even out of a given city. This also eradicates the need for brokers to send their staff (dealers) to the trading floor to conduct business. However, brokers under certain circumstances can still conduct trading from the floor. During the designated trading floor sessions at the CMAC secretariat, all members must report all their transactions that they conducted from the closure of the previous official trading session up to the time just before the beginning of the next trading session. Depending on the size of the exchange and market, there are designated days for trading, and designated hours. Most exchanges are open for 5 days in a week, with trading lasting from 10.00 am to 4.00 pm. Transaction fees are payable by investors when buying and selling equity securities at the exchange. The fees are dependant on the amount of securities traded (bought, or sold), and are based on percentile basis, with a minimum commission transaction fee, and then as the number of securities traded rises, the fee is lowered. Total Commission chargeable covers the following payments: ‫ ٮ‬Brokerage commission: money paid to the broker for their services. ‫ ٮ‬Regulators Levy: money paid to the SEC or CMA, and used for insurance of the investment. ‫ ٮ‬Exchange Levy: fee paid to the exchange market. ‫ ٮ‬Fidelity fees: money paid for insurance purposes. Invest - 44 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ ٮ‬CDS fees: Money paid for maintanance of a central depository accoint, an elecronic account for client’s transactions. $ Primary Market Transaction Process ¥ ¥ ¥ ¥ ¥ ¥ ¥ Step Step Step Step Step Step Step 1: 2: 3: 4: 5: 6: 7: Issuer Decides to raise capital Issuer appoints advisors Issuer applies to CMA to list securities on the capital market. Issuer Offers securities to the public-initial public offer (IPO) Public investors subscribe to securities Issuer is admitted to list on the Capital Market Secondary Market Trading Commences $ Secondary Market Transaction Process How to Buy Securities The process of buying bonds or shares is as below: 1. 2. 3. 4. Visit any one of the stockbrokers (members) of the capital market Open an investment account Seek guidance from stockbroker, banker or investment advisor Make payment or deposit funds into an investment account the money equivalent of the number of shares to be bought, and get an acknowledgement from the stockbroker 5. The Dealer/Broker will deposit the money so received in a Trust (nominee) a/c- an account specifically opened by the brokers to keep clients money intended for USE transactions. It is a requirement that for local orders, payment is made upfront by the investor 6. Sign a purchase order or instruction to authorize the stockbroker to buy shares or bonds 7. give instruction on which securities (bonds, shares, etc) to be bought and from which company (listed company), and at what price (ordered price) 8. Sign purchase transfer form to allow the securities to be transferred to the me 9. Follow up the order after 24 hours. 10. The selected dealer will post the order (bid) on the trading board on the following trading day. When the bid matches an offer (an order to sell) by either the same broker or other brokers, then the transaction is considered to have been concluded. 11. CMA sends matched transfers to the Registrar for registration and change of ownership. 12. Registrar transfers ownership from the seller to the buyer. How to Sell Securities Invest - 45 - Invest- 55 Assets That Grow Savings and Earn Passive Income 1. 2. 3. 4. Visit any one of the stockbrokers (members) of the capital market Open an investment account Seek guidance from stockbroker, banker or investment advisor Deposit the securities with the stockbroker and get an acknowledgement from the stockbroker 5. Surrender the share certificate to the Licensed Brokers/Dealers and conclude the process of opening up an account at the Central Depository System (CDS) 6. The Licensed Brokers/Dealers will have to verify the validity of the certificate with the issuer (The verification process takes less than a day), one of the listed companies and deposit the shares/bonds in the CDS. 7. Sign a sell order or instruction to authorize the stock broker to sell 8. Give instruction on the price of selling the securities (ordered price) 9. Sign a sell transfer form 10. Follow up the order after 24 hours 11. The Licensed Brokers/Dealers, having opened a CDS account for the client, deposited the shares therein and verified the certificate, will then come to the USE Trading Floor and post the offer on the board. The dealer will post the order (bid) on the trading board on the following trading day. When the bid matches an offer (an order to sell) by either the same broker or other brokers, then the transaction is considered to have been concluded. 12. When the offer equals a bid price quotation, the transaction is considered to have been concluded, and the shares will have been sold. 13. CMA sends matched transfers to the Registrar for registration and change of ownership 14. Registrar transfers ownership from the seller to the buyer. Types of Orders A client may instruct a broker to process several types of orders. An order may be; € € € A LIMIT ORDER: An order which has a specified price when it is posted for execution; or A MARKET ORDER: An order, which does not have a specific price when posted for execution. This type of an order must be executed promptly at the best price obtainable and will have priority over limit order at the same price levels .It assumes an initial price limit value normally based on the price most advantageous in the market. A market order trades through a range of prices starting at the best price in the market. ALL OR NONE (AON): A stipulation to either a buy or a sell order which instructs the broker to either fill the order in its entirety or to fill none at all, the customer will not accept a partial. Invest - 46 - Invest- 55 Assets That Grow Savings and Earn Passive Income € € € € € € € € € € € ASKED PRICE: The lowest price that anyone has declared that he will sell his security for at a given time. In over-the-counter stocks, the ‘ask’ is the best quoted price at which a Market Maker is willing to sell a stock. BID PRICE: The highest price anyone has declared that he wants to pay for a security at a given time. CANCEL: Instruction given to a broker to stop work on an order previously given. If part of the order has already been executed, a cancel instruction stops work on the remainder of the order. DAY ORDER: An order to invest which, if not executed, expires at the end of the trading day it was entered. DO NOT REDUCE (DNR): Stipulation to order that instructs the broker not to decrease the limit price on buy-limit and sell-stop orders on the record date of a cash dividend. FILL OR KILL (FOK): An order stipulation instructing the broker to present the order in the marketplace and either fill it in its entirety or kill it if it cannot be filled immediately at its stipulated price limit. GOOD DELIVERY: Designation meaning a certificate has the necessary endorsements and meets all requirements so that title can be transferred by delivery on the settlement date to the buying broker. OPEN ORDER/GOOD 'TIL CANCELED (GTC): An order to invest which remains in effect until it is either executed or canceled. For GTC orders executed over several days, a commission is charged based on each day's activity. Customers are responsible for monitoring GTC orders to avoid duplication. Open orders placed electronically expire automatically after one calendar month. SETTLEMENT DATE: Date on which a securities transaction must be settled. Buy orders must be paid for in cash and sell orders must have securities in legal (good) delivery form presented to the new owner. REGULAR WAY SETTLEMENT of stock and bond transactions is three business days after the trade was executed. Listed options, government securities and mutual funds settle the next business day following the transaction. The brokerage firm representing the customer must settle on the specified settlement date whether or not the customer has paid the monies or delivered securities to the firm. How the Capital Market Operates The stock exchanges operate a dual trading process. Firstly members trade securities directly with investors and among themselves. Secondly, trading sessions are conducted at the trading floors of the stock exchanges. In Rwanda and Uganda, traders use the open cry method; but Kenya and Tanzania have an electronic trading system allowing the traders to trade from their offices. € Advantages of the Capital Markets The following are the advantages of the capital markets; Invest - 47 - Invest- 55 Assets That Grow Savings and Earn Passive Income  Savings: Investing in securities that are listed in the Capital or Stock market encourages investors to accumulate their savings in small amounts over time  Income: Investment in the stock market provides a source of income. Shares pay dividend income when companies declared profits and decide to distribute part of the profits to shareholders. Bonds pay an interest income to the bondholders. Sometimes the income earned from listed securities is higher than interest earned from the money or banking sector.  Wealth or Capital gain: Whenever the prices of securities listed in the market go up, the value of the investment of the holders of those securities increases. This is called capital gain and is an important way of growing wealth through the stock market. It is important to note that a one –off investment in the Capital market does not make sense. It is therefore the accumulative investment over time that creates opportunities for growth in wealth through the Capital Market. € € CAPITAL GAIN: The gain (selling price minus cost basis) on an asset. COST BASIS: for tax purposes, the cost of an asset (including commissions and other fees) used to determine the gain or loss.  Securities as Collateral: Listed securities are easily acceptable as collateral against loans from financial institutions.  Liquidity: Liquidity is the ability to convert shares or bonds into cash by selling within the shortest time possible without losing much value. When one needs funds urgently, listed securities could be very useful because they are more liquid than most other forms of assets.  Ease of reinvestment of income: Through automatic Dividend Reinvestment Plans (DRiPS), the stock brokers can easily reinvest the returns. Despite the above advantages, there are no guarantees to returns on investments as prices of stocks or bonds will always rise and fall and sometime, investors could lose wealth in the capital market. It is therefore wise to seek advice before investing in stocks. $ Derivatives Market In the financial markets, stock prices, bond prices, currency rates, interest rates and dividends go up and down, creating risk. Derivative products are financial products which are used to control risk or paradoxically exploit risk. Derivative markets are investment markets that are geared toward the buying and selling of derivatives. € A DERIVATIVE is a financial instrument - or more simply, an agreement between two people or two parties - that has a value determined by the price of something else (called the underlying/underlier). There are many kinds of derivatives, with the most notable being swaps, futures, and options. The underlier can come in many forms including, commodities, mortgages, stocks, bonds, or currency. Invest - 48 - Invest- 55 Assets That Grow Savings and Earn Passive Income It is a financial contract with a value linked to the expected future price movements of the asset it is linked to - such as a share or a currency. The reason investors may invest in a derivative security is to hedge their bet. By investing in something based on a more stable underlier, I am assuming less risk than if I invested in a risky security without an underlier. The overall derivatives market has five major classes of underlying assets: £ Interest Rate Derivatives (The Largest) - a derivative where the underlying asset is the right to pay or receive a notional amount of money at a given interest rate. £ Foreign Exchange Derivatives- a financial derivative where the underlying is a particular currency and/or its exchange rate. These instruments are used either for currency speculation and arbitrage or for hedging foreign exchange risk. £ Credit Derivatives- a credit derivative is a securitized derivative whose value is derived from the credit risk on an underlying bond, loan or any other financial asset. In this way, the credit risk is on an entity other than the counterparties to the transaction itself. £ Equity Derivatives- an equity derivative is a class of derivatives whose value is at least partly derived from one or more underlying equity securities. Options and futures are by far the most common equity derivatives; however there are many other types of equity derivatives that are actively traded. £ Commodity Derivatives- markets where raw or primary products are exchanged. These raw commodities are traded on regulated commodities exchanges, in which they are bought and sold in standardized contracts. The appeal of a derivative market has to do with the potential for a larger return than is usually the case with other forms of investment. In like manner, the ability to transfer the liability from one party to another is also appealing in some situations. While it is true that derivatives can be somewhat volatile, the fact is that many of the trades conducted on a derivative market carry no more risk than in investment markets. As long as the investor performs due diligence as it relates to understanding past, current, and projected performance, it is possible to do very well in a derivatives market. The market can be divided into two, that for exchange-traded derivatives and that for over-the-counter derivatives. However, it is not unusual for investors who are interested in derivatives to actively participate in both of these financial markets. € Exchange-Traded Derivatives Markets Exchange-traded derivative contracts (ETD) are those derivatives instruments that are traded via specialized derivatives exchanges or other exchanges. The Futures exchanges, trade in standardized derivative contracts. These are Invest - 49 - Invest- 55 Assets That Grow Savings and Earn Passive Income options contracts and futures contracts on a whole range of underlying products. Futures markets provide standardized forward contracts for trading products at some future date. When one party goes long (buys a futures contract), another goes short (sells). When a new contract is introduced, the total position in the contract is zero. Therefore, the sum of all the long positions must be equal to the sum of all the short positions. In other words, risk is transferred from one party to another. Trading is carried on through open yelling and hand signals in a trading pit. Volume in the futures market usually increases when the stock market outlook is uncertain. VOLUME: The number of shares of stock traded in a day. In this financial market environment, the exchange functions as a counterparty to members engaged in buying and selling activity. This approach essentially transfers the bulk of the risk to the counterparty in the arrangement and makes it possible to earn a return by exchanging a long position for a short one. The following financial products trade in this market: £ £ £ £ £ £ € Credit derivative Hybrid security Options Futures Forwards Swaps Over-The-Counter (OTC) Markets Along with futures, a derivative market situation may also exist in over-thecounter (OTC) markets. In this scenario, the derivatives focus on larger clients such as government entities, investment banks and hedge funds. The volume of the trading activity is substantial, involving significant amounts of resources on the part of the investors involved. Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way. The OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds. Products that are always traded over-the-counter are swaps, forward rate agreements, forward contracts, credit derivatives, etc. These agreements are usually governed by an International Swaps and Derivatives Association agreement. Invest - 50 - Invest- 55 Assets That Grow Savings and Earn Passive Income There is no central exchange or meeting place for this market. The market participants trade over the telephone, facsimile or electronic network instead of a physical trading floor. OTC trading accounts for the majority of trading in gold and silver. OTC trading occurs via a network of middlemen, called dealers, who carry inventories of securities to facilitate the buy and sell orders of investors, rather than providing the order matchmaking service seen in specialist exchanges. It is an off-exchange trading, that is, trading financial instruments such as stocks, bonds, commodities or derivatives directly between two parties. It is contrasted with exchange trading, which occurs via facilities constructed for the purpose of trading (i.e., exchanges), such as futures exchanges or stock exchanges. An over-the-counter contract is a bilateral contract in which two parties agree on how a particular trade or agreement is to be settled in the future. It is usually from an investment bank to its clients directly. $ The Eurobond Market The Eurobond market is made up of investors, banks, borrowers, and trading agents that buy, sell, and transfer Eurobonds. EUROBOND: A bond issued in a currency other than the currency of the country or market in which it is issued. They are also issued by international bodies such as the World Bank. The Eurobond market consists of several layers of participants. First there is the issuer, or borrower, which could be a bank, a business, an international organization, or a government that needs to raise funds by selling bonds. The borrower approaches a bank and asks for help in issuing its bonds. This bank is known as the lead manager and may ask other banks to join it to form a managing group that will negotiate the terms of the bonds and manage issuing the bonds. The managing group will then sell the bonds to an underwriter or directly to a selling group. The underwriter will actually purchase and sell the bonds to a selling group that then places bonds with investors. The three levels—managers, underwriters, and sellers—are known collectively as the syndicate. The syndicate companies and their investor clients are considered the primary market for Eurobonds; once they are resold to general investors, the bonds enter the secondary market. In the secondary market, Eurobonds are traded over-the-counter. After the bonds are issued, a bank acting as a principal paying agent has the responsibility of collecting interest and principal from the borrower and disbursing the interest to the investors. Often the paying agent will also act as fiscal agent, that is, on the behalf of the borrower. If, however, a paying agent acts as a trustee, on behalf of the investors, then there will also be a separate bank acting as fiscal agent on behalf of the borrowers appointed. $ Cash Market Invest - 51 - Invest- 55 Assets That Grow Savings and Earn Passive Income The market for a cash commodity or actual, as opposed to the market for its futures contract. A cash market may take the following forms: self-regulated centralized markets, such as commodity exchanges; decentralized over-thecounter markets where private transactions may occur; or localized community organizations, such as grain elevators. At these locations, I can purchase the actual physical commodity rather than just the futures contract. Strategic Investors : Corporate or individual investors that add value to investments they make through industry and personal ties that can assist companies in raising additional capital as well as provide assistance in the marketing and sales process. Subscription Agreement: The application submitted by an investor wishing to join a limited partnership. All prospective investors must be approved by the General Partner prior to admission as a partner. Subordinated Note /Subordinated Debt: Debt which by its terms has no right to be paid until another debt holder is paid. Also referred to as “junior” debt. Syndicate : Underwriters or broker/dealers who sell a security as a group. Tax - free re-organizations : Types of business combinations in which shareholders do not incur tax liabilities. There are four types — A, B, C, and D reorganizations. They differ in various ways in the amount of stock/cash that can be offered. Tender offer: An offer to purchase stock made directly to the shareholders. One of the more common ways hostile takeovers are implemented. Term Sheet: A summary of the terms the investor is prepared to accept. A nonbinding outline of the principal points which the Stock Purchase Agreement and related agreements will cover in detail. ‫ق‬ Financial Market Incentives $ Fiscal Incentives to Investors in Listed Securities 1. Stamp duty – there is no stamp duty on the secondary market trades involving listed securities. The incentive is intended to develop an interest in the Securities Exchange secondary market activities. 2. Capital gains tax – there is no tax on capital gain realized by selling listed securities. This incentive is aimed at and is meant to encourage them to participate on the Securities Exchange secondary market. Further, this incentive is aimed at and is meant to encourage them to participate on the Securities Exchange secondary market; and 3. Reduced tax rate for newly listed companies. 4. Tax deductible expenses for listed companies, especially, those expenses related with the authorization and issue of shares, debentures or similar securities offered for purchase by the general public. Invest - 52 - Invest- 55 Assets That Grow Savings and Earn Passive Income 5. Dividends received by a registered venture capital company are tax exempt. 6. Gain arising from trade in shares of a venture company earned by a registered venture capital company, within the first ten years from the date of first investment in that venture company by the venture capital company, is tax exempt. 7. Investment income of a pooled fund or other kind of investment consisting of retirement schemes is tax exempt; 8. Gains arising from trade in securities listed on any securities exchange are tax exempt. 9. Withholding tax on dividend income – The incentive is intended to encourage investor participation on the Securities Exchange. € WITHHOLDING TAX is a government requirement for the payer of an item of income to withhold or deduct tax from the payment, and pay that tax to the government. In most jurisdictions withholding tax applies to employment income. Many jurisdictions also require withholding tax on payments of interest or dividends. Tax is deducted not only from dividends, but from other income paid to non-residents of a country. $ Fiscal Incentives to Issuers of Securities Below are the incentives granted by the Government to issuers with the purpose of encouraging issuance and listing and development of capital markets: 1. Reduced corporate tax for a period of years. The reduced rate is applicable for five years starting from the date of listing. The rationale for this incentive is to attract more listings. 2. Tax deductibility of all IPO costs for the purposes of income tax determination. All IPO costs are accepted as acceptable expenses used in the generation of income and profits, and therefore are taken into consideration when determining profit for tax purposes. This incentive is meant to make IPO costs tax deductible and extend the benefits to investors; 3. Withholding tax on investment income made by CIS is final tax. Investors in CIS will not be charged tax on the income distributed by CIS after the scheme income taxation. The incentive is intended to develop an interest in the Securities Exchange secondary market activities. 4. Stamp duty – there is no stamp duty on the secondary market trades involving listed securities. The incentive is intended to develop an interest in the Securities Exchange secondary market activities. Time Value of Money : The basic principle that money can earn interest; therefore, something that is worth $1 today will be worth more in the future if invested. This is also referred to as future value. Trust Indenture: Agreement between the Company, the debt holders, and the trustee for the debt holders. Required for registered offerings of debt securities. Invest - 53 - Invest- 55 Assets That Grow Savings and Earn Passive Income Warrant: A type of security that entitles the holder to buy a proportionate amount of common stock or preferred stock at a specified price for a period of years. Warrants are usually issued together with a loan, a bond, or preferred stock and act as sweeteners, to enhance the marketability of the accompanying securities. They are also known as stock-purchase warrants and subscription warrants. Workout : A negotiated agreement between the debtor and its creditors outside the bankruptcy process. Right of First Refusal: The right of first refusal gives the holder the right to meet any other offer before the proposed contract is accepted. Invest - 54 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Professional Players (Individuals & Firms) The various stock exchanges have several players as below: ‫ق‬ Investment Advisors Investment advisor is any person or institution that makes investment recommendations or conducts securities analysis in return for a fee, whether through direct management of client assets or via written publications. An investment advisor who has sufficient assets to be registered with the SEC or CMA, is known as a Registered Investment Advisor, or RIA. Mutual fund companies are generally included in the definition of investment advisors, but stockbrokers are not (they receive fees from commissions and not asset-based compensation). ‫ق‬ (Personal) Financial Advisers/Planner Financial Planner or Personal Financial Planner is a practicing professional who helps people deal with various personal financial issues through proper planning. The work engaged in by this professional is commonly known as personal financial planning. Personal financial planning is ‘a process of determining an individual's financial goals, purposes in life and life's priorities, and after considering his resources, risk profile and current lifestyle, to detail a balanced and realistic plan to meet those goals.’ The individual's goals are used as guideposts to map a course of action on 'what needs to be done' to reach those goals. In carrying out the planning function, I am guided by the financial planning process to create a financial plan; a detailed strategy tailored to a client's specific situation, for meeting a client's specific goals. Ideally, the financial adviser helps the client maintain the desired balance of investment income, capital gains, and acceptable level of risk by using proper asset allocation. Many financial advisers receive a commission payment for the various financial products that they broker, although ‘fee-based’ planning is becoming increasingly popular in the financial services industry. A further distinction should be made between ‘fee-based’ and ‘fee-only’ advisers. Fee-based advisers often charge asset based fees but may also collect commissions. Fee-only advisers do not collect commissions or referral fees paid by other product or service providers. Scope of Financial Planning: Financial planning should cover all areas of the client’s financial needs and should result in the achievement of each of the client's goals. Invest - 55 - Invest- 55 Assets That Grow Savings and Earn Passive Income The scope of planning would usually include the following: ¥ Goal Setting: To match the financial goals of the client, with the finances; ¥ Cash Budgeting & Management: to address sources and uses of cash by the client; ¥ Risk Management and Insurance Planning: Managing cash flow risks through sound risk management and insurance techniques ¥ Investment Planning Issues: Planning, creating and managing capital accumulation to generate future capital and cash flows for reinvestment and spending ¥ Retirement Planning: Planning to ensure financial independence at retirement including etc. ¥ Tax Planning: Planning for the reduction of tax liabilities and the freeing-up of cash flows for other purposes ¥ Estate Planning: Planning for the creation, accumulation, conservation and distribution of assets ¥ Cash Flow and Liability Management: Maintaining and enhancing personal cash flows through debt and lifestyle management ¥ Education Planning for kids and the family members The Process: The personal financial planning process is a six-step process, which has been adopted by the International Organization for Standardization (ISO). ‫ ق‬Step 1: Setting goals with the client: This step (that is usually performed in conjunction with Step 2) is meant to identify where the client wants to go in terms of his finances and life. ‫ ق‬Step 2: Gathering relevant information on the client: This would include the qualitative and quantitative aspects of the client's financial and relevant non-financial situation. ‫ ق‬Step 3: Analyzing the information: The information gathered is analysed so that the client's situation is properly understood. This includes determining whether there are sufficient resources to reach the client's goals and what those resources are. ‫ ق‬Step 4: Constructing a financial plan: Based on the understanding of what the client wants in the future and his current financial status, a roadmap to the client goals is drawn to facilitate the achievements of those goals. ‫ ق‬Step 5: Implementing the strategies in the plan: Guided by the financial plan, the strategies outlined in the plan are implemented using the resources allocated for the purpose. ‫ ق‬Step 6: Monitoring implementation and reviewing the plan: The implementation process is closely monitored and periodic reviews and revisions undertaken to ensure it stays in alignment to the client's goals. Invest - 56 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Licensed Firms The Capital Market Advisory or SEC or regulators, by any other name called, licenses and admits members to operate in the capital markets. There are several categories of membership. These are: 1. 2. 3. 4. 5. 6. 7. 8. Stockbrokers, Broker dealers, Dealers, Investment Advisors, Investment banks Investment companies fund managers and Sponsors. Any person or institution can apply for membership in any of the above categories provided they meet and adhere to the rules and conditions set. $ Dealers  A dealer is a securities firm acting as a principal in a particular trade. A firm is acting as a dealer when it buys or sells a security for its own account, with its own cash, and at its own risk and then charges the customer a markup or markdown. $ Brokers (Licensed Dealing Members (LDMs))  A broker is an individual or a firm that charges a fee or commission for executing buy and sells orders submitted by another individual or firm. Whenever a stockbroker sells or buys shares or bonds on behalf of an investor they charge a fee called brokerage commission. $ Broker Dealers  A Broker-Dealer is a securities firm that is acting as either a broker and/or a dealer. Most securities firms act in both capacities. $ Sponsors  Sponsors provide advisory services to companies looking to raise Capital by listing in the stock exchange. $ Investment banks These are banks which have special license to collect, pool, and invest money from, the public. They mainly deal with institutional investors, and or high net worth individuals, also refered to as accredited investors. ACCREDITED INVESTORS: These are individuals with a net worth of more than a given amount of money (usually $1 million or equivalent in various Invest - 57 - Invest- 55 Assets That Grow Savings and Earn Passive Income counties), and have a high annual income, either individually, or as spouses (usually $ 200,000, o equivalent in various countries). The high net worth requirement is to protect the investors since they engage in very high risk investments, with initial sums not less than $30,000 (or equivalent in various countries).if such high risk, high return investments were not regulated, then any member of the public would get in them, and lose their life savings. The high risk areas of their investments include private placements, mortgage re-financing, private equity funding, etc. $ Investment Companies Investment companies are corporations founded for the purposes of poling funds from the public, and investing in various vehicles, and they include funds, trusts, and or private equity/venture capital firms. They have different targets in terms of markets, industries, and or regions. Some are general, while others, for instance, emerging market fund, are specific to certain markets. EMERGING MARKETS FUND: A mutual fund that invests primarily in countries with developing economies (that is, those that are becoming industrialised). Emerging markets funds tend to be more volatile than domestic stock funds due to currency fluctuation and political instability. Consequently, fund prices can fluctuate dramatically. $ fund managers (unit trust trustee/ trust manager), money maanger, Fund managers are also refered to as trustees, and can be managing a balance fund, unit trust fund, and or high yield fund, or any other type of fund depending on their investment portfolio. They are individuals, or institutions, with a certain amount of capitalization under their control for investing, regulated by the SEC/CMA. ‫ق‬ Regulators (SEC/CMA) Every country had a financial market regulator, commonly referred to as Capital Markets Authority (CMA) or Securities Exchange Commission (SEC). They are established by acts of parliament and/and or decrees, with the overall objectives of market regulation and investor protection by promoting and facilitating the development of an orderly, fair and efficient Capital Markets. They carry out the following functions: £ Approve the offers of all securities to the public, £ Licence market professionals like broker/dealers, investment advisors and fund managers. £ Licence stock exchanges. £ License and approve accredited investors. Invest - 58 - Invest- 55 Assets That Grow Savings and Earn Passive Income Their overall role is to promote market confidence, investor protection and access to financial services within capital markets through effective regulation and innovation. Invest - 59 - Invest- 55 Assets That Grow Savings and Earn Passive Income FINANCIAL INVESTMENT PRODUCTS This part of the guide takes me through the various financial instruments, how to invest in them, and the risks and advantages. CASH ¥ Bank Deposit Accounts ‫ق‬ Definition A deposit account is a current account, savings account, or other type of bank account, at a banking institution that allows money to be deposited and withdrawn by the account holder. Deposit accounts are available in banking institutions. I just need to walk in to the bank and open an account, often supplying certain personal information, like my address, occupation, etc. This is called the Know Your Client (KYC) Form. Such investments in cash and cash equivalents provide enhanced liquidity, diversification, or yield. The term “cash” is typically used to refer to assets that have maturities in a very short time horizon and present little risk over that horizon, thus supplying necessary liquidity and security to very shortterm portfolios. The term “cash or cash equivalents” refers to domestic securities with a high enough level of liquidity and principal protection to be considered as good as cash. Cash equivalents are any highly liquid security with a known market value and maturity, when acquired, of less than three months. ‫ق‬ Characteristics Of the three however, the current account is not interest earning and hence cannot be used as an investment vehicle. ‫ق‬ Major Types € Current Account A transactional account/ checking account or chequing account/current account or cheque account) is a deposit account held at a bank or other financial institution, for the purpose of securely and quickly providing frequent access to funds on demand, through a variety of different channels. Because money is available on demand these accounts are also referred to as demand accounts or demand deposit accounts. Invest - 60 - Invest- 55 Assets That Grow Savings and Earn Passive Income € Savings Accounts Most people have a savings account. A savings account is an account established at a financial banking institution which guarantees me, the depositor, and some kind of interest payment. This payment is often calculated on an annual or bi-annual basis. The total interest payment earned on a savings account depends on the offered interest rate and the total amount in the account. All savings accounts in are insured by various countries’ National Insurance Corporation. Regular savings accounts are designed for people who want to put a regular amount of money into their savings each month. Often banks will only offer high-rate regular savings accounts to customers who have a current account with them, as an incentive to build loyalty. Some regular savings accounts also offer an annual bonus on top of their interest rate. Again, if I fail to make the required deposits I will lose the annual bonus. Most of these accounts limit the number of withdrawals I can make each year so they are not much good for emergency cash but they are an ideal way of getting into the savings habit and I can start a regular savings account with as little as USD5 a month. The chief drawback of such accounts is that interest rates tend to be low since they offer a very high degree of safety. These usually pay higher interest rates and sometimes carry higher security restrictions. Those with high interest rates have risen in popularity with the rise of the internet. This is the most simple investment instrument available in the markets today. € Time Deposit Account A time deposit (also known as a term deposit; a bond or a fixed deposit and in some other countries) is a money deposit at a banking institution that cannot be withdrawn for a certain ‘term’ or period of time. When the term is over it can be withdrawn or it can be held for another term. Generally speaking, the longer the term the better the yield on the money. A certificate of deposit is a time-deposit product. The opposite is a Demand deposit or a sight deposit which can be withdrawn at any time, without any notice or penalty; e.g. money deposited in a checking account or savings account in a bank. € Individual Savings Accounts (ISAs) Cash Individual Savings Accounts (ISAs) are savings accounts where I earn taxfree interest. However there are limits on how much I can deposit each tax year. While cash ISAs do not always offer the highest rates of interest in the savings account market, after tax I will find the best ones easily beat the higher-paying ordinary savings accounts. To compare rates, look at the gross rate paid on cash Isa with the net rate I will receive on a standard savings account. If I am a non-taxpayer then I should opt for the highest paying savings account, regardless of whether it is an Isa, as I am entitled to receive my interest tax-free anyway. € Investment Accounts Investment account gives the option to invest savings or money to gain high returns. With absolutely no bank charges, it is ideal for short and long-term Invest - 61 - Invest- 55 Assets That Grow Savings and Earn Passive Income savings. It offers tiered interest rates that mean, the more I save, the higher the interest rate. ¥ Money Market Account A Money Market Account (MMA) or Money Market Deposit Account (MMDA) is a deposit account offered by a bank, which invests in government and corporate securities and pays the depositor interest based on current interest rates in the money markets. Money market accounts typically have a relatively high rate of interest and require a higher minimum balance to earn interest or avoid monthly fees. The resulting investment strategy is therefore similar to, and meant to compete with, a money market fund offered by a brokerage, which is considered almost as safe as savings. The two account types are otherwise unrelated. A deposit account with a relatively high rate of interest, and short notice (or no notice) required for withdrawals. Founders’ Share s : Shares owned by a company’s founders upon its establishment. Dividend: The payments designated by the Board of Directors to be distributed pro-rata among the shares outstanding. On preferred shares, it is generally a fixed amount. On common shares, the dividend varies with the fortune of the company and the amount of cash on hand and may be omitted if business is poor or if the Directors determine to withhold earnings to invest in capital expenditures or research and development. Debenture : A debt instrument; basically the same as a Promissory Note. Debt: Any obligation by one person to pay another. May be a primary (direct) obligation as in a Note, or a secondary (contingent) obligation as in a guaranty. Debt Instrument: Any instrument evidencing the obligation of the maker to pay the holder of the debt instrument. Includes Bonds, Debentures and Notes of all kinds. Cumulative Voting Rights: When shareholders have the right to pool their votes to concentrate them on an election of one or more directors rather than apply their votes to the election of all directors. For example, if the company has 12 openings to the Board of Directors, in statutory voting, a shareholder with 10 shares casts 10 votes for each opening (10x12 = 120 votes). Under the cumulative voting method however, the shareholder may opt to cast all 120 votes for one nominee (or any other distribution he might choose). Cumulative Preferred Stock: A stock having a provision that if one or more dividend payments are omitted, the omitted dividends (arrearage) must be paid before dividends may be paid on the company’s common stock. Invest - 62 - Invest- 55 Assets That Grow Savings and Earn Passive Income Convertible Note or Convertible Debenture: Debt instrument that automatically or voluntarily converts to some Conversion Ratio: The number of shares of stock into which a convertible security may be converted. The conversion ratio equals the par value of the convertible security divided by the conversion price. Convertible Security: A bond, debenture or preferred stock that is exchangeable for another type of security (usually common stock) at a pre-stated price. Convertibles are appropriate for investors who want higher income, or liquidation-preference protection, than is available from common stock, together with greater appreciation potential than regular bonds offer. (See Common Stock, Dilution, and Preferred Stock). Committed Capital: The total dollar amount of capital pledged to a private equity fund. Common Stock: A unit of ownership of a corporation. In the case of a public company, the stock is traded between investors on various exchanges. Owners of common stock are typically entitled to vote on the selection of directors and other important events and in some cases receive dividends on their holdings. Investors who purchase common stock hope that the stock price will increase so the value of their investment will appreciate. Common stock offers no performance guarantees. Additionally, in the event that a corporation is liquidated, the claims of secured and unsecured creditors and owners of bonds and preferred stock take precedence over the claims of those who own common stock. Invest - 63 - Invest- 55 Assets That Grow Savings and Earn Passive Income STOCKS “Great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause the stock to be misappraised.” -Warren Buffet ‫ق‬ Definition Stock, sometimes referred to as shares or equity, is ownership in part of a company. For every stock I own in a company, I own a part of the company’s assets and profits. More importantly, stock entitles me to vote at the shareholders' meeting and to receive any profits that the company allocates to its owners. These profits are referred to as dividends. The more shares I own, the larger the portion of the company (and profits) I own. Advisory shares are the shares given to an individual, or institution, who/which brings strategic value to the company through advise. ‫ق‬ Characteristics Over the long term, no investment provides better returns at a reasonable risk than common stock. History dictates that common stocks average 11-12% per year and outperform just about every other type of security including bonds and preferred shares. Stocks also provide potential for capital appreciation and income and offer protection against moderate inflation. APPRECIATION: The increase in the value of an asset. The stock of a business is divided into shares, the total of which must be stated at the time of business formation. Given the total amount of money invested in the business, a share has a certain declared face value, commonly known as the par value of a share. The par value is the de minimis (minimum) amount of money that a business may issue and sell shares for in many jurisdictions and it is the value represented as capital in the accounting of the business. In other jurisdictions, however, shares may not have an associated par value at all. Such stock is often called non-par stock. Before companies trade in shares, they must first go public, also called, launching their Initial Public Offering (IPO). This is when it gives it shares to the public for the first time, so as to raise money for operations, while giving the public a chance to own part of the company. This is done in line with the Securities and Exchange Commission (SEC), or Capital Markets Authority Invest - 64 - Invest- 55 Assets That Grow Savings and Earn Passive Income (CMA) regulations for the stock markets. When I buy a stock, the company registers a stock certificate in my name to cover my investment. € A STOCK CERTIFICATE is a legal document (paper or electronic) that specifies the amount of shares owned by the shareholder, and other specifics of the shares, such as the par value, if any, or the class of the shares. I can only own stock of a company that is public traded, or that has held an initial public offer and allows the public to own its shares. Private companies are not traded publicly and hence I cannot invest in them in the stock market, BUT I can buy the shares through share transfer by a shareholder in the private company. Traditionally, ownership of shares/stocks is documented by issuance of a stock certificate. The percentage ownership is indicated and stated in a monthly statement by my brokerage. A company might issue different classes of stocks and give different privileges to each class, such as different voting rights. A business may declare different types (classes) of shares, each having distinctive ownership rules, privileges, or share values. When I buy stocks, I am looking more for capital gains. Once these stocks are registered, I may receive periodic dividends or sell my stock at a profit. The stock hence becomes available to investors who are looking for a regular stream of income. Blue Chips have a history of paying dividends over a long period of time in both good and bad economic conditions. These dividends are typically paid quarterly, which provides investors with a regular and predictable stream of income. Buffet says, “we invest in businesses that are predictable”. € BLUE CHIP: A company that has a history of solid earnings, regular and increasing dividends, and an impeccable balance sheet. Stocks generally go up in value over time, but they may also go down in value if the company does poorly and the stock price falls. This is the risk associated with stocks. Stocks are volatile. That is, they fluctuate in value on a daily basis. When I buy a stock, I am not guaranteed anything. However, stocks are the best way to earn a good return on my money. The fact is that most stocks, on average, have increased in value over the long-term. Thus it is a risky investment but one that provides a good return. Ideally, no single equity holding in an investment manager’s portfolio, measured on trade date, shall exceed 5% of the manager’s portfolio, at market value, or exceed 5% of the issuer’s outstanding equity. Invest - 65 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Analyzing a company “When buying shares, ask yourself, would you buy the whole company?”- Rene Rivkin. Before I invest in stocks, I need to look at how the company is doing by looking at their financial statements. This form of analysis is termed Fundamental Analysis. The other method of analysis the company before investing is Technical Analysis; that is, looking at price movements and charts. Technical Analysis will help me time the market. Finally, I can also look at insider activity or even watch news about the company. $ Bull & Bear Markets In stock trading and investing, there are bulls and bears. It sounds dangerous but it is not. By recognizing the different kinds of markets (market timing), I can make money on stock trading and investing. € A BULL MARKET is when the market showing is confidence. Indicators of confidence are prices going up and market indices going up too. At this time, the number of shares traded is high and even the number of companies entering the stock market is high: the market is confident. These are bullish characteristics. Technically, a bull market is a rise in value of the market of at least 20%. € A BEAR MARKET is the opposite of a bull, when the markets fall by more than 20%. It is a show of lack of confidence in the market. Prices hover at the same price then go down, indices fall too and volumes are stagnant. In a bear market people are waiting for the bulls to start driving the prices up again. However, a bear is a very tentative bull or a bull that is asleep. So, to make money, I buy stocks in a bear market when stock prices are low and sell stocks in a bull market when stock prices are high. The basic idea behind buying stocks is to buy low and sell high; also referred to as buy gloom, and sell boom, or buy bear, and sell bull. This will give me a profit. J. Paul Getty, the billionaire American investor advises me thus: ‘Buy when everyone else is selling and hold when everyone else is buying. This is not merely a catchy slogan. It is the very essence of successful investments.’ However, knowing when is the best time to buy and sell is not that simple. Unfortunately, most investors are too emotional and they sell in a bear market because they are scared to lose money and they buy in a bull market because they do not want to miss the big gains. I can make some money that way, but it also explains why many investors lose money by trying to time the market. The safest way to prevent myself from making these mistakes (timing the market) is to buy stocks and invest in the market by regularly making fixed size investments, Invest - 66 - Invest- 55 Assets That Grow Savings and Earn Passive Income and holding my investments for a long period of time. This is called dollar cost averaging. When calculating the amount I want to start with, I will take into consideration how much my transaction fees and initial investment fees will be. The transaction fees depend on the frequency of my trading. If I am only buying stock once or twice a year, it does not make much difference, but if I am trading on a regular basis, those fees can easily total thousands of dollars very quickly. If I start out with $500, but am paying $25 for each buy and sell transaction, there is virtually no possibility of getting ahead. Further, whereas full-service brokers will charge much higher transaction fees, the online discount brokers do offer excellent services, free information and convenient utilities such as on-line stock tickers, and represent an excellent value for those who are able to do their own research and make their own investment decisions. The amount I need to start out depends first on the broker I use. Some brokers require me to put more into an account to start. Full-service brokers typically require a larger initial account than discount brokers. A common misconception is that I must buy stock in ‘blocks’ of 100 shares; this is simply not true. I can buy as many or as few stocks, even in odd numbers, as I wish. There is no doubt that it will take longer to build that $500 up to several thousand, but it can certainly be done with wise decisions and good research. ‫ق‬ Stock Symbols Each security has a particular letter that has been assigned to it to make it unique and so that I can easily identify it. A - Class A B - Class B C - Issuer qualification exceptions D - New E - Delinquent in required filings with the SEC F - Foreign G - First convertible bond H -Second convertible bond, same company I - Third convertible bond, same company J - Voting K - Nonvoting L- Miscellaneous situations, such as depository receipts, additional warrants, units M - Fourth preferred, same company N - Third preferred, same company O - Second preferred, same company P - First preferred, same company Invest - 67 - Invest- 55 Assets That Grow Savings and Earn Passive Income Q - Bankruptcy proceedings R - Rights S - Shares of beneficial interest T - With warrants or with rights U - Units V - When-issued and when-distributed W - Warrants Y - ADR (American Depository Receipts) Z - Miscellaneous situations as above (L) ‫ق‬ Stock Analysis, Valuation & Investment Strategies Stock Valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally potential market prices, and thus to profit from price movement – stocks that are judged undervalued (with respect to their theoretical value) are bought, while stocks that are judged overvalued are sold, in the expectation that undervalued stocks will, on the whole, rise in value, while overvalued stocks will, on the whole, fall. $ Value Investing Value investing is an investment paradigm that involves buying securities whose shares appear underpriced by some form(s) of fundamental analysis. Highprofile proponents of value investing, including Berkshire Hathaway chairman Warren Buffett, have argued that the essence of value investing is buying stocks at less than their intrinsic value. The discount of the market price to the intrinsic value is what Benjamin Graham called the ‘margin of safety’. The intrinsic value is the discounted value of all future distributions. In Graham's book The Intelligent Investor, he advocated the important concept of margin of safety— which calls for a cautious approach to investing. Tainted by a scandal involving one of its clients, American Express saw its shares drop from $65 to $35 almost overnight. Buffett had learned Ben Graham’s lesson well: When stocks of a strong company are selling below their intrinsic value, act decisively. Buffett made the bold decision to put 40 percent of the partnership’s total assets, $13 million, into American Express stock. Over the next two years, the shares tripled in price, and the partners netted a cool $20 million in profit. It was pure Graham—and pure Buffett. The idea of value investing is to buy stocks whose price is lower than their true value and then to hold those stocks until their price returns to the true value earning a return on the investment. I should not take Mr. Market seriously, but should do my own analysis of how the company is performing, then invest, so as to benefit from Mr. Markets irrational offers, and not be its victim. Benjamin Graham advises thus: Invest - 68 - Invest- 55 Assets That Grow Savings and Earn Passive Income “You are neither right or wrong because the crowd disagrees with you. You are right because your data and reasoning are right.” Buffet says, It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price. I can invest in stocks using momentum investing, depending on the market, where I seek to predict the market, or value investing, depending on the value of the company, where I look at the intrinsic value through the competitive advantage of the company, and how long the advantage will last. Value formula means I look for the most value, at the last price. High value means high percentage net earnings, and high percentage dividends, with a low price to book ratio. When the score is over ten, that is the value, divided by the price to book ratio, is over ten, then such a company is likely to grow, and the stocks are good for purchase. I can also invest using the long investing, or short investing. I go long as a buyer to secure as low a price as possible. I go short as a seller to secure as high a price as possible. If I do not have cash or capital which I can put out in risk, and yet there is a good opportunity, I can use stock options, which is really trading, and not investing. Options have less risk, and high returns. Buffett’s preference is to “buy certainties at a discount.” “Certainties” are defined by the predictability of a company’s economics. Post money valuation is the value of a company after investments have been made. The opposite, that is, valuation of a company before investments, is pre-money valuation. ‫ق‬ Types of Stocks There are two types of Stocks, namely Preferred Stocks and Common Stocks. Preferred Stocks give a fixed dividend; the payment given out when investors hold stocks. Common Stocks do not guarantee fixed dividends and the company need not issue dividends. Invest - 69 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Preferred Stock ‫ق‬ Definition Preferred stock, also called preferred shares, preference shares, or simply preferreds, has properties of both equity and a debt instrument and is generally considered a hybrid instrument. It represents ownership in a company, but it usually does not give the holder voting rights. ‫ق‬ Characteristics With preferred shares, investors are guaranteed a fixed dividend forever, while common stocks have variable dividends. The major objective of a preferred stock is to provide a much higher dividend than that provided by common stock. The precise details as to the structure of preferred stock are specific to each corporation. Terms of the preferred stock are stated in a ‘Certificate of Designation’. The three main uses of preferred stock are to provide income; capital appreciation and to lower risk. Preferred stocks offer a company an attractive alternative to financing. In most cases, a company can defer dividends by going into arrears without much of a penalty or risk to their credit rating. With traditional debt, payments are required and a missed payment would put the company in default. Occasionally companies use preferred shares as means of preventing hostile takeovers, creating preferred shares with a poison pill or forced exchange or conversion features that exercise upon a change in control. Some corporations contain provisions in their charters authorizing the issuance of preferred stock whose terms and conditions may be determined by the board of directors when issued. These ‘blank checks’ are often used as takeover defense. These shares may be assigned very high liquidation value that must be redeemed in the event of a change of control or may have enormous super voting powers. Sometimes preferred shares can contain protective provisions which prevent the issuance of new preferred shares with a senior claim. Individual series of preferred shares may have a senior, pari-passu or junior relationship with other series issued by the same corporation. Preferred shares are more common in private or pre-public companies, where it is more useful to distinguish between the control of and the economic interest in the company. Government regulations and the rules of stock exchanges may discourage or encourage the issuance of publicly traded preferred shares. In many countries banks are encouraged to issue preferred stock as a source of Tier 1 Capital. Invest - 70 - Invest- 55 Assets That Grow Savings and Earn Passive Income € TIER 1 CAPITAL: A term used to describe the capital adequacy of a bank. Tier I capital is core capital; this includes equity capital and disclosed reserves. A single company may issue several classes of preferred stock. For example, a company may undergo several rounds of financing, with each round receiving separate rights and having a separate class of preferred stock; such a company might have ‘Series A Preferred,’ ‘Series B Preferred,’ ‘Series C Preferred’ and of course, common stock. ‫ق‬ Preferred Stocks (Types) There are two major types of preferred stocks: straight preferreds and convertible preferreds. £ Straight preferreds are issued in perpetuity and pay the stipulated rate of interest to the holder. Advantages of straight preferreds include higher yields and tax advantages. Like a bond, a straight preferred does not participate in any future earnings and dividend growth of the company and any resulting growth of the price of the common. But the bond has greater security than the preferred and has a maturity date at which the principal is to be repaid. Like the common stock, the straight preferred has less security protection than the bond. But the potential of increases of market price of the common and its dividends paid from future growth of the company is lacking for the preferred. One big advantage that the preferred provides its issuer is that the preferred gets better equity credit at rating agencies than straight debt, since it is usually perpetual. Also, as pointed out above, certain types of preferred stock qualifies as Tier 1 capital. This allows financial institutions to satisfy regulatory requirements without diluting common shareholders. Said another way, through preferred stock, financial institutions are able to put on leverage while getting Tier 1 equity credit. £ Convertible preferreds are preferred issues that the holders can exchange for a predetermined number of the company's common stock of the issuing company, (or, sometimes, into the common stock of an affiliated company). This exchange can occur at any time the investor chooses regardless of the current market price of the common stock. It is a one way deal so one cannot convert the common stock back to preferred stock. There is great diversity in the preferred stock market. Other types of preferred stock include: £ Prior Preferred Stock is the stock issued and designated to be the one with the highest priority in cases where the company has different issues of preferred stock. If the company has only enough money to meet the dividend schedule on one of the preferred issues, it makes the dividend payments on the prior Invest - 71 - Invest- 55 Assets That Grow Savings and Earn Passive Income preferred. Therefore, prior preferred have less credit risk than the other preferred stocks but it usually offers a lower yield than the others. £ Preference Preferred Stock is ranked behind the company's prior preferred stock (on a seniority basis). These issues receive preference over all other classes of the company's preferred. If the company issues more than one issue of preference preferred, then the various issues are ranked by their relative seniority. One issue is designated first preference; the next senior issue is the second and so on. £ Cumulative preferred stock refers to the stock which is not paid. £ Exchangeable preferred stock carries the option to be exchanged for some other security upon certain conditions. £ Participating Preferred Stock offers the holders the opportunity to receive extra dividends if the company achieves some predetermined financial goals. If the company achieves predetermined sales, earnings or profitability goals, the investors receive an additional dividend. £ Perpetual preferred stock has no fixed date on which invested capital will be returned to the shareholder, although there will always be redemption privileges held by the corporation. Most preferred stock is issued without a set redemption date. £ Putable preferred stocks have a ‘put’ privilege whereby the holder may, upon certain conditions, force the issuer to redeem shares. £ Monthly income preferred stock is combination of preferred stock and subordinated debt. £ Non-cumulative preferred stock will not accumulate if it is unpaid. Very common in TRiPS and bank preferred stock, since preferred stock must be non-cumulative if it is to be included in Tier 1 Capital. ¥ TIER 1 CAPITAL is a measure of a bank's core capital, which includes its common stock and its disclosed reserves. Tier 1 capital is looked upon to determine the solvency of a financial institution. Common stock equity is a key measure of a bank's financial strength and represents the most commonly used component in calculating a bank's tier 1 capital. ‫ق‬ Advantages £ Preferred stock generally has priority over common stock in the payment of dividends and upon liquidation. Preferred stock is hence much less risky and if the company goes bankrupt, a preferred shareholder is far more likely than a common shareholder to get at least some of his/her money back. As a company liquidates, bondholders are Invest - 72 - Invest- 55 Assets That Grow Savings and Earn Passive Income paid first, followed by preferred shareholders. Common shareholders are at the bottom of the ladder. £ There are income tax advantages generally available to corporations that invest in preferred stocks that are not available to individuals. £ Preferred stock may have a convertibility feature into common stock. £ Dividends are higher than those of common stocks. ‫ق‬ Disadvantages £ Preferred stock usually carries no voting rights. £ Preferred stock may be callable, meaning that the company has the option to purchase the shares from shareholders at any time - and usually for a premium. £ Dividends are taxed at the same rate as income, so higher dividends mean I will likely pay more taxes. £ Rates of return on preferred stock are very close to those for corporate bonds, and corporate bonds are considered less risky. Outstanding Stock: The amount of common shares of a corporation which are in the hands of investors. It is equal to the amount of issued shares less treasury stock. Oversubscription: Occurs when demand for shares exceeds the supply or number of shares offered for sale. As a result, the underwriters or investment bankers must allocate the shares among investors. In private placements, this occurs when a deal is in great demand because of the company’s growth prospects. Oversubscription Privilege: In a rights issue, arrangement by which shareholders are given the right to apply for any shares that are not purchased. Pari Passu : At an equal rate or pace, without preference. Preemptive Right: A shareholder's right to acquire an amount of shares in a future offering at current prices per share paid by new investors, whereby his/her percentage ownership remains the same as before the offering. Preferred Dividend: A dividend ordinarily accruing on preferred shares payable where declared and superior in right of payment to common dividends. Underwriter : In jargon, the “underwriters” are the investment banks selling the securities in an underwritten registered offering. But beware, under the Securities Act, the class of persons who are considered “underwriters” is far more expansive and problematic. Underwritten Offering: Registered offering that is sold through a consortium of investment banks assembled by one or more lead investment banks. Invest - 73 - Invest- 55 Assets That Grow Savings and Earn Passive Income Invest - 74 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Common Stock ‫ق‬ Definition It is called ‘common’ to distinguish it from preferred stock. It can also be known as Ordinary Shares. Common stock holders have voting rights (one vote per share) to elect the board members who oversee the major decisions made by management. ‫ق‬ Characteristics Common stock is the most typical type of stock. It is just, ‘common’. The majority of stocks trading today are in this form. When people discuss investing in stocks in general they are most likely referring to this type of stock. In fact, the greatest number of stock issued is in this form. Study of investing and stock market has revealed that in the long term, common stock, by means of capital growth, yields higher returns than almost every other investment. This higher return comes at a cost, because common stock carries the greatest risk. In case the company goes bankrupt and liquidates, the investor holding common stock shares will not receive money until the creditors, bondholders, and preferred shareholders are paid. Holders of common stock are able to influence the corporation through votes on establishing corporate objectives and policy, stock splits, and electing the company's board of directors. Some holders of common stock also receive preemptive rights, which enable them to retain their proportional ownership in a company should it issue another stock offering. The three main uses of common stock include capital appreciation; income; and liquidity. ‫ق‬ Advantages £ In the long term, common stock, by means of capital growth, yield higher rewards than other forms of investment securities. Specifically, common shares on average perform better than preferred shares. £ Common stock earns dividends and capital appreciation. £ Common stock is very easy to buy and sell. £ Thanks in large part to the growth of the Internet; it is very easy to find reliable information on public companies, making analysis possible. £ Shares can be transferred in form from one person to another, that is, it can be inherited, sold, gifted, etc, just like any other property; £ Shares can be used as collateral and or security for loan; £ Shares give voting rights to the shareholder to attend and vote at company’s Annual General Meting, or Special General Meeting, in person, or by proxy, and hence influence the policy of the company; £ When shares are sold at a higher price, this represents a profit. This profit is called capital gain. £ As a shareholder, I have a right to participate in Corporate Action. Corporate Action is when the company issues rights, share split, or Invest - 75 - Invest- 55 Assets That Grow Savings and Earn Passive Income bonuses. A Rights Issue is when the company issues new shares, and in such instances, a shareholder has a right to purchase the new shares or allocate to willing buyers, at his own price. A Bonus Issue is when the company issues new shares to shareholders automatically at no additional cost. A share split is when a company divides its shares into more shares, hence increasing the number of shares, and reducing/splitting their value, and so, the marketability of the shares increases. ‫ق‬ Disadvantages ¥ ¥ ¥ ¥ ¥ ¥ ‫ق‬ In the event of bankruptcy, common stock investors receive their funds after preferred stock holders, bondholders, creditors, etc. This higher return comes at a cost, as common stock entails the most risk. There is no fixed dividend paid out to common stock holders and so their returns are uncertain, contingent on earnings, company reinvestment, and efficiency of the market to value and sell stock. Common stockholders are also on the bottom of the priority ladder for ownership structure. In the event of liquidation, common shareholders have rights to a company's assets only after bondholders, preferred shareholders and other debt holders have been paid in full. My original investment is not guaranteed. There is always the risk that the stock I invest in will decline in value, and I may lose my entire principal. My stock is only as good as the company in which I invest; hence a poor company means poor stock performance. How to Invest in Stocks I can buy shares during an Initial Public Offer, IPO, or from an existing shareholder. I can sell or buy shares by contacting a licensed stock broker/dealer, who will help me sell or buy my shares. The broker dealers will charge me a commission for the service, which is around 2%. The commission goes down with increase in the amount of money I am investing. When I purchase shares, I will be required to open a Securities Central Depository Accounts, (CDS) which is an electronic account opened by the stock brokers on my behalf after filling the Know Your Client (KYC) Form. It is like a bank account in which all my securities are deposited. To buy shares during an initial public offer, I obtain a Share Application Form, SAF, from a dealer/broker, which I complete. The SAF is then handed back with the payment, during which time a receipt is issued to me, the purchaser. If the offer is oversubscribed, as happens most times, (that is, applications for shares exceeding the number of shares available), t hen the shares available Invest - 76 - Invest- 55 Assets That Grow Savings and Earn Passive Income are divided among the applicants according to the allotment criteria and I receive a refund for the shares paid for, but not received. When I am successful, I am then sent my share certificate through the broker/dealer. During an IPO, a Prospectus is given free of charge. A Prospectus is a legal document that gives general information about the company which is offering shares to the public, including, but not limited to the company history, operations, management, products, market share, etc. it usually has a summary, an the whole document. It can be a notice, an advertisement, or a circular. Either way, I need to obtain the whole document, read it, and then seek opinion of a professional, like an investment advisor, lawyer, or accountant, before investing my money. I can invest in stocks through the following avenues: Investment club: I do not have to be rich to play the stock market. It is possible to start out with a very small stake, and build it over time-giving me far greater rewards than I would realize from simply putting that same amount of money in the bank. Alternatively, I can join an investments club and pool resources to invest while also learning and networking. To read more about how to form or join an investment club, I should read The Ojijo Investment Club Manual. Brokers: The most common method for buying stocks is to use a brokerage, either full service or discount. There is no minimum investment for most stocks (other than the price per share), but many brokerages require clients to have at least $500 to open an account. Companies: Companies also allow for walk in to their investing officers and buying of stocks. Dividend Reinvestment Plans (DRiPS) and Direct Investment Plans (DIPs) are two ways individual companies allow shareholders to purchase stock directly from them for a minimal cost. DRiPS are also a great way to invest money at regular intervals. Commissions to buy preferred stock are usually the same as common stock fees. Mutual Funds: I may also consider purchasing shares of mutual funds, which in turn invest in a broad array of stocks. This provides the added advantage of professional management and diversification. Unit Offering: Private or public offering of securities in groups of more than one security. Most often a share of stock and warrant to purchase some number of shares of stock, but could be two shares of stock, a note and a share of stock, etc. Also used in some cases to refer to the Invest - 77 - Invest- 55 Assets That Grow Savings and Earn Passive Income sale of LP and LLC interests, since those interests are composed of more than one right. Secondary Sale: The sale of private or restricted holdings in a portfolio company to other investors. Securities: Includes all types of equity and debt instruments and rights in and to them. Securities and Exchange Commission: The SEC is an independent, nonpartisan, quasi-judicial regulatory agency that is responsible for administering the federal securities laws. These laws protect investors in securities markets and ensure that investors have access to all material information concerning publicly traded securities. Additionally, the SEC regulates firms that trade securities, people who provide investment advice, and investment companies. Senior Securities: Securities that have a preferential claim over common stock on a company’s earnings and in the case of liquidation. Generally, preferred stock and bonds are considered senior securities. Series A Preferred Stock: The first round of stock offered during the seed or early-stage round by a portfolio company to the venture investor or fund. This stock is convertible into common stock in certain cases such as an IPO or the sale of the company. Later rounds of preferred stock in a private company are called Series B, Series C, and so on. Stock Options: 1) The right to purchase or sell a stock at a specified price within a stated period. Options are a popular investment medium, offering an opportunity to hedge positions in other securities, to speculate on stocks with relatively little investment, and to capitalize on changes in the market value of options contracts themselves through a variety of options strategies. 2) A widely used form of employee incentive and compensation. The employee is given an option to purchase its shares at a certain price (at or below the market price at the time the option is granted) for a specified period of years. For example, if a stock currently trades at $40 and you believe the price will rise to $50 next month, you would buy a call option today so that next month you can buy the stock for $40, sell it for $50, and make a profit of $10. Stock options trade on a securities exchange, just like stocks. stock warrant A stock warrant is just like a stock option because it gives you the right to purchase a company's stock at a specific price and at a specific date. However, a stock warrant differs from an option in two key ways: A stock warrant is issued by the company itself New shares are issued by the company for the transaction. Unlike a stock option, a stock warrant is issued directly by the company. When a stock option is exercised, the shares usually are received or given by Invest - 78 - Invest- 55 Assets That Grow Savings and Earn Passive Income one investor to another; when a stock warrant is exercised, the shares that fulfill the obligation are not received from another investor, but directly from the company. Companies issue stock warrants to raise money. When stock options are bought and sold, the company that owns the stocks does not receive any money from the transactions. However, a stock warrant is a way for a company to raise money through equity (stocks). A stock warrant is a smart way to own shares of a company because a warrant usually is offered at a price lower than that of a stock option. The longest term for an option is two to three years, while a stock warrant can last for up to 15 years. So, in many cases, a stock warrant can prove to be a better investment than a stock option if mid- to long-term investments are what you seek. Tag-Along Rights / Rights of Co-Sale: A minority-shareholder protection affording the right to include their shares in any sale of control and at the offered price. Treasury Stock: Stock issued by a company but later reacquired. It may be held in the company’s treasury indefinitely, reissued to the public, or retired. Treasury stock receives no dividends and does not carry voting power while held by the company. Voting Right: The common stockholders’ right to vote their stock in the affairs of the company. Preferred stock usually has the right to vote when preferred dividends are in default for a specified amount of time. The right to vote may be delegated by the stockholder to another person. Invest - 79 - Invest- 55 Assets That Grow Savings and Earn Passive Income BONDS ‫ق‬ Definition A bond is a debt investment in which an investor loans a certain amount of money, for a certain amount of time, with a certain interest rate, to an organisation. Bonds are forms of debt that organizations use to raise money. When I purchase a bond, I am lending out my money to a company or government or organisation. In return, the organisation agrees to give me interest on my money and eventually pay I back the amount I lent out, (when the bond matures), plus interest compounded annually or semi-annually. The Treasury Department invests in fixed income securities to provide stability and a predictable flow of income to the programs for which it serves as fiduciary. ‫ق‬ Characteristics Issuer: Bonds have many characteristics such as the way they pay their interest, the market they are issued in, the currency they are payable in, protective features and their legal status. Bond issuers may be governments, corporations, special purpose trusts or even non-profit organizations and international, supra-national agencies. Usually it is the type of issuer or the particular nature of a bond that sets it apart in its own category. The type of lender will determine many of a bond's features. But there are other characteristics to consider besides the lender. To maintain a diversified portfolio, a fixed income manager shall ensure that the cumulative value of any single issuer in the manager’s portfolio shall not exceed 10% of the overall market value of the manager’s portfolio on trade date. An investment manager’s portfolio may not contain adjustable rate or variable rate fixed income securities whose total market value on trade date exceeds 15% of the portfolio’s market value. ‘Fixed-Income’ Securities: Bonds are known as ‘fixed-income’ securities because the amount of income the bond will generate each year is ‘fixed,’ or set, when the bond is sold. No matter what happens or who holds the bond, it will generate exactly the same amount of money. Independent bond-rating agencies rate the likelihood that any given bond will default. Bond terms can range from a few months to 30 years. In general, fixed-income securities are classified according to the length of time before maturity. Categories: These are the three main categories: £ Bills - debt securities maturing in less than one year. Invest - 80 - Invest- 55 Assets That Grow Savings and Earn Passive Income £ Notes - debt securities maturing in one to 10 years. £ Bonds - debt securities maturing in more than 10 years. The main attraction of bonds is their relative safety. Bonds are generally considered a safer than stocks because bondholders are paid before stockholders if a company becomes bankrupt. When a company goes into bankruptcy, bondholders get paid first, followed by Preferred Stockholders and finally Common Stockholders if there is any money left. When I buy bonds, I just got to make sure that a company has enough to pay off its debts and I will be pretty much safe. If I am buying bonds from a stable government, my investment is virtually guaranteed, or risk-free. The safety and stability, however, come at a cost. Because there is little risk, there is little potential return. As a result, the rate of return on bonds is generally lower than other securities. A bond differs from a stock in that it is a debenture or a debt owed to me. I am essentially providing the company that owns the bond with money, which they can use. In return they agree to pay me back at a specified interest rate. This investment is therefore somewhat protected if the company goes bankrupt because the debt follows them into bankruptcy. This is why bonds are overall normally safer than stocks from the same company. However because of this safety their return is not as great. There are three important things to know about any bond before I buy it: the par value, the coupon rate, and the maturity date. Knowing these three items (and a few other odds and ends depending on what kind of bond I am buying) allows me to analyze the bond and compare it to other potential investments. ¥ Par value is the amount of money the investor will receive once the bond matures, meaning that the entity that sold the bond will return to the investor the original amount that it was loaned, called the principal. As mentioned earlier, par value for corporate bonds is normally $1,000, although for government bonds it can be much higher. ¥ Coupon rate is the amount of interest that the bondholder will receive expressed as a percentage of the par value. Thus, if a bond has a par value of $1,000 and a coupon rate of 10%, the person holding the bond will receive $100 a year. The bond will also specify when the interest is to be paid, whether monthly, quarterly, semi-annually, or annually. ¥ The maturity date is the date when the bond issuer has to return the principal to the lender. After the debtor pays back the principal, it is no longer obligated to make interest payments. Sometimes a company will decide to ‘call’ its bond, meaning that it is giving the lenders their money back before the maturity date of the bond. All corporate bonds specify whether they can be Invest - 81 - Invest- 55 Assets That Grow Savings and Earn Passive Income called and how soon they can be called. Government bonds are never called, although local government bonds can be called. How to calculate bond yields: The key piece of information to know about a bond in order to compare it with other potential investments is the yield. I can calculate the yield on a bond by dividing the amount of interest it will pay over the course of a year by the current price of the bond. If a bond that cost $1,000 pays $75 a year in interest, then its current yield is $75 divided by $1,000, or 7.5%. Current yield = $75/$1000 = 0.075 = 7.5% Why not just look at the coupon rate to determine the bond's yield? Bond prices fluctuate as interest rates change, so a bond can trade above or below the par value based on what interest rates are. If I hold the bond to maturity, I am guaranteed to get my principal back. However, if I sell the bond before it matures, I will have to sell it at the going rate, which may be above or below par value. Say I bought a $1,000 bond with a coupon rate of 10% that matures in 10 years. This bond would pay me $100 per year for a decade, at which time I will get back the $1,000 in principal. Now say I still own that bond seven years later, when long-term interest rates touch 5%. Newly issued bonds, paying that interest rate, would only pay $50 a year, not $100. As a reflection of the fact that interest rates have dropped since the coupon rate was set on the bond, I would actually be able to sell my bond for more than the $1,000 par value. This is because an investor would be willing to pay a premium rate for a bond that paid 10%. If I hold a bond to maturity, I will not lose my principal as long as the borrower does not default or go belly-up. If I buy and sell bonds before they mature, I can make or lose money on the bonds themselves completely separate from the interest rates. Yield to maturity: Because I can buy a bond above or below par value, bond investors often use another kind of yield called ‘yield to maturity.’ The yield to maturity includes not only the interest payments I will receive all the way to maturity, but it also assumes that I reinvest that interest payment at the same rate as the current yield on the bond and takes into account any difference between the current par value of the bond and the actual trading price of the bond at that time. If I buy a bond at par value, then the yield to maturity will be very close to the current yield, which is exactly the same as the coupon rate. Yield to maturity is especially important when looking at zero-coupon bonds, a special type of bond that pays no interest until the maturity date, when I receive all of my principal back plus interest for the entire period the money was borrowed. Because zeros have no present yield, any yield I see associated with them is always a yield to maturity. Invest - 82 - Invest- 55 Assets That Grow Savings and Earn Passive Income € YIELD TO MATURITY: The rate of return an investor would receive if the securities held by a portfolio were held to their maturity dates. Bond rating: Bonds are assigned Bond ratings and generally, the better a bond is rated, the lower interest the company will pay. This is because better bond ratings assure that the company will pay I back, so investors can live with lower returns. Bond ratings indicate how financially stable the issuer of the bonds really is. Developed by third parties such as Standard and Poor's and Moody's, bond-rating services give bonds letter or mixed letter and number ratings based on the financial soundness of the bond issuer. To complicate things, the rating agencies use entirely different rating systems, making it very important that I check what the ratings mean before I make any assumptions. The higher the rating, the higher the quality of the bond, with Treasury bonds being rated the highest and ‘junk’ bonds being those with the lowest ratings. € € INTEREST RATE RISK refers to the risk of the market value of a bond changing in value due to changes in the structure or level of interest rates or credit spreads or risk premiums. THE CREDIT RISK of a high-yield bond refers to the probability and probable loss upon a credit event (i.e., the obligor defaults on scheduled payments or files for bankruptcy, or the bond is restructured), or a credit quality change is issued by a rating agency. Rating scales vary; the most popular scale uses (in order of increasing risk) ratings of AAA, AA, A, BBB, BB, B, CCC, CC, C, with the additional rating D for debt already in arrears. Government bonds and bonds issued by government sponsored enterprises (GSE's) are often considered to be in a zero-risk category above AAA; and categories like AA and A may sometimes be split into finer subdivisions like ‘AA-’ or ‘AA+’. Bonds rated BBB- and higher are called investment grade bonds. Bonds rated lower than investment grade on their date of issue are called speculative grade bonds, derisively referred to as ‘junk’ bonds. The lower-rated debt typically offers a higher yield, making speculative bonds attractive investment vehicles for certain types of financial portfolios and strategies. Many pension funds and other investors (banks, insurance companies), however, are prohibited in their by-laws from investing in bonds which have ratings below a particular level. As a result, the lower-rated securities have a different investor base than investment-grade bonds. The value of speculative bonds is affected to a higher degree than investment grade bonds by the possibility of default. For example, in a recession interest rates may drop and the drop in interest rates tends to increase the value of investment grade bonds; however, a recession tends to increase the possibility of default in speculative-grade bonds. Invest - 83 - Invest- 55 Assets That Grow Savings and Earn Passive Income Commission: Depending on the bond, it can either trade very frequently at a low commission or it may be very difficult to find a buyer or seller and involve large transaction costs. Highly liquid bonds include Treasuries and debt issued by large, blue-chip corporations. Illiquid bonds would include the bonds of a company viewed as close to bankruptcy. Because it is no longer a safe investment, only those speculating that there will be a corporate turnaround are willing to buy those bonds, meaning they trade a lot less frequently. Liquidity has a direct effect on the commission I pay to trade a bond, which unlike stocks, rarely trade on a fixed commission schedule. € ‫ق‬ LIQUIDITY is the term used to describe how easy it is to sell something. Advantages Almost all investors who buy bonds buy them because they are generally safe investments. ‫ق‬ Disadvantages Except for bonds from the government, bonds carry the potential risk of default, no matter how remote that risk might be. Whether it is a high-yield corporate bond or a bond sold by the government, there is always a chance that the entity that borrowed the money will not be able to make the interest payment. ‫ق‬ How to Invest Use a brokerage The most common way to buy bonds, much like stocks, is to use a brokerage account. I can either use a full-service (or full-price) broker or a discount broker to execute my trades. Bond commissions vary widely from brokerage to brokerage, so it does not hurt to shop around a little before making my decision. Through a brokerage, I can buy anything from a 10-year Treasury to a one-year junk bond issued by a corporation on the edge of bankruptcy. I can either participate in the direct offering of the bonds or pick them up in the secondary market, depending on my brokerage. TreasuryDirect. This program enables investors to purchase bonds directly from the Treasury, completely avoiding a brokerage. Investors can establish a single TreasuryDirect account that will hold all of their Treasury notes, bills, and bonds. Investors are issued account statements periodically. Interest and the repayment of principal are made electronically via direct deposit to a bank or brokerage designated by the account holder. As long as I have enough money, I can buy any type of Treasury security I want. Mutual funds: One of the easiest ways to purchase bonds is through a mutual fund. I can invest small amounts (sometimes as little as $25 at a time). Further, I can sign up for an automatic investment plan (which transfers money from my checking account to my investment account), and achieve the benefits of dollar cost averaging, and instant diversification (since a mutual fund owns thousands of bonds from hundreds of issuers). In fact, for small Invest - 84 - Invest- 55 Assets That Grow Savings and Earn Passive Income amounts, bond funds are usually the best bet for investors. However, they do have drawbacks, such as ongoing expenses and a potential loss of principal. ‫ق‬ Types There are many types of bonds from many different issuers, but four basic kinds of bonds, all defined by who is selling the debt. Invest - 85 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Municipal Bonds ‫ق‬ Definition Municipal bonds, or ‘munis’ for short, are debt securities issued by municipal or devolved governments to finance its capital expenditures, and not by the central government. They can be issued by a state, municipality or county. Such expenditures might include the construction of highways, bridges or schools. ‫ق‬ Characteristics Unlike corporations, the only way that a state can get more income is to raise taxes on its citizens, always an unpopular move. As a way around this problem, the central government permits state and local governments to sell bonds that are free of central government income tax on the interest paid. For the most part, investors should buy munis for income. While capital appreciation is possible in a falling interest rate environment, this is not considered a primary objective of munis. There are no substantial risks associated with buying a muni. Cities do not go bankrupt that often, but it can happen. Because state and local governments can go bankrupt, they have to offer competitive interest rates just like corporate bonds. Munis returns are free from central/central government tax. State and local governments can also waive state and local income taxes on the bonds, so even though they pay lower rates of interest, for borrowers in high tax brackets the bonds can actually have a higher after-tax yield than other forms of fixed-income investments. Munis are hence bought for their favorable tax implications and are popular with people in high income tax brackets. Furthermore, local governments will sometimes make their debt non-taxable for residents, thus making some municipal bonds completely tax-free, especially if I live in the state that issues the municipal bond. Because of these tax savings, the yield on a muni is usually lower than that of a taxable bond. Depending on my personal situation, a muni can be a great investment on an after-tax basis. Invest - 86 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Types There are two types of municipal debt: ¥ Public Purpose - These are bonds used for government projects and are always tax exempt. ¥ Private Purpose - These usually fund a project that will benefit both government and a private entity. They are only tax exempt if it clearly says so, otherwise I am subject to the provisions placed on the bond. (This can vary widely from bond to bond.) The two basic types of municipal bonds are: ¥ General obligation bonds: Principal and interest are secured by the full faith and credit of the issuer and usually supported by either the issuer’s unlimited or limited taxing power. In many cases, general obligation bonds are voter-approved. ¥ Revenue bonds: Principal and interest are secured by revenues derived from tolls, charges or rents from the facility built with the proceeds of the bond issue. Public projects financed by revenue bonds include toll roads, bridges, airports, water and sewage treatment facilities, hospitals and subsidized housing. Many of these bonds are issued by special authorities created for that particular purpose. ‫ق‬ Advantages £ £ ‫ق‬ Disadvantages £ ‫ق‬ Income from municipal bonds is tax exempt, but capital gains are not. Munis are considered to be very low-risk investments. Municipal bonds in smaller municipalities can sometimes be difficult to sell quickly. How to Invest Municipal bonds can be purchased from almost any full-service broker and most discount brokers. Some municipalities also allow investors to purchase the bonds directly through them. Minimum investment in a muni can start in the thousands of dollars. A popular new way to invest in munis is through municipal bond funds, which pool together munis from various states and cities, allowing me to have a well-diversified portfolio while getting all the benefits that I would get purchasing the muni myself. Invest - 87 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Corporate Bond ‫ق‬ Definition A corporate bond is a bond issued by companies. Corporations offer bonds to finance particular projects or for expansion. The other option for corporations to raise money is to sell ownership in the company as shares, but a company is limited by the number of shares it can sell and may have no other option but to finance activities through debt. The term is usually applied to longer-term debt instruments, generally with a maturity date falling at least a year after their issue date. The term ‘commercial paper’ is sometimes used for instruments with a shorter maturity. ‫ق‬ Characteristics Corporate bonds are debt instruments because money is lent to a corporation. Corporate bonds create cash flow for corporations. Companies sell debt through the public securities markets just as they sell stock. A company has a lot of flexibility as to how much debt it can issue and what interest rate it will pay, although it must make the bond attractive enough to interest investors or no one will buy them. Corporate bonds normally carry higher interest rates than government bonds because there is a risk that the company could go bankrupt and default on the bond, unlike the government, which can just print more money if it really needs it. The creditworthiness of corporate bonds is tied to the business prospects and financial capacity of the issuer. Corporate bonds tend to be for lesser amounts than government bonds. Corporate bond rating: Corporate bonds are rated, ranging from AAA (the most secure and low-risk bonds) to C (the riskiest investments), based upon the financial strength of each company. The business prospects of companies are dependent on the economy and the competitive situation of industries. Issuers are grouped by industry, for example real estate, resource and retail bonds. Industries with stable revenues and earnings are called ‘non-cyclicals’, whereas those whose revenues and earnings rise and fall with the economy and commodity prices are called ‘cyclicals’. Issuers are also grouped by their credit ratings. Companies that have financial risk because of high levels of debt and variable revenues and earnings are called ‘below investment grade’ or ‘junk’ bonds because of their speculative nature. Higher quality bonds are considered ‘investment grade’. Generally, a short-term corporate bond is less than five years; intermediate is five to 12 years, and long term is over 12 years. Corporate bonds are debt on a company's balance sheet and do not dilute the ownership of the company. This is important because issuing bonds keeps the stock price of a company higher than if the company issued new stock to fund its capital needs. Invest - 88 - Invest- 55 Assets That Grow Savings and Earn Passive Income Returns: Corporate bonds are characterized by higher yields because there is a higher risk of a company defaulting than a government. The upside is that they can also be the most rewarding fixed-income investments because of the risk the investor must take on. Function of Corporate Bonds: Corporate bonds are a cornerstone of capitalism. They provide a way for corporations to borrow hundreds of millions of dollars to finance product development, growth and global expansion. Large institutional investors that need to make multimillion-dollar investments, such as pension funds, mutual funds and foundations, buy corporate bonds for their investment portfolios because they pay higher interest than Treasury bonds and, if rated investment quality (AAA, AA or A), are considered safe investments. This allows corporations to borrow large blocks of funds they couldn't access by issuing stock. Features: Interest is paid semiannually and in most cases must be paid before dividends can be paid on stock if there is a financial crisis in the issuing company. Some corporate bonds have other provisions, such as collateralization by specific assets, conversion to stock or put options to shorten maturity. Maturities range from notes that mature in one to 10 years to bonds with maturities out 30 years or more. Bonds that have first right of recovery in case of bankruptcy are called first mortgage bonds. Unsecured bonds are called debentures and subordinated debentures. In taking money, the corporation issuing the bond promises interest (also called ‘coupon’). Sometimes this coupon can be zero with a high redemption value. Considerations: Corporate bonds are good investments for individuals and can be bought in amounts as small as one bond. It is best to hold them to maturity, because it is not easy to sell an odd lot if I need the money. A better way to invest in corporate bonds is through a corporate bond mutual fund. What to consider when buying: There are three important factors I need to consider before buying a bond. ¥ The first is the person issuing the bond. ¥ The second is the interest (or coupon) I will receive. ¥ The third is the maturity date, the day when the borrower must pay back the principal Corporate bonds are often listed on major exchanges (bonds there are called ‘listed’ bonds) and the coupon (i.e. interest payment) is usually taxable. However, despite being listed on exchanges, the vast majority of trading volume in corporate bonds takes place in decentralized, dealer-based, overthe-counter markets. Invest - 89 - Invest- 55 Assets That Grow Savings and Earn Passive Income Availability: Primary corporate bonds are offered privately, so it is difficult for novice investors to enter this market. Secondary bonds can be obtained through my broker. ‫ق‬ How to Invest I can purchase a bong during an initial public offer, or from existing bond holders. When I buy at initial public offer, I wait for when a company is issuing corporate bond, during which time the company will issue an Information Memorandum. This is a document which provides information about the issuer of the debt, including name of company, business area, amount issued, reason for the issue of debt security, whether it is guaranteed or not, an the repayment terms, to mention but a few. Again, as with Prospectus for investing in shares, I need to read the whole Memorandum, and then seek professional advise from a lawyer, investment advisor, or accountant. The Information Memorandum will be available at the press, stock brokers, or the company offices. Corporate bonds can also be purchased from almost any full-service broker and most discount brokers; which allows me to buy bond from existing bond holders. The procedure is the same as that of buying shares in the secondary market, and I pay a commission on the transaction. ‫ق‬ Types The two types of corporate bonds are primary and secondary. ¥ Primary Bonds: Primary corporate bonds are new issues, similar to IPOs on the stock market. ¥ Secondary Bonds: Secondary corporate bonds create additional cash flow for existing companies. Further, corporate bonds maybe classified under the following categories: € High Yield or ‘Junk’ Bonds High-yield bonds, also known as junk bonds, are corporate bonds issued by companies whose credit quality is below investment grade. These bonds have a higher risk of default or other adverse credit events, but typically pay higher yields than better quality bonds in order to make them attractive to investors. The credit rating of a high yield bond is considered ‘speculative’ grade or below ‘investment grade’. High yield or ‘junk’ bonds get their name from their characteristics. Since most investors are restricted to investment grade bonds, speculative grade bonds have negative connotations and are not widely held in Invest - 90 - Invest- 55 Assets That Grow Savings and Earn Passive Income investment portfolios. Mainstream investors and investment dealers do not deal in these bonds. They are hence known as ‘junk’ since few people accept the risk of owning them. The ‘risk-adjusted’ returns for portfolios of junk bonds are quite high. This means that the credit risk of these bonds is more than compensated for by their higher yields, suggesting that the actual credit losses are exceeded by the higher interest payments. € CREDIT QUALITY: A measure of a bond issuer's ability to repay interest and principal in a timely manner. Many mutual funds have been established that invest exclusively in high yield bonds, which have continued to have high risk-adjusted returns. High yield bond investment relies on credit analysis. Credit analysis is very similar to equity analysis in that it concentrates on issuer fundamentals, and a ‘bottomup’ process. It is concentrated on the ‘downside’ risk of default and the individual characteristics of issuers. Portfolios of high yield bonds are diversified by industry group, and issue type. Due to the high minimum size of bond trades and the specialist credit knowledge required, most individual investors are best advised to invest through high yield mutual funds, and not directly. € Convertible Bonds ‫ق‬ Definition These are corporate bonds that can be converted into stock if certain provisions are met. A convertible bond gives the holder the right to ‘convert’ or exchange the par amount of the bond for common shares/stock of the issuer at some fixed ratio ‘conversion ratio’ during a particular period. ‫ق‬ Characteristics Their conversion feature gives them features of equity securities. Convertible bonds have a coupon payment and are legally debt securities, which rank prior to all equity securities in a default situation. Their value, like all bonds, depends on the level of prevailing interest rates and the credit quality of the issuer. The conversion ratio will vary from bond to bond, and company to company. I can find the terms of the convertible, such as the exact number of shares or the method of determining how many shares the bond is converted into, in the indenture. Occasionally, the indenture might have a provision that states the conversion ratio will change through the years, but this is rare. For example, a conversion ratio might give the holder the right to convert $100 par amount of the convertible bonds of Ensolvint Corporation into its common shares at $25 per share. This conversion ratio would be said to be ‘4:1’ or ‘four to one’. Convertibles typically offer a lower yield than regular bonds because there is the option to convert the shares into stock and collect the capital gain. However, Invest - 91 - Invest- 55 Assets That Grow Savings and Earn Passive Income should the company go bankrupt, convertibles are ranked the same as regular bonds, so I have a better chance of getting some of my money back than those people holding common stock. A convertible bond with an ‘exercise price’ far higher than the market price of the stock is called a ‘busted convertible’ and generally trades at its bond value, although the yield is usually a little higher due to its lower or ‘subordinate’ credit status. When the share price attached to the bond is sufficiently high or ‘in the money’, the convertible begins to trade more like equity. If the exercise price is much lower than the market price of the common shares, the holder of the convertible can convert into the stock attractively. For instance, if the exercise price is $25 and the stock is trading at $50, the holder can get 4 shares for $100 par amount that have a market value of $200. This would force the price of the convertible above the bond value and its market price should be above $200 since it would have a higher yield than the common shares. Issuers sell convertible bonds to provide a higher current yield to investors and equity capital upon conversion. Convertibles are an excellent choice for investors looking for capital appreciation, while still protecting their original investment in a bond. While CVs do provide some income, it is not very high. Investors give up higher returns on the bond in exchange for the option to convert into shares at a later date. Investors buy convertible bonds to gain a higher current yield and less downside, since the convertible should trade to it bond value in the case of a steep drop in the common share price. Investors traditionally use ‘breakeven’ analysis to compare the coupon payment of the convertible to the dividend yield of the common shares. Modern techniques of option analysis examine the convertible as a bond with an equity option attached and value it in this manner. One risk associated with convertibles is that most are callable. In other words, the company can force convertible bondholders to convert the bonds to common stock by calling the bonds. This is called ‘forced conversion‘. When investing in convertibles, remember that the CV is only as good as the underlying stock, and if the CV is offering a high premium, be very wary. ‫ق‬ How to Invest The most common method for buying stocks is to use a brokerage, either full service or discount. Convertible preferred stock trades on the stock market like regular shares. Invest - 92 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Advantages My original investment cannot go lower than the market value of the bond; it does not matter what the stock price does until I convert into stock. $ Convertibles can be purchased through tax-deferred retirement accounts. $ CVs gain popularity in times of uncertainty, when interest rates are high and stock prices are low. This is the best time to buy a convertible. ‫ق‬ Disadvantages € $ The return on the bond or preferred stock is usually quite low. $ ‘Forced conversion’ means the company can make me convert my bond into stock at virtually any time. Pay very close attention to the price at which the bonds are callable. Extendible Bonds vis-a-vis Retractable Bonds ‫ق‬ Definition Extendible and retractable bonds have more than one maturity date. An extendible bond gives its holder the right to extend the initial maturity to a longer maturity date. A retractable bond gives its holder the right to advance the return of principal to an earlier date than the original maturity. ‫ق‬ Characteristics Investors use extendible/retractable bonds to modify the term of their portfolio to take advantage of movements in interest rates. When interest rates are rising, extendible/retractable bonds act like bonds with their shorter terms. When interest rates fall, they act like bonds with their longer terms. Extendible/retractable bonds are created by issuers because they pay a lower interest rate on these bonds than would otherwise be case or they ‘sweeten’ the issue with this feature, making the issue easier to sell. Buyers are attracted to these bonds because the extension or retraction option is attractive to them. An extendible bond gives its holder the right to ‘extend’ its initial maturity at a specific date or dates. An investor purchases an extendible bond to have the ability to take advantage of potentially falling interest rates without assuming the risk of a long term bond. As interest rates fall, the price of a shorter term bond rises less than the price of a longer term bond. This means the extendible bond begins to behave or ‘trade’ as a longer term bond. On the other hand, if interest rates rose, the extendible bond would behave as a shorter term bond. The investor initially purchases a shorter term bond combined with the right to extend its term to a longer maturity date. Consider an investor that believes that interest rates will rise and bond prices will fall, but is not willing or able to sell out of bonds completely. This investor can buy a longer term retractable bond which behaves initially as a similar term long term bond. As interest rates rise the bond falls in price. Once its Invest - 93 - Invest- 55 Assets That Grow Savings and Earn Passive Income price is low enough, it will begin to behave as a short term bond and its price fall will be much less than a normal long term bond. At worst, the investor can retract it at the retraction date and receive the par amount back to reinvest. Pricing Extendible/Retractable Bonds: Usually, the extension or retraction feature means that the price of an extendible/retractable bond is higher and the interest rate lower than other similar term bonds. The motivation of the issuer is obvious, having to pay a lower interest rate than would otherwise be the case. The investor's motivation comes from the ‘defensive’ feature of these bonds. The investor gains the potential upside of a longer term bond with the price risk of a shorter term bond. Looking at it another way, the investor can lock in a longer term interest rate with the option to shorten at her discretion. If an investor constantly invested in these bonds, the net result would be a lower return due to the lower yield of these bonds compared to normal bonds of the same term. An investor unable to accept the price risk of longer term bonds would be better off in extendible/retractable bonds than with exclusively shorter term bonds, as this would generate a higher yield and reduce the income risk of the portfolio. Investors with an interest rate view but not willing to accept the risk of being ‘out of the market’ should use these bonds to protect their portfolios. Invest - 94 - Invest- 55 Assets That Grow Savings and Earn Passive Income € Inflation-Linked Bonds An inflation-linked bond is a bond that provides protection against inflation. Most inflation-linked bonds are principal indexed. This means their principal is increased by the change in inflation over a period. In most countries, the Consumer Price Index (CPI) or its equivalent is used as an inflation proxy. As the principal amount increases with inflation, the interest rate is applied to this increased amount. This causes the interest payment to increase over time. At maturity, the principal is repaid at the inflated amount. In this fashion, an investor has complete inflation protection, as long as the investor's inflation rate equals the CPI. By applying a ‘real’ interest rate or coupon to the principal amount, an inflation-linked bond protects the investor from unexpected changes in the CPI. Normally, bond investors demand an extra ‘yield premium’ or compensation for inflation risk. Since inflation-linked bonds are not exposed to inflation, their yield is lower than normal or nominal bonds. € Eurobonds A Eurobond is an international bond that is denominated in a foreign currency. It can be categorized according to the currency in which it is issued. It is issued and traded in countries other than the one in which the bond is denominated. This means that the bond uses a certain currency, but operates outside the jurisdiction of the central bank that issues that currency. It is important to note that the term has nothing to do with the euro, and the prefix ‘euro-’ is used more generally to refer to deposits outside the jurisdiction of the domestic central bank. A Eurobond is normally a bearer bond, payable to the bearer. It is also free of withholding tax. The bank will pay the holder of the coupon the interest payment due. Usually, no official records are kept. A Eurobond is a debt contract, which records the borrower’s obligation to pay interest at a given rate and the principal amount of the bond on specified dates. Eurobonds are popular with issuers and investors because they offer certain tax shelters and anonymity to their buyers. They also offer borrowers favorable interest rates and international exchange rates. The majority of Eurobonds are now owned in 'electronic' rather than physical form. The bonds are held and traded within one of the clearing systems (Euroclear and Clearstream being the most common). Coupons are paid electronically via the clearing systems to the holder of the Eurobond (or their nominee account). Conventional foreign bonds are much simpler than Eurobonds; generally, foreign bonds are simply issued by a company in one country for purchase in another. Invest - 95 - Invest- 55 Assets That Grow Savings and Earn Passive Income Eurobonds are issued by multinational corporations; for example, a British company may issue a Eurobond in Germany, denominating it in U.S. dollars. Usually a foreign bond is denominated in the currency of the intended market. Like many bonds, Eurobonds are usually fixed-rate, interest-bearing notes, although many are also offered with floating rates and other variations. Most pay an annual coupon and have maturities of three to seven years. They are also usually unsecured, meaning that if the issuer were to go bankrupt, Eurobond holders would normally not have the first claim to the defunct issuer's assets. However, the terms of many Eurobond issues are uniquely tailored to the issuers' and investors' needs and can vary in terms and form substantially. A large number of Eurobond transactions involve elaborate swap deals in which two or more parties may exchange payments on parallel or opposing debt issues to take advantage of arbitrage conditions or complementary financial advantages (e.g., cheaper access to capital in a particular currency or funds at a lower interest rate) that the various parties can offer one another. Trading: Eurobond is a treadable instrument: it is intended to be bought and sold during the period up to it maturity. It is usually launched through a public offering and is listed on a stock exchange. The London and Luxemburg stock exchanges are those most frequently used. Payments: It is important to notice that there is no central register where holders of the issue are named. So Eurobond is in this sense a bearer instrument: interests are paid upon presentation of detachable coupons, while the principal amount is repaid on presentation of the Eurobond itself. Taxation: Eurobonds are not subject to tax and largely free from government regulation. Invest - 96 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Foreign Currency Bonds ‫ق‬ Definition A ‘foreign currency’ bond is a bond that is issued by an issuer in a currency other than its national currency. Issuers make bond issues in foreign currencies to make them more attractive to buyers and to take advantage of international interest rate differentials. Foreign currency bonds can be ‘swapped’ or converted in the swap market into the home currency of the issuer. The ‘euromarket’ is another major source of foreign currency bond issues. European investors will buy the bonds of well known issuers like Ford, Toyota or General Electric or their international subsidiaries, in many different currencies depending on their currency views. This makes for a constant arbitrage between the foreign and domestic bond markets as investors seek to gain the best possible yield employing currency hedges and swaps. The large international swap banks like Citibank make markets buying and selling these swaps, which gives investors tremendous liquidity in these transactions. ‫ق‬ Characteristics Foreign currency bonds have a vocabulary all their own. Bonds issued in foreign currencies are given the names listed beside the currencies below: £ £ £ £ ‘Yankee Bonds’ for U.S. dollars; ‘Samurai Bonds’ for Japanese Yen; ‘Bulldog Bonds’ for British pounds; and ‘Kiwi Bonds’ for New Zealand dollars. A more recent innovation is bonds that are hybrids in currency terms, with their coupon and principal payments in different currencies. For example, some recent bonds have had their coupon payments in Yen with their principal amounts in Canadian dollars. This satisfies the needs of Japanese institutional investors for yen income while keeping the eventual return of principal in the national currency of the issuer. Foreign currency bonds have a much different risk and return profile than domestic bonds. Not only is their price affected by movements in a foreign country's interest rate, they also change in value depending on the foreign exchange rates. This exchange rate movement would result in price changes which completely overwhelms the coupon income of a bond. Studies have shown that the longer term risk and return characteristics of foreign bonds in domestic currencies are closer to domestic equity returns than domestic fixed income returns. Invest - 97 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Advantages ¥ Less Security: Corporate bonds are not backed by anyone except the corporation; there is no recourse if the company goes out of business. ¥ Often Convertible to Stock: Corporate bonds can be converted into common stock of the company; this removes the interest, but allows them to be sold at the market value of the stock. ¥ Profit as Interest Rates Drop: As interest rates fall, new bonds are issued with lower coupon rates since there is not as much need to be competitive. When this happens, high interest bonds can be sold for a profit. ¥ Higher Coupon Rate: Corporate bonds generally pay higher coupon rates than government bonds because there is more risk associated with them. ¥ Corporate bonds are good sources of fixed income. If my goal is to have a certain level of income every month, corporate bonds may be a good addition to my portfolio. ¥ Corporate bonds offer a slightly higher yield because they carry a higher default risk than government bonds. Corporate bonds are not the greatest for capital appreciation, but they do offer an excellent source of income, especially for retirees. Corporate bonds are also highly useful for tax-deferred retirement savings accounts, which allow me to avoid taxes on the semiannual interest payments. ¥ Many corporate bonds offer a higher rate of return than government bonds, for only slightly more risk. ¥ The risk of losing my principal is very low if I only buy bonds in wellestablished companies with a good track record. This may take a bit of research. ‫ق‬ ‫ق‬ Disadvantages ¥ Possible Loss When Sold: If interest rates have gone up since the bond was purchased, or if the company has become less stable, losses could occur if the bond was sold. ¥ Return: When I purchase a corporate bond, the term and interest rate is specified such as 10 years at 6 percent. However, if I sell the bond prior to maturity, I risk losing money, depending on market conditions. ¥ Ethical Concerns: If money is lent to a company in the form of a bond, it may do things with the money that are objectionable to investors, either morally or ethically. ¥ Oversight: Since corporate bonds are not publicly traded, researching them is more difficult than researching stocks. ¥ The higher the risk, the higher the return if the company is successful. However, I equally risk the company defaulting, so due diligence is needed. ¥ The risks associated with corporate bonds depend entirely on the issuing company. Purchasing bonds from well-established and Invest - 98 - Invest- 55 Assets That Grow Savings and Earn Passive Income profitable companies is much less risky than purchasing bonds from firms in financial trouble. Bonds from extremely unstable companies are called junk bonds and are very risky because they have a high risk of default. ¥ Fixed interest payments are taxed at the same rate as income. ¥ Corporate bonds offer little protection against inflation because the interest payments are usually a fixed amount until maturity. ‫ق‬ How to Invest Corporate bonds can be bought through a full service or discount broker, a commercial bank or other financial intermediaries. The best time to buy a corporate bond is when interest rates are relatively high. Some banks may actually waive fees or commissions on the sales of such bonds if I meet certain criteria as a customer, such as maintaining a specific minimum balance in a savings or money market account. This should give me a financial advantage over dealing with a bond broker. Traditional broker charge higher commissions and fees. I can use a discount broker and pay substantially less commissions. I should determine which type of bond is best for my needs. For instance, a short-term bond may mature in 3 years or less, and may fit in better with my financial plan. Buying a long-term corporate bond increases the risk involved, since many things can happen to a company over a longer period of time, such as corporate takeovers, mergers and bankruptcies. ¥ Buy from an online trading company: I can also purchase corporate bonds from an online trading company, such as eTrade.com. While this is an easy and convenient way to deal with all types of securities, I may not receive the same level of service and advice as with more conventional services, and I will still pay fees and commissions. ¥ Buy from a Mutual Fund: I can buy Corporate Bonds for income by investing in Corporate Bonds Mutual Funds. Many of the major mutual funds company have corporate bond funds for investment. Investing this way should reduce my financial risk and give me a reasonable interest income. Buy directly from the company: I can buy Corporate Bonds for income directly from the corporation I am interested, through the Investors Relations department. Corporations usually have more than one type of bonds outstanding with different interest rates and maturities dates. I will have to make the selections. This is another way to circumvent the paying of fees and commissions, although I may receive a biased view of the performance of the bond. But I must do homework before contacting the company, and find out the specific bond rating from an impartial source, such as my bank. 401(K) Plan: A type of qualified retirement plan in which employees make salary-reduced, pre-tax contributions to an employee Invest - 99 - Invest- 55 Assets That Grow Savings and Earn Passive Income trust. In many cases, the employer will match employee contributions up to a specified level. Accredited Investor : Rule 501 of the SEC regulations defines an individual accredited investor as: “Any natural person whose individual net worth or joint net worth with that person’s spouse at the time of his purchase exceeds $1,000,000”; OR “Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.” For the complete definition of “accredited investor,” see the SEC web site. ACRS : Accelerated Cost Recovery System. The approved method of calculating depreciation expense for tax purposes. Also known as Accelerated Depreciation. Advisory Board : A group of external advisors to a private equity group or portfolio company. Advice provided varies from overall strategy to portfolio valuation. Less formal than a Board of Directors. Allocation: The amount of securities assigned to an investor, broker, or underwriter in an offering. An allocation can be equal to or less than the amount indicated by the investor during the subscription process, depending on market demand for the securities. Amortization: An accounting procedure that gradually reduces the book value of an intangible asset through periodic charges to income through depreciation, and or payment of interest on loans. A M T: Alternative Minimum Tax. A tax designed to prevent wealthy investors from using tax shelters to avoid income tax. The calculation of the AMT takes into account tax-preference items. Balance Sheet: A condensed financial statement showing the nature and amount of a company’s assets, liabilities, and capital on a given date. Bankruptcy: An inability to pay debts. Chapter 11 of the bankruptcy code deals with reorganization, which allows the debtor to remain in business and negotiate for a restructuring of debt. Bear Hug: An offer made directly to the Board of Directors of a target company. Usually made to increase the pressure on the target with the threat that a tender offer may follow. Best Efforts: An offering in which the investment banker agrees to distribute as much of the offering as possible and return any unsold shares to the issuer. Invest - 100 - Invest- 55 Assets That Grow Savings and Earn Passive Income Blue Sky Laws: A common term that refers to laws passed by various states to protect the public against securities fraud. The term originated when a judge ruled that a stock had as much value as a patch of blue sky. Book Value: Book value of a stock is determined from a company’s balance sheet by adding all current and fixed assets and then deducting all debts, other liabilities, and the liquidation price of any preferred issues. The sum arrived at is divided by the number of common shares outstanding, and the result is book value per common share. The difference between the book value and actual share price is the profit/loss, and hence, gain/loss to shareholder. Invest - 101 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Government Bonds/Treasuries, Treasury Bills ‫ق‬ Definition Also known as ‘government securities‘, or ‘treasuries’, government bonds are a debt obligation of a national government. Government bonds are called Treasuries because they are sold by the Treasury Department in order to fund the operations of the government. ‫ق‬ Characteristics A government bond is a bond issued by a national government denominated in the country's own currency. Governments issue bonds to try and influence the economy by injecting new funds into the market or to pay off other government debts that have come due. These bonds are offered in sets, a certain amount at a time. They are backed by the government's guarantee, so they tend to depend less on the economy than their corporate counterparts. Because they are backed by the credit and taxing power of a country, they are regarded as having little or no risk of default. Treasuries include short-term Treasury bills (T-bills), medium-term Treasury notes and long-term Treasury bonds (T-bonds). Treasuries are mainly used as safe havens for investors, especially when the markets head south. The fact that these debt instruments offer very little risk of default means the interest rate investors receive is relatively low. The price of treasuries rises as interest rates fall, and the opposite is true when interest rates rise. Therefore, the best time to buy treasuries is when interest rates are relatively high. The following institutions issue government bonds: £ Supranational Agencies: A supranational agency, such as the World Bank, levies assessments or fees against its member governments. Ultimately, it is this support and the taxation power of the underlying national governments that allow these organizations to make payments on their debts. £ National Governments: The ‘central’ or national governments also have the power to print money to pay their debts, as they control the money supply and currency of their countries. This is why most investors consider the national governments of most modern industrial countries to be almost ‘risk-free’ from a default point of view. Invest - 102 - Invest- 55 Assets That Grow Savings and Earn Passive Income £ £ ‫ق‬ Municipal and Regional Governments: cities, towns, counties and regional municipalities issue bonds supported by their property taxes. School boards also issue bonds, supported by their ability to levy a portion of property taxes for education. Quasi-Government Issuers: Most government related institutions issue bonds, some supported by the revenues of the specific institution and some guaranteed by a government sponsor. Types Treasuries come in a variety of different ‘maturities,’ or lengths of time until maturity, ranging from three months to 30 years. Various types of Treasuries include Treasury notes, Treasury bills, Treasury bonds, and inflation-indexed notes. These all vary based on maturity and amount of interest paid. Treasuries are guaranteed by the government and are free of state and local taxes on the interest they pay. € Treasury Bills (T-Bills) T-Bills are short-term debt obligation backed by the government with a maturity of less than one year. Treasury Bills (T-bills) are the most marketable money market security. Their popularity is mainly due to their simplicity. Essentially, T-bills are a way for the government to raise money from the public. T-bills commonly have maturities of one month, three-month, six-month and oneyear. T-Bills are typically sold at a discount from the par amount (face value); then when they mature, the government pays the holder the full par value; which means that rather than paying fixed interest payments like conventional bonds, the appreciation of the bond provides the return to the holder. T-bills do not pay a fixed interest rate. This also differs from coupon bonds, which pay interest semi-annually. The difference between the purchase price and face value is interest. It is possible for a bill auction to result in a price equal to par, which means that Treasury will issue and redeem the securities at par value. Investing in T-bills can be done by both individuals and various types of entities including trusts, estates, corporations, partnerships, etc. € Treasury Notes A marketable, fixed-interest rate government debt security with a maturity between one and 10 years. € Treasury Bonds A marketable, fixed-interest government debt security with a maturity of more than 10 years. Treasury bonds are usually issued with a minimum denomination of $1,000. Treasury bonds are popular investments for both individual and institutional investors. Invest - 103 - Invest- 55 Assets That Grow Savings and Earn Passive Income € Sovereign Bonds Sovereign bonds are bonds issued by national governments in foreign currencies. The bonds issued by national governments in the country's own currency are referred to as government bonds. The total amount owed to the holders of the sovereign bonds is called sovereign debt. Nations with very high or unpredictable inflation or with unstable exchange rates often find it uneconomic to issue bonds in their own currencies and so are forced to issue bonds denominated in more stable foreign currencies. Because of the risk of default, investors require the bonds to be issued with a higher yield. This makes the debt more expensive to service, increasing risk of default. In the event of default, unlike a corporation or even a municipal subdivision, a nation cannot file for bankruptcy. But on the rare occasions that a default occurs, just as in defaults on corporate bonds, recent practice has been that the defaulting borrower presents an exchange offer to its bond holders in an effort to restructure the sovereign debt. However, getting the bond holders to accept an exchange offer has become very difficult, something caused by the holdout problem. HOLDOUT PROBLEM occurs when a bond issuer is in default or nears default, and launches an exchange offer in an attempt to restructure debt held by existing bond holders. Such exchange offers typically require the consent of holders of some minimum portion of the total outstanding debt, often in excess of 90%, because, unless the terms of the bond provide otherwise, non-consenting bondholders will retain their legal right to demand repayment of their bonds at par (the full face amount). Bondholders, who withhold their consent and retain their right to seek the full repayment of original bonds, may disrupt the restructuring process, creating a situation known as the holdout problem. SOVEREIGN DEBT: A debt obligation of any government, including political sub-divisions, local authorities, government agencies, government-owned, controlled sponsored or guaranteed corporations and supra-nationals. € Zero Coupon or ‘Strip’ Bonds ‫ق‬ Definition A zero-coupon security, or ‘stripped bond’, is basically a regular coupon-paying bond without the coupons. Zero coupon or strip bonds are created from the cash flows that make up a normal bond. ‫ق‬ Characteristics The process of ‘stripping’ or ‘zeroing’ a bond is usually done by a brokerage or a bank. The bank or broker stripping the bonds then registers and trades these zeros as individual securities. This type of bond makes no coupon payments but instead is issued at a considerable discount to par value. Invest - 104 - Invest- 55 Assets That Grow Savings and Earn Passive Income Once the bonds are stripped, there are two parts: the principal and the coupons. The interest payments are known as ‘coupons’, and the final payment at maturity is known as the ‘residual’ since it is what is left over after the coupons are stripped off. Both coupons and residuals are bundled and referred to as zero-coupon bonds or ‘zeros’. The cash flows of a normal bond consist of the regular interest or ‘coupon’ payments, which take place over the term of the bond, and the principal repayment that occurs at maturity of the bond. The process of ‘stripping’ a bond involves depositing bonds with a trustee and having the trustee separate the bond into its individual payment components. This allows the components to be registered and traded as individual securities. The interest payments are known as ‘coupons’ after their source of cash flow, and the final payment at maturity is known as the ‘residual’ since it is what is left over after the coupons are stripped off. Both coupons and residuals are known as ‘zero coupon’ bonds or ‘zeros’. Once a bond has been stripped, a trustee directs the appropriate amount of the interest or maturity payment to the security holders. The holder of a zero coupon receives the par amount of the particular term of the zero that she holds. The investor pays something up front in exchange for a promise to receive a given amount on the maturity date. The longer the time to maturity, the cheaper I can buy the bond for. This predictability also makes zeros popular - when I buy the security, the yield is essentially locked in. The yield of a zero coupon bond is different than the yield of a normal bond of the same issuer. This difference of ‘spread’ reflects the economics or profits available to investment dealers from ‘stripping’ activities and the supply and demand for zero coupon bonds. There is also a difference in yield between coupons and residuals which reflects the larger size of residuals and the economies of trading compared to many smaller coupon positions or ‘lines’. The basic objective of a zero-coupon security is ‘buy low, sell high’. I purchase the bond for a sum of money, and once it reaches maturity I will be paid an even larger sum of money. When interest rates are low, the price of the zero will be higher. The best time to buy a zero is when interest rates are high because the bond will be at a deeper discount. The one major problem with zeros is that the annual accumulated return is actually considered to be income, and while I do not actually collect that interest until the bond reaches maturity, I still have to pay income tax on it. In other words, the gains on a zero are not treated as capital gains, instead they are considered to be interest. Invest - 105 - Invest- 55 Assets That Grow Savings and Earn Passive Income € ‫ق‬ Treasury Inflation Protected Securities (TIPS) Definition TIPS (Treasury Inflation Protected Securities) are a special type of bond sold to individual investors with built in inflation protection mechanisms. They are also called Inflation-Indexed Bonds, Inflation-Linked Bonds or colloquially as Linkers. The principal is indexed to inflation thus designed to cut out the inflation risk of an investment. ‫ق‬ Characteristics of TIPS Returns: Inflation-indexed bonds pay a periodic coupon that is equal to the product of the inflation index and the nominal coupon rate. Liquidity: They are the most liquid instruments amongst treasuries. Stability: TIPS are officially backed by the government; in other words, if I buy TIPS I am essentially lending money to the government and they pay me interest. The government has a huge amount of income and the ability to print money if necessary to service its debt, meaning it is highly unlikely that the government will ever be unable to pay interest and repay principal on bonds like TIPS. While the interest rate earned on bonds is typically lower than could potentially be earned in more risky investments, the return on the investment is essentially guaranteed. This can make TIPS especially attractive to older investors nearing retirement who cannot afford to take risks and absorb short-term losses in the hopes of long-term gains. Inflation Protection: Another key advantage of TIPS is that the principle invested is protected against inflation. TIPS were created for investors wanting to avoid the negative effects of inflation. The price and coupon rate of TIPS is adjusted each year to compensate for inflation. The principle invested in TIPS is adjusted based on changes in the Consumer Price Index (CPI), which is a common measure of inflation based on the prices of a variety of consumer goods. If the CPI rises, the principle in TIPS increases, while if the CPI falls, the principle will decrease. The amount of interest earned by TIPS will increase with inflation, since interest will be paid on a larger amount of principle. TIPS also have a built in deflation protection mechanism: at the maturity date for TIPS I will be paid the greater of the current principle value of the security or the original principle value. Predictable Interest Payments: TIPS pay investors interest twice a year at a fixed interest rate. Unlike some debt securities and financial instruments which have variable interest rates, the fixed rate of TIPS means that investors can count on a certain amount of income to be paid every six months. This can be important for investors living on a fixed income. Risks: Although government bonds are safe, income-producing investments, they are not entirely risk-free. Usually the biggest concern for investors is interest rate risk. When I purchase a government bond I accept the possibility that interest rates may go up, leaving me with the choice of earning below market Invest - 106 - Invest- 55 Assets That Grow Savings and Earn Passive Income rates or selling the bond at a loss. Government bonds are usually referred to as risk-free bonds, because the government can raise taxes to redeem the bond at maturity. Many governments issue inflation-indexed bonds, which should protect investors against inflation risk. Tax Considerations: Government bonds typically have lower yields than corporate bonds. An investor should compare the after-tax return, not just the pre-tax yield. Investors in high tax brackets get the most benefit from tax exemptions on government bonds. Tax shelters may negate the tax advantages. Safety: Government bonds are intrinsically safer than corporate bonds. They offer the stability and creditworthiness of the government, compared to the uncertainty of businesses which can fail more easily. The only caveat is that bonds offered by unstable governments may not be secure, so well established corporate bonds are preferred to these. Availability: The government borrows money by issuing bonds of various types. Most are sold to institutions at regular auctions, but some are sold to individuals directly through the Treasury Department. State and local governments also issue bonds (collectively called municipal bonds). Although government bonds usually have lower yields than corporate bonds, they are popular with investors because they are low-risk and most have tax advantages. Availability: Government bonds tend to be more available to individual consumers than corporate bonds. These bonds are sold directly through regular government auctions that all investors can participate in. ‫ق‬ Types The inflation-linked market primarily consists of sovereign bonds, with privately issued inflation-linked bonds constituting a small portion of the market. ‫ق‬ Disadvantages Low Return: The trade-off for the safety of Treasury bonds is their lower interest rate compared with other investment-grade debt securities. Taxable Income: The interest paid on government bonds is included in an investor's income for central government income tax purposes. Treasury bond interest is exempt from state income taxes but is still taxable at the central government level. Coupled with the low interest rates, the taxes make it difficult for government bond investments to keep up with the rate of inflation. Prices Can Fall: Government bonds are marketable debt securities. Once a bond is issued, the amount of annual interest it pays is fixed. The bond market adjusts for changing interest rates by changing the market price of bonds. Increasing interest rates will cause bond prices to fall. Longer-term bonds will have a greater market price change than short-term bonds. Investors who Invest - 107 - Invest- 55 Assets That Grow Savings and Earn Passive Income want to sell the government bonds to reinvest the proceeds at higher rates will suffer a loss of principal on the sale. Political Risk: The payment of principal and interest on Treasury bonds is subject to political risk. It is possible that national parliaments could decide to stop or reduce the payment of interest on outstanding government bonds. No market expert believes that this outcome is probable. However, the Treasury does issue 30-year bonds, and a lot could happen in such a long time frame. Broker Markup: Investors who buy government bonds through a bond dealer or broker receive the yield and price the broker offers. Bond dealers and brokers buy bonds on the open market and add a markup to the bond price for their profit margin. The bond markup reduces the yield to the investor. Bond investors who buy smaller amounts of government bonds will have a greater percentage markup and greater reduction of yield. Investors who want to sell their government bonds will also receive a price lower than the current secondary market price, providing additional margin to the dealer. If the company issuing the zero goes bankrupt or defaults, then I have everything to lose. Whereas, with a regular coupon bond, I may have at least gotten some interest payments out of the investment. ‫ق‬ Advantages Safety: Treasury bonds are considered to be one of the safest investments in the world. Treasury debt interest and principal payments are backed by the full faith and taxing power of the government. Treasuries are considered to be almost risk free. Their low risk makes it fairly easy to borrow against the bonds. Security: These bonds are either tax exempt or 100% secured by the government and as such, my investment is guaranteed to earn high returns at low risk. Liquidity: Government bonds are very liquid investments, meaning that a person can easily buy and sell government bonds. The Treasury market is the most liquid financial market in the world. Treasury bonds have active primary and secondary markets. This means investors can buy and sell Treasury bonds quickly and at market prices. Less liquid securities than Treasuries will take longer to sell or the investor may have to take a lower price to sell a bond quickly. This is not a problem with the selling of Treasury bonds. The reason for this is that government securities are sold worldwide in markets that sell previously issued securities (stocks and bonds) 24 hours a day. The treasury market is among the most active, thus lack of liquidity is not a concern. Coupon Payments: Government bonds pay interest payments, which are called coupon payments, twice a year. The amount of interest paid on a bond is the coupon rate, which is stated when the bond is sold. The coupon rate is the Invest - 108 - Invest- 55 Assets That Grow Savings and Earn Passive Income yearly interest rate. The government must pay this stated rate of interest every year until the bond matures. Reinvestment: When government bonds mature, a person can choose not to redeem their bonds. Instead a person can reinvest in bonds of the same type and term. To do this, a person can request that the bond be reinvested before it matures. Non-Callable: The majority of corporate and municipal bonds are callable after a period of time. This means if interest rates fall, an issuer can call in their high rate bonds and issue new bonds at lower interest rates. Owners of high yield, non-callable Treasury bonds can hold on to them until maturity and continue to collect the high interest payments. Electronic Bookkeeping: The buying, selling, trading and owning of Treasury bonds is all done electronically. The Treasury Department keeps electronic records of bond ownership and sales. This means an investor's bonds cannot be lost or stolen. They are easily sold if the investor wants to cash out. Electronic bond bookkeeping also means the interest payments are credited directly to the owner's bank or investment account. No State Income Taxes: The interest from Treasury bonds is exempt from state income tax. This tax feature gives Treasuries an advantage over other highquality debt investments. Discounts: Zeros can be bought at huge discounts. The only downside to T-bills is that I will not get a great return because Treasuries are exceptionally safe. Corporate bonds, certificates of deposit and money market funds will often give higher rates of interest. What's more, I might not get back all of my investment if I cash out before the maturity date. ‫ق‬ How to Invest The Treasury has auctions for new Treasury debt every week and Treasury bonds are actively traded on the secondary market. Treasuries can be bought through various discount and full service brokers. Bond brokers also allow me to buy and sell treasuries. Perhaps the best way for individuals to Invest in treasuries is through the ‘Treasury Direct‘ program, which provides transactions for little or no fees. The biggest reason that T-Bills are so popular is that they are one of the few money market instruments that are affordable to the individual investors. If I want to buy a T-bill, I submit a bid that is prepared either non-competitively or competitively. In non-competitive bidding, I will receive the full amount of the security I want at the return determined at the auction. With competitive bidding, I have to specify the return that I would like to receive. If the return I specify is too high, I might not receive any securities, or may receive just a portion of what I bid for. Invest - 109 - Invest- 55 Assets That Grow Savings and Earn Passive Income Zero-coupon securities can be bought through most full service or discount brokers, commercial banks, and some other financial intermediaries. Invest - 110 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Assets Backed Securities & Mortgage Backed Securities ABS/MBS When I invest in Mortgage Backed Securities (MBS) and Asset Backed Securities (ABS), I am purchasing an interest in pools of loans or other financial assets. As the underlying loans are paid off by the borrowers, the investors in MBS and ABS receive payments of interest and principal over time. These securities help make credit available to more people by giving lenders access to large pools of capital as well as help them manage their risk. € Mortgage-Backed Securities (MBS) ‫ق‬ Definition A mortgage-backed security (MBS) is a security that is based on a pool of underlying mortgages. MBS are usually based on mortgages that are guaranteed by a government agency for payment of principal and a guarantee of timely payment. ‫ق‬ Characteristics The largest sector of the MBS market is the ‘agency’ securities market. Agency securities are issued by a government agency or a government-sponsored enterprise. These agencies typically guarantee the interest and principal payments on their securities and are considered to offer strong credit quality due to their explicit government backing. The mortgage-backed securities market also includes ‘private-label’ mortgage securities issued by subsidiaries of banks, financial institutions and home builders, but this market is smaller than the Agency MBS market. By grouping a large number of mortgages together in a ‘pool’, the uniqueness of each mortgage is submerged in the whole. Let me take 500 mortgages at $200,000. This gives me a pool of $100 million of mortgages. Arrangements are made such that the ‘servicing agent’ collects the mortgage payments and gives them to ‘central paying agent’ who, in turn, ‘passes through’ the payments to the final investor. I now have something that looks very much like a bond. Mortgage insurance guarantees the principal of a mortgage against default by the borrower. This process provides investors with a ‘commoditized’ credit risk. The large mortgage insurers in are government or quasi-government agencies. These agencies use the credit standing of their respective national governments to guarantee mortgage loans. Investors could then view the credit risk on the principal amount as equivalent to the credit risk of government bond. This guarantee of principal and timely payment means that the credit risk is removed from the equation. With a defaulted mortgage, the payments would be kept up until the principal amount is repaid by the guarantor. The removal of credit risk does not mean that MBS are without risk. There is a major risk inherent in the cash flows called ‘prepayment risk’. Invest - 111 - Invest- 55 Assets That Grow Savings and Earn Passive Income Mortgage-backed securities are an undiscovered gem. While these securities are primarily used to provide safe income, there is also the opportunity to get some capital appreciation as interest rates fall. Another advantage to MBSs is that they are very suitable for most tax-deferred savings accounts. Generally, MBSs are traded actively, much like bonds are, so there is very little liquidity risk. Furthermore, they are considered an extremely safe investment, often said to have the same credit worthiness as treasuries but with a return that is 1-2% greater. Monthly income from MBSs can vary as interest rates change because mortgages can be prepaid, and when interest rates are falling, prepayments tend to rise. Prepayments only shorten the life of the MBS and are passed directly to the investors. ‫ق‬ Advantages £ Very low-risk investment that offers a return that is 1-2% higher than comparable low-risk securities. £ Most MBSs are either fully backed or sponsored by the government. ‫ق‬ Disadvantages £ Minimum investment can be fairly high. £ Outside of a retirement account, there are virtually no tax advantages to owning an MBS. The income from an MBS is taxed as regular income. ‫ق‬ How to Invest Mortgage-backed securities can be purchased at almost any full-service broker. More and more discount brokers are offering MBSs as well. These securities do not come cheap – they are sold in chunks of huge denominations. € Asset-Backed Securities (ABS) ‫ق‬ Definition Asset-backed securities (ABS) are bonds that are based on underlying pools of assets. A special purpose trust or instrument is set up which takes title to the assets and the cash flows are ‘passed through’ to the investors in the form of an asset-backed security. The types of assets that can be ‘securitized’ range from residential mortgages to credit card receivables. With asset-backed securities, the assets might be credit card receivables, auto loans and leases or home equity loans. Asset-backed securities (ABS) often carry some form of credit enhancement, such as bond insurance, to make them attractive to investors. ‫ق‬ Characteristics All asset-backed securities are securities based on pools of underlying assets. These assets are usually illiquid and private in nature. A securitization occurs to make these assets available for investment to a much broader range of Invest - 112 - Invest- 55 Assets That Grow Savings and Earn Passive Income investors. The ‘pooling’ of assets occurs to make the securitization large enough to be economical and to diversify the qualities of the underlying assets. Administration of the pool of mortgages is more systematic as well. I can have the same ‘servicing agent’ collect all the monies from all the mortgages and ‘pass it through’ to the investors via a central trustee. I can have the payments made to the investors at the same date each month. I can even supply aggregate data and statistics on the pool to investors, such as the ‘Weighted Average Coupon’ (WAC), or ‘Remaining Amortization’ (RAM). One can now see that this unruly mass of mortgages is starting to look pretty much like a bond to an investor. One payment from one source, once a month. Combined with a ‘book-based’ custody system, I have now made a source of cash flows that ‘walks and talks like a bond’. Not bad for something that used to be a lump of unique assets. ‫ق‬ Advantages The wonder of securization is that it takes a wide variety of formerly illiquid and directly held assets and makes them available to many investors in the form of asset-backed securities. This simple process can be applied to all sorts of cash flow producing assets. If a retailer needs cash, it securitizes part of its outstanding credit card balances from its customers into a ‘credit card receivables trust’. Invest - 113 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Money Market Investment/Cash Market Instruments ‫ق‬ Definition Money market investments are fixed-income, short-term maturity instruments. Money market investments are also called cash investments because of their short maturities. In other words, money market instruments are forms of debt that mature in less than one year and are very liquid. ‫ق‬ Characteristics Generally producing lower but more secure returns, cash investments are a foundational link in the investment chain. Cash investments are excellent for investors looking to make guaranteed but modest returns with little risk to their initial capital. Whenever a bear market comes along, investors realize (yet again!) that the stock market is a risky place for their savings. It is a fact we tend to forget while enjoying the returns of a bull market! Unfortunately, this is part of the riskreturn tradeoff. To get higher returns, I have to take on a higher level of risk. For many investors, a volatile market is too much to stomach - the money market offers an alternative to these higher-risk investments. The difference between the money market and the bond or equity market is that the money market specializes in very short-term debt securities (debt that matures in less than one year). Money markets are the closest thing to cash I will find in the investment world. Very liquid and very little fluctuation makes for a safe and dependable investment appropriate for funds I may need on the spur of the moment or in emergencies. These instruments are very liquid and considered extraordinarily safe. Because they are extremely conservative, money market securities offer significantly lower returns than most other securities. Institutional investors have used the money market as a safe haven for quite some time. The emergence of money market mutual funds has allowed individual investors to take part in the money market's rates of return, which are higher than those of a savings account or other low-risk investments. The performance of a money market fund depends heavily on the interest rate situation; the best time to put my money in money market funds is when interest rates are peaking. ‫ق‬ Advantages Invest - 114 - Invest- 55 Assets That Grow Savings and Earn Passive Income £ £ £ ‫ق‬ Disadvantages £ £ £ ‫ق‬ Gains on money market funds are usually tax exempt because they invest mainly in government securities. However, any dividends are taxable. Because they are a good low-risk investment, money market funds are widely used defensive investments when the stock markets are declining. Money market funds are low-risk investments because they invest in short-term government treasuries such as T-bills and in highly regarded corporations. Although returns on a money market fund are higher than those on a savings account, they are still much lower than returns on equities or bonds. Some money market securities are very costly (easily in the $100,000 range), which makes it difficult for individual investors to purchase them. They are not covered by the same securities insurance that covers bank accounts, although some funds pursue insurance through private companies. Types There are several different instruments in the money market, offering different returns and different risks, as below. Invest - 115 - Invest- 55 Assets That Grow Savings and Earn Passive Income $ Eurodollars ‫ق‬ Definition Eurodollars are U.S.-dollar denominated deposits at banks outside of the United States. ‫ق‬ Types A variation on the Eurodollar time deposit is the Eurodollar certificate of deposit. A Eurodollar CD is basically the same as a domestic CD, except that it is the liability of a non-national. ‫ق‬ Characteristics Liquidity: Because Eurodollar CDs are typically less liquid, they tend to offer higher yields. Trading: Contrary to the name, Eurodollars have very little to do with the euro or European countries. This market evolved in Europe (specifically London), hence the name, but Eurodollars can be held anywhere outside the United States. Regulation: The Eurodollar market is relatively free of regulation; therefore, banks can operate on narrower margins. As a result, the Eurodollar market has expanded largely as a way of circumventing regulatory costs. ‫ق‬ How to Buy or Sell The average Eurodollar deposit is very large (in the millions) and has a maturity of less than six months. The Eurodollar market is obviously out of reach for all but the largest institutions. The only way for individuals to invest in this market is indirectly through a money market fund. Not many brokers offer the ability to buy money market securities because money market securities trade in very high denominations, giving the average investor limited access to them. This is why the money market is better known as a place for large institutions and government to manage their shortterm cash needs. Money market securities are essentially IOUs issued by governments, financial institutions and large corporations. Furthermore, the money market is a dealer market, which means that firms buy and sell securities in their own accounts, at their own risk, due to the lack of a central trading floor or exchange. Deals are transacted over the phone or through electronic systems, as contrasted with the stock market where a Invest - 116 - Invest- 55 Assets That Grow Savings and Earn Passive Income broker receives commission to acts as an agent, while the investor takes the risk of holding the stock. The easiest way for retail investors to gain access is through money market mutual funds or a money market bank account. These accounts and funds pool together the assets of thousands of investors to buy money market securities on their behalf. These accounts generally earn higher interest than savings accounts. They are very safe and provide easy access to my money. They are also insured by the government. They offer many of the services that checking accounts offer, however, a limit is normally placed on the number of withdrawals or transfers I can make during a given period of time. $ Guaranteed Investment Contracts Within many employer-sponsored retirement accounts, guaranteed investment contracts (GICs) are an option. GICs are fixed-interest-bearing contracts generally issued by insurance companies. Since they are purchased through retirement plans, they are, in essence, a contract between the employer and the issuing company. The issuing company accepts funds for investment for a specific period of time during which the money will earn a guaranteed interest rate or rates, and guarantees both the GIC’s principal and interest for the specified time period. The participating employee may then elect to invest all or some of their money in the plan’s fixed-interest account, to the extent that the plan allows. It is through the GIC that the plan provides for the fixed-interest account. The employee’s money may stay in this account for as long as the employee wishes, or for as long as the GIC lasts. Typically, GICs have maturation periods of three to five years. At maturity, the employer and issuing company may enter into a new GIC. This new GIC may have a different interest rate, given the current interest rates and market conditions. Representative current GIC interest rates for certain amounts and time periods may be found in the financial pages of some publications. GICs are backed by the issuing company. Therefore, when considering investing my money through a GIC, I should take a look at the financial soundness of the issuer. There are state guaranty funds that cover insurance companies, but there is no government insurance covering GICs that would be comparable to the FDIC’s insuring bank deposits. While they are not as safe as federal insurance protection, your principal will remain safe even when interest rates rise, barring default by the issuing company. Invest - 117 - Invest- 55 Assets That Grow Savings and Earn Passive Income $ Repos ‫ق‬ Definition Repo is short for repurchase agreement. Repos are a form of short term borrowing in the bank, from overnight to 30 days. ‫ق‬ Characteristics Those who deal in government securities use repos as a form of overnight borrowing. A dealer or other holder of government securities (usually T-bills) sells the securities to a lender and agrees to repurchase them at an agreed future date at an agreed price. They are usually very short-term, from overnight to 30 days, more or less. This short-term maturity and government backing means repos provide lenders with extremely low risk. Repos are popular because they can virtually eliminate credit problems. However, there can be loses if lenders in this market do not check their collateralization closely enough. ‫ق‬ Types of Repos There are also variations on standard repos: € Reverse Repo - The reverse repo is the complete opposite of a repo. In this case, a dealer buys government securities from an investor and then sells them back at a later date for a higher price € Term Repo - exactly the same as a repo except the term of the loan is greater than 30 days. ‫ق‬ How to Buy or Sell Repos are bought at the bank, or through brokers. Invest - 118 - Invest- 55 Assets That Grow Savings and Earn Passive Income $ Certificate of Deposit (CD) ‫ق‬ Definition A certificate of deposit or CD is a time deposit, a financial product commonly offered to consumers by banks, thrift institutions, and credit unions for investment. Certificate of Deposit is savings certificate entitling the bearer to receive interest. ‫ق‬ Characteristics Fixed Interest: A CD bears a maturity date, a specified fixed interest rate and can be issued in any denomination. CDs are generally issued by commercial banks and are insured. Period: The term of a CD generally ranges from one month to five years. Although it is still possible to withdraw the money, this action will often incur a penalty. CDs of less than $100,000 are called ‘small CDs’; CDs for more than $100,000 are called ‘large CDs’ or ‘jumbo CDs’. Almost all large CDs, as well as some small CDs, are negotiable. CDs are similar to savings accounts in that they are insured and thus virtually risk-free; they are ‘money in the bank’. Investment accounts: CDs are investment accounts established by financial institutions such as banks for investment needs of individuals. In exchange for keeping the money on deposit for the agreed-on term, institutions usually grant higher interest rates than they do on accounts from which money may be withdrawn on demand; hence certificates of deposit pay considerably higher interest payments compared to savings accounts. Insurance: Just like savings accounts, CDs are also insured. They are different from savings accounts in that the CD has a specific, fixed term (often three months, six months, or one to five years), and, usually, a fixed interest rate. Usually, the longer the period, higher is the interest rate. When I purchase a CD, I invest a fixed sum of money for fixed period of time. There are penalties for early withdrawal. ACCRUED INTEREST: Interest accrued on a bond or other fixed income security since the last interest payment was made. At the time of a sale, the buyer of a bond pays the market price plus accrued interest to the seller. Exceptions are bonds that are in default (termed to be 'trading flat'). Accrued interest is calculated by multiplying the coupon rate by the number of days that have elapsed since the last payment. How CDs work: CDs typically require a minimum deposit and offer higher rates for larger deposits. The consumer who opens a CD may receive a passbook or paper certificate, it now is common for a CD to consist simply of a book entry Invest - 119 - Invest- 55 Assets That Grow Savings and Earn Passive Income and an item shown in the consumer's periodic bank statements; that is, there is usually no ‘certificate’ as such. Interest Payout: At most institutions, the CD purchaser can arrange to have the interest periodically mailed as a check or transferred into a checking or savings account. This reduces total yield because there is no compounding. Some institutions allow the customer to select this option only at the time the CD is opened. CDs offer a slightly higher yield than T-Bills because of the slightly higher default risk for a bank but, overall, the likelihood that a large bank will go broke is pretty slim. Closing a CD: Withdrawals before maturity are usually subject to a substantial penalty. For a five-year CD, this is often the loss of six months' interest. These penalties ensure that it is generally not in a holder's best interest to withdraw the money before maturity—unless the holder has another investment with significantly higher return or has a serious need for the money. Commonly, institutions mail a notice to the CD holder shortly before the CD matures requesting directions. The notice usually offers the choice of withdrawing the principal and accumulated interest or ‘rolling it over’ (depositing it into a new CD). Generally, a ‘window’ is allowed after maturity where the CD holder can cash in the CD without penalty. In the absence of such directions, it is common for the institution to roll over the CD automatically, once again tying up the money for a period of time (though the CD holder may be able to specify at the time the CD is opened not to roll over the CD). Annual Percentage Yield (APY) and Annual Percentage Rate (APR): a fundamental concept to understand when buying a CD is the difference between annual percentage yield (APY) and annual percentage rate (APR). APY is the total amount of interest I earn in one year, taking compound interest into account. APR is simply the stated interest I earn in one year, without taking compounding into account. The difference results from when interest is paid. The more frequently interest is calculated, the greater the yield will be. When an investment pays interest annually, its rate and yield are the same. But when interest is paid more frequently, the yield gets higher. For example, say I purchase a one-year, $1,000 CD that pays 5% semiannually. After six months, I will receive an interest payment of $25 ($1,000 x 5 % x .5 years). Here's where the magic of compounding starts. The $25 payment starts earning interest of its own, which over the next six months amounts to $ 0.625 ($25 x 5% x .5 years). As a result, the rate on the CD is 5%, but its yield is 5.06. It may not sound like a lot, but compounding adds up over time. ‫ق‬ ‫ق‬ Types of CDs Invest - 120 - Invest- 55 Assets That Grow Savings and Earn Passive Income Callable CDs: A callable CD is similar to a traditional CD, except that the bank reserves the right to ‘call’ the investment. After the initial non-callable period, the bank can buy (call) back the CD. Callable CDs pay a premium interest rate. Banks manage their interest rate risk by selling callable CDs. On the call date, the banks determine if it is cheaper to replace the investment or leave it outstanding. This is similar to refinancing a mortgage. Brokered CDs: Many brokerage firms – known as ‘deposit brokers’ – offer CDs. These brokerage firms can sometimes negotiate a higher rate of interest for a CD by promising to bring a certain number of deposits to the institution. Unlike traditional bank CDs, brokered CDs are sometimes held by a group of unrelated investors. Instead of owning the entire CD, each investor owns a piece. If several investors own the CD, the deposit broker may not list each person's name in the title but the account records should reflect that the broker is merely acting as an agent (e.g., ‘XYZ Brokerage as Custodian for Customers’). In some cases, the deposit broker may advertise that the CD does not have a prepayment penalty for early withdrawal. In those cases, the deposit broker will instead try to resell the CD if the investor wants to redeem it before maturity. If interest rates have fallen since the CD was purchased, and demand is high, he/she may be able to sell the CD for a profit. But if interest rates have risen, there may be less demand for such lower-yielding CD, which means that he/she may have to sell the CD at a discount and lose some of the investor’s original deposit. In the event of bank failure, insurance applies but may be more difficult to realize. Direct deposit CDs are often allowed to mature at the original rate by the acquiring bank, but brokered accounts usually stop paying interest immediately. Brokered depositors may not be timely notified. Further, the insurer will pay claims on direct deposits within 7-10 days; brokered CD claims may take 30-60 days. Additionally, the insurer may require that brokered depositors prove they do not hold simultaneous direct and brokered deposits which exceed FDIC limits. Bump Up CDs: A Bump Up CD allows the account holder the option to increase the interest rate once during the term of the CD. Upon request, the bank will ‘bump up’ the interest rate on the certificate of deposit to a higher rate being offered by the issuing bank on that CD (or a comparable term CD). The rate change does not change the original maturity date of the CD. Liquid CDs: This type of CD is generally a fixed rate certificate of deposit, which allows me to withdraw a portion of the original deposit during the term without paying a penalty. There will be some limits on when I can take the money out, the amount that can be withdrawn and how many separate withdrawals I can make from the CD. Step Up CD or Step Down CDs: These can also be called a flex CD and can be confused with a Bump Up CD. Certificates of deposit with a step up or down Invest - 121 - Invest- 55 Assets That Grow Savings and Earn Passive Income feature have a fixed interest rate for a period of time, usually one year and then the interest rate automatically rises up to a predetermined rate or is lowered to a predetermined rate. Variable Rate CDs: Unlike traditional CD's that pay a fixed rate of interest, a variable rate CD or index based CD is tied to the outcome of a market index. The interest I earn at maturity is based on the percentage gain (or loss) from the Initial Index to the final Index value. These certificates of deposit can be tied to a bond or stock index or a reference rate like the Treasury bills, Prime Rate or the Consumer Price Index. Add On CDs: These are fixed or variable rate CDs to which I can make additional deposits. There can be restrictions, such as a minimum deposit that can be made to the account. Zero Coupon CD: These certificates of deposit are issued at a substantial discount from the face amount of the CD. Typically the maturity terms are much longer, 15 to 20 years, which results in the discounted price. Zero coupon CDs do not pay interest until the maturity date. ‫ق‬ Advantages The main advantage of CDs is their relative safety and the ability to know my return ahead of time. I will generally earn more than in a savings account, and I will not be at the mercy of the stock market. ‫ق‬ Disadvantages Despite the benefits, there are two main disadvantages to CDs. First of all, the returns are paltry compared to many other investments. Furthermore, my money is tied up for the length of the CD and I will not be able to get it out without paying a harsh penalty. ‫ق‬ How to Buy or Sell CDs are generally issued by commercial banks but they can also be bought through brokerages. Invest - 122 - Invest- 55 Assets That Grow Savings and Earn Passive Income $ Commercial Paper ‫ق‬ Definition Commercial paper is an unsecured, short-term loan issued by a corporation, typically for financing accounts receivable and inventories. It is usually issued at a discount, reflecting current market interest rates. ‫ق‬ Characteristics For many corporations, borrowing short-term money from banks is often a laborious and annoying task. The desire to avoid banks as much as possible has led to the widespread popularity of commercial paper. Maturities on commercial paper are usually no longer than nine months, with maturities of between one and two months being the average. For the most part, commercial paper is a very safe investment because the financial situation of a company can easily be predicted over a few months. Furthermore, typically only companies with high credit ratings and credit worthiness issue commercial paper. Commercial paper is usually issued in large denominations hence smaller investors can only invest in commercial paper indirectly through money market funds. A higher yield acts as compensation for investors who choose the higher-risk commercial bills. In general, when there are two bills with the same maturity, the bill that has the lower credit quality or rating will offer a higher yield to investors because there is a greater chance that the creditor will be unable to meet its debt obligation. Invest - 123 - Invest- 55 Assets That Grow Savings and Earn Passive Income $ Bankers Acceptance ‫ق‬ Definition A Bankers' Acceptance (BA) is a short-term credit investment created by a nonfinancial firm and guaranteed by a bank to make payment. ‫ق‬ Characteristics Acceptances are traded at discounts from face value in the secondary market. For corporations, a BA acts as a negotiable time draft for financing imports, exports or other transactions in goods. This is especially useful when the creditworthiness of a foreign trade partner is unknown. Acceptances sell at a discount from the face value, for instance: Face Value of Banker's Acceptance $1,000,000 Minme2% Per Annum Commission for One Year -$20,000 Amount Received by Exporter in One Year $980,000 ‫ق‬ Advantages of Bankers Acceptances £ One advantage of a banker's acceptance is that it does not need to be held until maturity, and can be sold off in the secondary markets where investors and institutions constantly trade BAs. Invest - 124 - Invest- 55 Assets That Grow Savings and Earn Passive Income DERIVATIVES ‫ق‬ Definition A derivative is a financial instrument - or more simply, an agreement between two people or two parties - that has a value determined by the price of something else (called the underlying). Its value is linked to the expected future price movements of the asset it is linked to - such as a share or a currency. Referring to derivatives as assets is a misconception, since a derivative is incapable of having value of its own. However, some more commonplace derivatives, such as swaps, futures, and options, have a theoretical face value and are frequently traded on open markets before their expiration date as if they were assets. EXPIRATION DATE: The date on which an option expires. If an option has not been exercised prior to expiration, it expires worthless and the buyer no longer has any rights. Marshall, the great economic though leader and author of Principles of Economics, supports derivatives markers when he notes, ‘But after all the chief cause of the modern prosperity of new countries lies in the markets that the old world offers, not for goods delivered on the spot, but for promises to deliver goods at a distant date.’ - VI.XII.3 The use of derivative strategies is designed to improve the potential for diversification, and in some cases, remove unwelcome risk through an appropriately and properly hedged position. Derivative strategies may be employed to reduce risk through hedged positions or to engage in trades on the public market of a representation of an underlying illiquid asset. In the use of derivative strategies, there is need to commingle limited partnership funds over separate accounts, to limit the risk implied by additional leverage. ‫ق‬ Characteristics A derivative has the following three main characteristics: £ The value changes in response to the change in an underlying variable such as an interest rate, commodity or security price, or index; £ Requires no initial investment, or one that is smaller than would be required for a contract with similar response to changes in market factors; and £ Settled at a future date. Invest - 125 - Invest- 55 Assets That Grow Savings and Earn Passive Income Derivatives are usually broadly categorized by the: £ Relationship between the underlying and the derivative (e.g., forward, option, swap) £ Type of underlying (e.g., equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives or credit derivatives) £ Market in which they trade (e.g., exchange-traded or over-the-counter) £ Pay-off profile (some derivatives have non-linear payoff diagrams due to embedded optionality) Another arbitrary distinction is between: £ Vanilla derivatives (simple and more common) and £ Exotic derivatives (more complicated and specialized) ‫ق‬ Types There are many kinds of derivatives, with the most notable being swaps, futures/forwards, and options. However, since a derivative can be placed on any sort of security, the scope of all derivatives possible is nearly endless. Invest - 126 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Futures/Forwards ‫ق‬ Definition Futures/Forwards are standardized contract between two parties to invest a specified asset (security or commodity) of standardized quantity and quality at a specified future date at a price agreed today (the futures price). Futures attempt to predict the value of a commodity/security at some date in the future. ‫ق‬ Characteristics If I buy a futures contract, I am basically agreeing to buy something that a seller has not yet produced for a set price. But participating in the futures market does not necessarily mean that I will be responsible for receiving or delivering large inventories of physical commodities. Buyers and sellers in the futures market primarily enter into futures contracts to hedge risk or speculate rather than to exchange physical goods (which is the primary activity of the cash/spot market). That is why futures are used as financial instruments by not only producers and consumers but also speculators. Purpose: To provide an efficient and effective mechanism for the management of price risks. Futures are a form of very high risk speculation, used as financial tools for reducing risk. Futures traders accept price risks from producers and users with the idea of making substantial profits. Price Discovery: Because the futures market is both highly active and central to the global marketplace, it is a good source for vital market information and sentiment indicators. Due to its highly competitive nature, the futures market is an important economic tool to determine prices based on today's and tomorrow's estimated amount of supply and demand. Futures market prices depend on a continuous flow of information from around the world and thus require a high amount of transparency. Factors such as weather, war, debt default, refugee displacement, land reclamation and deforestation can all have a major effect on supply and demand and, as a result, the present and future price of a commodity. This kind of information and the way people absorb it constantly changes the price of a commodity. This process is known as price discovery. Risk Reduction: Futures markets are also a place for people to reduce risk when making purchases. Risks are reduced because the price is pre-set, therefore letting participants know how much they will need to buy or sell. This helps reduce the ultimate cost to the retail buyer because with less risk there is less of a chance that manufacturers will jack up prices to make up for profit losses in the cash market. The futures market is extremely liquid, risky and complex by nature. The futures market is a major financial hub, providing an outlet for intense competition among buyers and sellers and, more importantly, providing a center to manage price risks. Invest - 127 - Invest- 55 Assets That Grow Savings and Earn Passive Income Specification: In every futures contract, everything is specified: the quantity and quality of the commodity, the specific price per unit, and the date and method of delivery. The ‘price’ of a futures contract is represented by the agreed-upon price of the underlying commodity or financial instrument that will be delivered in the future. The future date is called the delivery date or final settlement date. The official price of the futures contract at the end of a day's trading session on the exchange is called the settlement price for that day of business on the exchange. SETTLEMENT DATE: Date on which a securities transaction must be settled. Buy orders must be paid for in cash and sell orders must have securities in legal (good) delivery form presented to the new owner. The Players: The players in the futures market fall into two categories: hedgers and speculators. £ Hedgers invest in the futures market to secure the future price of a commodity intended to be sold at a later date in the cash market. This helps protect against price risks. Farmers, manufacturers, importers and exporters can all be hedgers. The holders of the long position in futures contracts (the buyers of the commodity), are trying to secure as low a price as possible. The short holders of the contract (the sellers of the commodity) will want to secure as high a price as possible. Hedging by means of futures contracts can also be used as a means to lock in an acceptable price margin between the cost of the raw material and the retail cost of the final product sold. € EXAMPLE: A silversmith must secure a certain amount of silver in six months time for earrings and bracelets that have already been advertised in an upcoming catalog with specific prices. But what if the price of silver goes up over the next six months? Because the prices of the earrings and bracelets are already set, the extra cost of the silver cannot be passed on to the retail buyer, meaning it would be passed on to the silversmith. The silversmith needs to hedge, or minimize her risk against a possible price increase in silver. How? The silversmith would enter the futures market and purchase a silver contract for settlement in six months time (let's say June) at a price of $5 per ounce. At the end of the six months, the price of silver in the cash market is actually $6 per ounce, so the silversmith benefits from the futures contract and escapes the higher price. Had the price of silver declined in the cash market, the silversmith would, in the end, have been better off without the futures contract. At the same time, however, because the silver market is very volatile, the silver maker was still sheltering himself from risk by entering into the futures contract. So that is basically what hedging is: the attempt to minimize risk as much as possible by locking in prices for future purchases and sales. Someone going long in a securities future contract now can hedge against rising equity prices in three months. If at the time of the contract's expiration the equity price has risen, the investor's contract can be closed out at the higher price. The opposite could happen as well: a hedger could go short in a contract today to Invest - 128 - Invest- 55 Assets That Grow Savings and Earn Passive Income hedge against declining stock prices in the future. A potato farmer would hedge against lower French fry prices, while a fast food chain would hedge against higher potato prices. A company in need of a loan in six months could hedge against rising interest rates in the future, while a coffee beanery could hedge against rising coffee bean prices next year. £ Speculators do not aim to minimize risk but rather to benefit from the inherently risky nature of the futures market. They aim to profit from the very price change that hedgers are protecting themselves against. In the futures market, a speculator buying a contract low in order to sell high in the future would most likely be buying that contract from a hedger selling a contract low in anticipation of declining prices in the future. Unlike the hedger, the speculator does not actually seek to own the commodity in question. Rather, she will enter the market seeking profits by offsetting rising and declining prices through the buying and selling of contracts. Trader Short Long The Hedger Secure a price now to protect against future declining prices Secure a price now to protect against future rising prices The Speculator Secure a price now in anticipation of declining prices Secure a price now in anticipation of rising prices Margins: When I open a futures contract, the futures exchange will state a minimum amount of money that I must deposit into my account. This original deposit of money is called the initial margin- the minimum amount required to enter into a new futures contract. The minimum-level margin is determined by the futures exchange and is usually 5% to 10% of the futures contract. When my contract is liquidated, I will be refunded the initial margin plus or minus any gains or losses that occur over the span of the futures contract. In other words, the amount in my margin account changes daily as the market fluctuates in relation to my futures contract. These predetermined initial margin amounts are continuously under review: at times of high market volatility, initial margin requirements can be raised. If my margin account drops to a certain level because of a series of daily losses, brokers make a margin call and request me to make an additional deposit into my account to bring the margin back up to the initial amount. The maintenance margin is the lowest amount an account can reach before needing to be replenished. When a margin call is made, the funds usually have to be delivered immediately. If they are not, the brokerage can have the right to liquidate my position completely in order to make up for any losses it may have incurred on my behalf. Invest - 129 - Invest- 55 Assets That Grow Savings and Earn Passive Income Let's say that I had to deposit an initial margin of $1,000 on a contract and the maintenance margin level is $500. A series of losses dropped the value of my account to $400. This would then prompt the broker to make a margin call to me, requesting a deposit of at least an additional $600 to bring the account back up to the initial margin level of $1,000. € INITIAL MARGIN: Amount of cash or eligible securities required to be deposited with a broker before engaging in margin transactions. The minimum equity to establish a margin account is currently $2,000, and 50% of the price of a new purchase must be in customer equity. € MAINTENANCE CALL: A demand for the deposit of additional cash or securities due to the account being below the firm's required maintenance levels. € MARGIN ACCOUNT: Brokerage account allowing customers to buy securities with money borrowed from the broker. A signed MARGIN AGREEMENT is a prerequisite to establishing a margin account. Leverage: In the futures market, leverage refers to having control over large cash amounts of commodities with comparatively small levels of capital. In other words, with a relatively small amount of cash, I can enter into a futures contract that is worth much more than I initially have to pay (deposit into my margin account). In the futures market, more than any other form of investment, price changes are highly leveraged, meaning a small change in a futures price can translate into a huge gain or loss. Futures positions are highly leveraged because the initial margins that are set by the exchanges are relatively small compared to the cash value of the contracts in question (which is part of the reason why the futures market is useful but also very risky). The smaller the margin in relation to the cash value of the futures contract, the higher the leverage. As a result of leverage, if the price of the futures contract moves up even slightly, the profit gain will be large in comparison to the initial margin. However, if the price just inches downwards, that same high leverage will yield huge losses in comparison to the initial margin deposit. EXAMPLE: So for an initial margin of $5,000, I may be able to enter into a long position in a futures contract for 30,000 pounds of coffee valued at $50,000, which would be considered highly leveraged investments. For example, say that in anticipation of a rise in stock prices across the board, I buy a futures contract with a margin deposit of $10,000, for an index currently standing at 1300 (index is a typical price for some good or service). The value of the contract is worth $250 times the index (e.g. $250 x 1300 = $325,000), meaning that for every point gain or loss, $250 will be gained or lost. If after a couple of months, the index realized a gain of 5%, this would mean the index gained 65 points to stand at 1365. In terms of money, this would mean that I as an investor earned a profit of $16,250 (65 points x $250); a profit of 162%! On the other hand, if the index declined 5%, it would result in a monetary loss of $16,250 - a huge amount compared to the initial margin deposit made to obtain the Invest - 130 - Invest- 55 Assets That Grow Savings and Earn Passive Income contract. This means I still have to pay $6,250 out of my pocket to cover my losses. Pricing and Limits: Contracts in the futures market are a result of competitive price discovery. Prices are quoted as they would be in the cash market: in dollars and cents or per unit (gold ounces, bushels, barrels, index points, percentages and so on). Prices on futures contracts, however, have a minimum amount that they can move. These minimums are established by the futures exchanges and are known as ‘ticks.’ Futures prices also have a price change limit that determines the prices between which the contracts can trade on a daily basis. The price change limit is added to and subtracted from the previous day's close and the results remain the upper and lower price boundary for the day. The exchange can revise this price limit if it feels it is necessary. It is not uncommon for the exchange to abolish daily price limits in the month that the contract expires (delivery or ‘spot‘ month). This is because trading is often volatile during this month, as sellers and buyers try to obtain the best price possible before the expiration of the contract. Further, in order to avoid any unfair advantages, the futures exchanges impose limits on the total amount of contracts or units of a commodity in which any single person can invest. These are known as position limits and they ensure that no one person can control the market price for a particular commodity. Standardization: Futures/Forwards contracts ensure their liquidity by being highly standardized, usually by specifying: € The underlying asset or instrument. This could be anything from a barrel of crude oil to a short term interest rate. € The type of settlement, either cash settlement or physical settlement. € The amount and units of the underlying asset per contract. This can be the notional amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc. € The currency in which the futures contract is quoted. € The grade of the deliverable. In the case of bonds, this specifies which bonds can be delivered. In the case of physical commodities, this specifies not only the quality of the underlying goods but also the manner and location of delivery. € The delivery month. € The last trading date. € Other details such as the commodity tick, the minimum permissible price fluctuation. Strategies: Essentially, futures contracts try to predict what the value of an index or commodity will be at some date in the future. Speculators in the futures market can use different strategies to take advantage of rising and declining prices. The most common are known as going long, going short and spreads. Going long and going short are positions Invest - 131 - Invest- 55 Assets That Grow Savings and Earn Passive Income that basically involve the buying or selling of a contract now in order to take advantage of rising or declining prices in the future. ¥ Going Long: When an investor goes long - that is, enters a contract by agreeing to buy and receive delivery of the underlying at a set price it means that I am trying to profit from an anticipated future price increase. For example, let's say, with an initial margin of $2,000 in June, Joe the speculator buys one September contract of gold at $350 per ounce, for a total of 1,000 ounces or $350,000. By buying in June, Joe is going long, with the expectation that the price of gold will rise by the time the contract expires in September. By August, the price of gold increases by $2 to $352 per ounce and Joe decides to sell the contract in order to realize a profit. The 1,000 ounce contract would now be worth $352,000 and the profit would be $2,000. Given the very high leverage (remember the initial margin was $2,000), by going long, Joe made a 100% profit! Of course, the opposite would be true if the price of gold per ounce had fallen by $2. The speculator would have realized a 100% loss. It is also important to remember that throughout the time that Joe held the contract; the margin may have dropped below the maintenance margin level. He would, therefore, have had to respond to several margin calls, resulting in an even bigger loss or smaller profit. ¥ Going Short: A speculator who goes short - that is, enters into a futures contract by agreeing to sell and deliver the underlying at a set price - is looking to make a profit from declining price levels. By selling high now, the contract can be repurchased in the future at a lower price, thus generating a profit for the speculator. Suppose, with an initial margin deposit of $3,000, Sara sold one May crude oil contract (one contract is equivalent to 1,000 barrels) at $25 per barrel, for a total value of $25,000. By March, the price of oil had reached $20 per barrel and Sara felt it was time to cash in on her profits. As such, she bought back the contract which was valued at $20,000. By going short, Sara made a profit of $5,000! But again, if Sara's research had not been thorough, and she had made a different decision, her strategy could have ended in a big loss. ¥ Spreads: This involves taking advantage of the price difference between two different contracts of the same commodity. Spreading is considered to be one of the most conservative forms of trading in the futures market because it is much safer than the trading of long/short (naked) futures contracts. There are many different types of spreads, including: € Calendar Spread: This involves the simultaneous purchase and sale of two futures of the same type, having the same price, but different delivery dates. Invest - 132 - Invest- 55 Assets That Grow Savings and Earn Passive Income Sometimes referred to as an interdelivery, Intermarket, time or horizontal spread, An example of a calendar spread would be going long on a crude oil futures contract with delivery next month and going short on a crude oil futures contract whose delivery is in six months. € Intermarket Spread - Here the investor, with contracts of the same month, goes long in one market and short in another market. For example, a trader may purchase May Chicago Board of Trade Corn and simultaneously sell May Kansas City Board of Trade Corn (in the same year) in the hope the long position will increase in price and the short position will fall in price. € Inter-Exchange Spread - This is any type of spread in which each position is created in different futures exchanges. For example, the investor may create a position in the Nairobi Stock Exchange and Uganda Stock Exchange. € Intercommodity Spread – This means going long on one futures market in a given delivery month and simultaneously going short on the same commodity and delivery month but a different futures market but with similar underlying asset. Examples of intercommodity spreads include the crack spread (crude oil vs. unleaded gasoline) and the crush spread (soybean oil vs. soybean meal). € Interdelivery Spread – It means simultaneously entering a long and short on the same futures contract but with different delivery months in the hopes that the price difference between the two months widens or narrows, depending on the underlying investment. Spread traders are only concerned that their long positions rise in value relative to their short positions. For example, if a trader is long June corn and short August corn, then the trader is hoping that the price of June corn rises and the price of August corn falls. ‫ق‬ Advantages £ £ ‫ق‬ Futures are extremely useful in reducing unwanted risk. Futures markets are very active, so liquidating my contracts is usually easy. Disadvantages £ £ Futures are considered one of the riskiest investments in the financial markets - they are for professionals only. In volatile markets, it is very easy to lose my original investment. Invest - 133 - Invest- 55 Assets That Grow Savings and Earn Passive Income £ The very high amount of leverage can create enormous capital gains and losses, I must be fully aware of any tax consequences. ‫ق‬ How to Buy & Sell Futures are not for the risk averse. The bottom line is that I should only invest in futures if I am very experienced and I have a lot of money. I can invest in the futures market in a number of different ways, as below: ¥ Do It Myself: As an investor, I can trade my own account without the aid or advice of a broker. This involves the most risk because I become responsible for managing funds, ordering trades, maintaining margins, acquiring research and coming up with my own analysis of how the market will move in relation to the commodity in which I've invested. It requires time and complete attention to the market. ¥ Open a Managed Account: Another way to participate in the market is by opening a managed account, similar to an equity account. My broker would have the power to trade on my behalf, following conditions agreed upon when the account was opened. This method could lessen my financial risk because a professional would be making informed decisions on my behalf. However, I would still be responsible for any losses incurred as well as for margin calls, and I would probably have to pay an extra management fee. ¥ Join a Commodity Pool A third way to enter the market, and one that offers the smallest risk, is to join a commodity pool. Like a mutual fund, the commodity pool is a group of commodities which can be invested in. No one person has an individual account; funds are combined with others and traded as one. The profits and losses are directly proportionate to the amount of money invested. By entering a commodity pool, I also gain the opportunity to invest in diverse types of commodities. I am also not subject to margin calls. However, it is essential that a skilled broker manage the pool, because the risks of the futures market are still present in the commodity pool. ¥ Use Brokers: Futures can be purchased through most full-service and some discount brokers. There are also brokers that specialize in futures trading. ‫ق‬ Differences Between Futures and Forwards While futures and forward contracts are both contracts to deliver an asset on a future date at a prearranged price, they are different in the following main respects: Margining Period: Futures are margined daily to the daily spot price of a forward with the same agreed-upon delivery price and underlying asset (based on mark to market). Forwards do not have a standard. They may transact only on Invest - 134 - Invest- 55 Assets That Grow Savings and Earn Passive Income the settlement date. More typical would be for the parties to agree to true up, for example, every quarter. This true-ing up occurs by the ‘loss’ party providing additional collateral; so if the buyer of the contract incurs a drop in value, the shortfall or variation margin would typically be shored up by the investor wiring or depositing additional cash in the brokerage account. The fact that forwards are not margined daily means, due to movements in the price of the underlying asset, a large differential can build up between the forward's delivery price and the settlement price, and in any event, an unrealized gain (loss) can build up. This differs from futures which get 'truedup' typically daily by a comparison of the market value of the future to the collateral securing the contract to keep it in line with the brokerage margin requirements. Credit Risk: The lack of daily true-up creates credit risk for forwards, but not so much for futures. Thus futures have significantly less credit risk, and have different funding. Simply put, the risk of a forward contract is that the seller will be unable to deliver the referenced asset, or that the buyer will be unable to pay for it on the delivery date or the date at which the opening party closes the contract. The daily margining of futures eliminates much of this credit risk by forcing the holders to update daily to the price of an equivalent forward purchased that day. This means that there will usually be very little additional money due on the final day to settle the futures contract: only the final day's gain or loss, not the gain or loss over the life of the contract. In addition, the daily futures-settlement failure risk is borne by an exchange, rather than an individual party, further limiting credit risk in futures. € € COUNTERPARTY DEFAULT: With an exchange-traded future, the clearing house interposes itself on every trade. Thus there is no risk of counterparty default. The only risk is that the clearing house defaults (e.g. become bankrupt), which is considered very unlikely. TRADING VENUES: Futures are exchange-traded, while forwards are traded over-the-counter. Thus futures are standardized and face an exchange, while forwards are customized and face non-exchange counterparty. Standardization: Futures are generic exchange-traded, whereas forwards are individually tailored. Thus futures are highly standardized, being exchangetraded, whereas forwards can be unique, being over-the-counter. In the case of physical delivery, the forward contract specifies to whom to make the delivery. The counterparty for delivery on a futures contract is chosen by the clearing-house. Settlement: Futures are generally settled through an offsetting (reversing) trade, whereas forwards are generally settled by delivery of the underlying item or cash settlement. Invest - 135 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Options ‫ق‬ Definition Options are contracts that give the purchaser the right to buy (call option) or sell (put option) a specified quantity of a particular financial instrument, commodity, or foreign currency, at or above a specified price (strike price), during or at a specified date/period of time (exercise date). This specific price is a fraction price, mostly 1/3 the price. Options are the insurance in investing. The same way I would not drive a car, or own a house, or run a business, without insuring it, so I should not invest without insurance. ‫ق‬ Characteristics Options are derivative instruments, as their fair price derives from the value of the other asset, called the underlying. These can be individually written or exchange-traded. The purchaser of the option pays the seller (writer) of the option a fee (premium) to compensate the seller for the risk of payments under the option. An option to buy something is called a call; an option to sell is called a put. The price specified at which the underlying may be traded is called the strike price. The process of activating an option and thereby trading the underlying at the agreed-upon price is referred to as exercising it. Most options have an expiration date. If the option is not exercised by the expiration date, it becomes void and worthless. In return for granting the option, called writing the option, the originator of the option collects a payment, the premium, from the buyer. The writer of an option must make good on delivering (or receiving) the underlying asset or its cash equivalent, if the option is exercised. Its original buyer can usually sell an option to another party. The price at which the sale takes place is known as the strike price, and is specified at the time the parties enter into the option. The option contract also specifies a maturity date. In the case of a European option, the owner has the right to require the sale to take place on (but not before) the maturity date; in the case of an American option, the owner can require the sale to take place at any time up to the maturity date. If the owner of the contract exercises this right, the counter-party has the obligation to carry out the transaction. Whereas a futures contract gives the holder the obligation to make or take delivery under the terms of the contract, an option grants the buyer the right, but not the obligation, to establish a position previously held by the seller of the option. In other words, the owner of an options contract may exercise the contract, but both parties of a ‘futures contract’ must fulfill the contract on the settlement date. Invest - 136 - Invest- 55 Assets That Grow Savings and Earn Passive Income The seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position has to offset his/her position by either selling a long position or buying back (covering) a short position, effectively closing out the futures position and its contract obligations. Options on futures: In many cases, options are traded on futures, sometimes called simply ‘futures options’. A put is the option to sell a futures contract, and a call is the option to buy a futures contract. For both, the option strike price is the specified futures price at which the future is traded if the option is exercised. Option valuation: The theoretical value of an option is evaluated according to any of several mathematical models. These models, which are developed by quantitative analysts, attempt to predict how the value of an option changes in response to changing conditions. Hence, the risks associated with granting, owning, or trading options may be quantified and managed with a greater degree of precision, perhaps, than with some other investments. Exchangetraded options form an important class of options which have standardized contract features and trade on public exchanges, facilitating trading among independent parties. Over-the-counter options are traded between private parties, often well-capitalized institutions that have negotiated separate trading and clearing arrangements with each other. Contract specifications: Every financial option is a contract between the two counterparties with the terms of the option specified in a term sheet. Option contracts may be quite complicated; however, at minimum, they usually contain the following specifications: € Whether the option holder has the right to buy (a call option) or the right to sell (a put option) € The quantity and class of the underlying asset(s) (e.g. 100 shares of xyz co. B stock) € The strike price, also known as the exercise price, which is the price at which the underlying transaction will occur upon exercise. The price that the owner (purchaser) of an option can buy (if calls are owned) or sell (if puts are owned) the underlying security by exercising his option. € The expiration date, or expiry, which is the last date the option can be exercised € The settlement terms, for instance whether the writer must deliver the actual asset on exercise, or may simply tender the equivalent cash amount € The terms by which the option is quoted in the market to convert the quoted price into the actual premium-–the total amount paid by the holder to the writer of the option. Invest - 137 - Invest- 55 Assets That Grow Savings and Earn Passive Income Option styles: Naming conventions are used to help identify properties common to many different types of options. These include: € € € € € € ‫ق‬ European option - an option that may only be exercised on expiration. American option - an option that may be exercised on any trading day on or before expiry. Bermudan option - an option that may be exercised only on specified dates on or before expiration. Barrier option - any option with the general characteristic that the underlying security's price must pass a certain level or ‘barrier’ before it can be exercised Exotic option - any of a broad category of options that may include complex financial structures. Vanilla option - by definition, any option that is not exotic. Types of Options The primary types of financial options are: € £ £ £ £ £ Exchange Traded Options (also called ‘listed options’) are a class of exchange-traded derivatives. Exchange traded options have standardized contracts, and are settled through a clearing house with fulfillment guaranteed by the credit of the exchange. Since the contracts are standardized, accurate pricing models are often available. Exchange traded options include: Stock options, Commodity options, Bond options and other interest rate options Stock market index options or, simply, index options and Options on futures contracts INDEX OPTIONS: Calls and Puts on indexes of stocks. Broad-based indexes cover a wide range of companies; narrow-based indexes consist of stocks in one industry or sector of the economy. Owning an option provides investors with the opportunity to buy or sell, but they are not committed to do so. OPTION PREMIUM: The amount per share paid by an option buyer to the seller. An option premium that is quoted at 2 1/8 means an option buyer would pay $212.50 for an option contract controlling 100 shares. OUT-OF-THE-MONEY: Description of an option when the current value of the underlying security is below (for calls) or above (for puts) the exercise (strike) price. € Over-The-Counter Options (OTC options, also called ‘dealer options’) are traded between two private parties, and are not listed on an exchange. The terms of an OTC option are unrestricted and may be individually tailored to meet any business need. In general, at least one of the counterparties to an OTC option Invest - 138 - Invest- 55 Assets That Grow Savings and Earn Passive Income is a well-capitalized institution. Option types commonly traded over the counter include: £ Interest rate options £ Currency cross rate options, and £ Options on swaps or swaptions. € Employee Stock Options, which are awarded by a company to its employees as a form of incentive compensation. € Other Types of options exist in many financial contracts, for example real estate options are often used to assemble large parcels of land, and prepayment options, usually included in mortgage loans. However, many of the valuation and risk management principles apply across all financial options. ‫ق‬ Why Options? Risk Management: An option is used for risk management; it is risk management that works. Leverage: Further, it provides the investor with leverage in option positions, by allowing the investment of a fraction, generally 1/3 of amount for purchasing the stock. I can control a large amount of stock for little cash. It hence also guarantees less stress in trading due to low investment. Cash Flow Monthly: It creates consistent amount of cash flow every month. Locking Prices: Options buyers have right to buy stock at specific prices in the future. As an investor, I get to choose what price I want to own it at. A lot of flexibility, hence options. ‫ق‬ How to Invest! Many options are created in standardized form and traded on an anonymous options exchange among the general public. Over-the-counter options are customized to the desires of the buyer on an ad hoc basis, usually by an investment bank. Options are sold in contracts, and each contract is sold in 100 shares. Invest - 139 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Swaps ‫ق‬ Definition Swaps are contracts to exchange cash (flows) on or before a specified future date based on the underlying value of currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets. ‫ق‬ Characteristics A swap is a derivative in which counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved. For example, in the case of a swap involving two bonds, the benefits in question can be the periodic interest (or coupon) payments associated with the bonds. Specifically, the two counterparties agree to exchange one stream of cash flows against another stream. These streams are called the legs of the swap. The swap agreement defines the dates when the cash flows are to be paid and the way they are calculated. Usually at the time when the contract is initiated at least one of these series of cash flows is determined by a random or uncertain variable such as an interest rate, foreign exchange rate, equity price or commodity price. The cash flows are calculated over a notional principal amount (the predetermined dollar amount on which the exchanged interest payments are based), which is usually not exchanged between counterparties. Consequently, swaps can be used to in cash or collateral (Assets pledged by a borrower to secure a loan or other credit, and subject to seizure in the event of default; Also called security. Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices. Swaps are among the most heavily traded financial contracts in the world according to International Swaps and Derivatives Association. Valuation: The value of a swap is the net present value (NPV) of all estimated future cash flows. A swap is worth zero when it is first initiated, however after this time its value may become positive or negative. There are two ways to value swaps: in terms of bond prices, or as a portfolio of forward contracts. ‫ق‬ Types of Swaps The five generic types of swaps, in order of their quantitative importance, are: interest rate swaps, currency swaps, credit swaps, commodity swaps and equity swaps. There are also many other types. Interest rate swaps: It is the exchange of a fixed rate loan to a floating rate loan. The life of the swap can range from 2 years to over 15 years. The reason for this exchange is to take benefit from comparative advantage. Some companies Invest - 140 - Invest- 55 Assets That Grow Savings and Earn Passive Income may have comparative advantage in fixed rate markets and others in floating rate markets. When companies want to borrow they look for cheap borrowing i.e. from the market where they have comparative advantage. However this may lead to a company borrowing fixed when it wants floating or borrowing floating when it wants fixed. This is where a swap comes in, to transform a fixed rate loan into a floating rate loan or vice versa. Equity Swap: A special type of total return swap, where the underlying asset is a stock, a basket of stocks, or a stock index. Compared to actually owning the stock, in this case I do not have to pay anything up front, but I do not have any voting or other rights that stock holders do have. Credit default swaps: A swap contract in which the buyer makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument - typically a bond or loan - goes into default (fails to pay). Less commonly, the credit event that triggers the payoff can be a company undergoing restructuring, bankruptcy or even just having its credit rating downgraded. CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if one of the events specified in the contract occur. Unlike an actual insurance contract the buyer is allowed to profit from the contract and may also cover an asset to which the buyer has no direct exposure. Other variations: There are myriad different variations on the vanilla swap structure, which are limited only by the imagination of financial engineers and the desire of corporate treasurers and fund managers for exotic structures. A total return swap: A swap in which party A pays the total return of an asset, and party B makes periodic interest payments. The total return is the capital gain or loss, plus any interest or dividend payments. Note that if the total return is negative, then party A receives this amount from party B. The parties have exposure to the return of the underlying stock or index, without having to hold the underlying assets. An option on a swap is called a swaption. These provide one party with the right but not the obligation at a future time to enter into a swap A variance swap is an over-the-counter instrument that allows one to speculate on or hedge risks associated with the magnitude of movement, a CMS, is a swap that allows the purchaser to fix the duration of received flows on a swap. An amortising swap is usually an interest rate swap in which the notional principal for the interest payments declines during the life of the swap, perhaps at a rate tied to the prepayment of a mortgage or to an interest rate benchmark. Invest - 141 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ How to Invest Most swaps are traded over-the-counter (OTC), ‘tailor-made’ for the counterparties. Some types of swaps are also exchanged on futures markets. $ Managed Futures Account Managed futures is a form of alternative investment. Managed Futures is an industry in which professional money managers direct investments in the global currency, interest rate, equity, metal, energy and agricultural markets. They do this through the use of futures, forwards and options. Specifically managed futures focuses on taking long and short positions in futures contracts, government securities, and options on futures contracts. They are generally managed on the basis of technical analysis, but also could have an approach on the basis of fundamental analysis, and involve going long or short in futures contracts in areas such as metals, grains, currencies equity indexes and commodities of all kinds. Because of the markets managed futures trade in and also because it takes a long/short trading approach, it may add substantial diversification to an investment portfolio. Potentially, they can enhance risk-adjusted rates of returns since managed futures' returns have historically shown low correlation compared to stock and bond investments. Following modern portfolio theory, this lack of correlation builds the robustness of the portfolio, reducing portfolio volatility and risk, without significant negative impacts on return. This lack of correlation stems from the fact that managed futures draw their returns from different sources than traditional stock and bond investments. Consequently, managed futures can often return positive returns while stock and bond markets do not. Invest - 142 - Invest- 55 Assets That Grow Savings and Earn Passive Income CLASS 3 VEHICLES: ALTERNATIVE PRODUCTS ‫ق‬ Introduction Alternative assets, such as venture capital, private equity, and real estate investment trusts, provide increased diversification and can reduce the overall risk profile of a portfolio. These non-traditional asset classes typically exist outside the auspices of well-established public markets, and are often only available to large institutional investors. Due to their funding structures, alternative assets typically involve reduced liquidity, but in exchange are able to offer an enhanced return profile and diversification. The objective of these investments will be to provide additional portfolio diversification through incorporation of assets that bear little correlation to traditional market indices and the potential for enhanced returns averaged over the life of the investment. ‫ق‬ Advantages $ Increased Asset Diversification Investing in these non-traditional investments allows for broader diversification, which helps to offset losses from other investments. $ Independence from Market Volatility Usually, the performance of traditional investments moves with the stock market. But this is typically not the case with non-traditional investments; therefore, they can help to balance the overall performance of the IRA. $ Potential for Higher Return As with other investments, the rate of return on alternative forms of investment is not guaranteed. However, many financial professionals project that the rate of return for these investments is usually higher than that for traditional investments. Investing in these non-traditional asset classes can be tempting for the investor who wants to diversify his or her portfolio. However, as the list above demonstrates, other factors need to be considered. For instance, will the rate of return be enough to offset expenses incurred from UBI taxes and administrative fees charged by the financial institution? Will additional legal expenses apply? I should also remember, as with other types of investments, the higher the potential return, the higher the risk. And with any form of investment, suitability and risk tolerance must be key determining factors. I must engage in serious, in-depth discussions with my financial advisor for assistance in making such decisions. ‫ق‬ Disadvantages $ Legal Expenses Invest - 143 - Invest- 55 Assets That Grow Savings and Earn Passive Income Financial institutions that offer non-traditional investments are likely to ensure that their applicable policies and procedures are followed, but it is usually not practical for them to make a determination regarding whether an investment violates prohibited transaction rules. Doing so would require hiring attorneys and reviewing documentation regarding ownership, including determining whether any owners of the business in which the IRA assets are to be invested fall under any category of disqualified persons. This process might even require the financial institution to make additions to staff to handle the extra work. Therefore, the individual investor will usually be responsible for the expense of engaging the services of legal counsel. This can range from a few hundred to a few thousand dollars, depending on several factors, including the investor's location and attorney fees in that area, the size of the investment and the time spent by the attorney reviewing the related documentation. In situations where it is clear that there is no ownership by disqualified persons, legal expenses may be minimal, or even inapplicable. Also note that a financial institution that specializes in alternative investments may charge lower fees, as its resources are dedicated to handling the product. $ Fees The individual investor will usually be responsible for the expense of engaging the services of legal counsel. This can range from a few hundred to a few thousand dollars, depending on several factors, including the investor's location and attorney fees in that area, the size of the investment and the time spent by the attorney reviewing the related documentation. Also note that a financial institution that specializes in alternative investments may charge lower fees, as its resources are dedicated to handling the product. $ Taxes Most alternative investments are taxed twice, both on capital gains, an on income. $ Lack of Liquidity Because alternative investments are usually not publicly traded, or they are of closely held corporations, liquidating the assets is usually a time consuming process that can take anywhere from a few days to a few months. This can create problems for the investor who needs to take cash from the assets for any reason. $ Infrequent Valuation The valuation process for these investments is usually not automated, and some investments are valued less frequently - even annually. Furthermore, the financial institution must wait until it receives the valuation from the responsible party in order to update and reflect the correct value of the asset in the retirement account. $ Investments Are Uninsured Invest - 144 - Invest- 55 Assets That Grow Savings and Earn Passive Income Assets in securities are always insured, as part of commission fee payment, but that is usually not the case for alternative assets. This means that the risk of loss is higher with these assets than with traditional assets. Invest - 145 - Invest- 55 Assets That Grow Savings and Earn Passive Income 1. PROPERTY & REAL ESTATE INVESTMENT “real estate is at the core of almost every business, and at the core of almost all rich peoples assets. If you want to become rich, you need to learn about real estate.” -Donald Trump INTRODUCTION TO REAL ESTATE ¥ Property vis-a-vis Real Estate When people talk of property investments, they think of real estate. However, property in investments includes any fixed asset. It can be tangible/physical assets (such as machinery, land, buildings, equipments, vehicles), or intangible/technological assets, (a tool, technique, craft, system or method of organization in order to solve a problem or serve some purpose). Assets in software/ computer application form are called Information Technology/IT Assets (commonly referred to as software, such as Facebook, Microsoft, etc). Real estate refers to ‘an interest in’ land and anything fixed, immovable, or permanently attached to it such as appurtenances, buildings, fences, fixtures, improvements, roads, shrubs and trees (but not growing crops), sewers, structures, utility systems, and walls. Real estate constitutes about 70% of a developed nation's economic wealth. It is a not a rule of the thumb, but a pretty well documented indicator. The word ‘interest’ can mean either an ownership interest (also known as a feesimple interest) or a leasehold interest. In an ownership interest, the investor is entitled to the full rights of ownership of the land (for example, to legally use and transfer the title of the land/property), and must also assume the risks and responsibilities of a landowner (for example, any losses as a result of natural disasters and the obligation to pay property taxes). If I own a home, I have an ownership interest in that home. On the other side of the relationship, a leasehold interest only exists when a landowner agrees to pass some of his rights on to a tenant in exchange for a payment of rent. If I rent an apartment, I have a leasehold interest in real estate. Some jurisdictions recognize other interests beyond these two, such as a life estate, but those interests are less common in the investment arena. As with other investment vehicles, I need to learn. Donald Trump, the real estate billionaire, TV personality, and business mogul says, “successful investing requires a high financial IQ.” Invest - 146 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Non-Real Estate Property Investments As mentioned earlier, property is a wide term for any fixed asset that I can own. There are various categories of property, base don asset characteristics, as below: ‫ق‬ Fixed Property vis-à-vis Movable Property I can invest in fixed property, which means that it is stationery, and these include heavy plant machinery (always fixed to the ground), for instance, generators, manufacturing machines, processing plans, etc. Movable property on the other hand include property whose location changes in the process of using them to generate income, for instance, (rentable) equipments (furniture & fixtures), vehicles, etc. I can invest in equipments by buying, and leasing, or hiring, chairs, tents, machines, clothes, etc. ‫ق‬ Tangible assets vis-a-vis intangible assets Property can also be tangible/physical assets (such as machinery, land, buildings, equipments, vehicles), or intangible/technological assets, (a tool, technique, craft, system or method of organization in order to solve a problem or serve some purpose). Assets in software/ computer application form are called Information Technology/IT Assets (commonly referred to as software, such as Facebook, Microsoft, etc). ‫ق‬ Intellectual Property Intellectual property (IP) is a term referring to a number of distinct types of creations of the mind for which a set of exclusive rights are recognized—and the corresponding fields of law. Under intellectual property law, owners are granted certain exclusive rights to a variety of intangible assets, such as musical, literary (writing), and artistic works; discoveries and inventions; and words, phrases, symbols, and designs. Common types of intellectual property rights include copyrights, trademarks, patents, industrial design rights and trade secrets in some jurisdictions. Once I invent any of the above, I can sell it, or license it, in which case, it generates money. Most computer application are licensed, and not sold, which means that I do not have the right to own the software, and I must keep paying periodic fees to renew the license. People will be paying me periodic fees to use my software. Invest - 147 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Real Estate Investment (Income- and Non-Income-Producing) Real estate investing involves dealing in real estate for profit. Improvement of realty property as part of a real estate investment strategy is generally considered to be a sub-specialty of real estate investing called real estate development. As a real estate investor, I will most likely be purchasing ownership interests and then earning a return on that investment by issuing leasehold interests to tenants, who will in turn pay rent. It is also not uncommon for an investor to acquire a long-term leasehold interest in land, which then has a building constructed upon it. At the end of the land lease, the land and building become the property of the original land-owner. ‫ق‬ Income-Producing Properties Vis-A-Vis Non-Income-Producing Properties I can invest in either income-producing properties or non-income-producing properties. Any leased property is income producing, and vacant properties are non-income producing. I can still earn a capital return on a non-income producing property, just as I would on an investment in a home. Hence, real estate can produce income (like a bond) and appreciate (like equity). Says Buffett “The best business to own is one that over time can employ large amounts of capital at very high rates of return.” $ Income-Producing Real Estate There are four broad types of income-producing real estate: $ $ $ $ Offices Retail Industrial Residential There are many other less common types as well, such as hotels, mini-storage, parking lots and seniors care housing. The key criteria in these investments that we are focusing on is that they are income producing. The most common type is income-producing real estate. Income-producing properties are also purchased by individual investors in the form of smaller apartment buildings, duplexes or even a single family homes or condominiums that are rented out to tenants. Whatever choice of the real estate investment I choose to make, I will remember the cardinal rule, “never wait then buy real estate, buy real estate then wait” Invest - 148 - Invest- 55 Assets That Grow Savings and Earn Passive Income $ Non-Income-Producing Real Estate Non-income-producing investments, such as houses, vacation properties or vacant commercial buildings, are as sound as income-producing investments. I should just keep in mind that if I invest equity in a non-income producing property I will not receive any rent, so all of my return must be through capital appreciation. If I invest in debt secured by non-income-producing real estate, the borrower's personal income must be sufficient to cover the mortgage payments, because there is no tenant income to secure the payments. ‫ق‬ Characteristics Capital Intensive: Real estate is an asset form with limited liquidity relative to other investments, it is also capital intensive (although capital may be gained through mortgage leverage ) and is highly cash flow dependent. If these factors are not well understood and managed by the investor, real estate becomes a risky investment. The primary cause of investment failure for real estate is that the investor goes into negative cash flow for a period of time that is not sustainable, often forcing them to resell the property at a loss or go into insolvency. There’s always a big risk in investing in real estate, since the capital is usually very large in comparison to other investments for beginners. Land is valueless, but for the things around it. Large and Long-Term: Investing in real estate is usually a large, and long-term investment where the buyer (investor) invests capital to acquire and own a building or land for the purpose of using the said land or building to earn income. This can be any type of property, ranging from family houses, apartment buildings to entire office complexes and skyscrapers. Usually for most investors though, it revolves around smaller buildings such as singlefamily homes or 2/3/4-plex apartment buildings. Leverage: An overwhelming number of millionaires and billionaires become so through real estate. Real Estate investors are usually very skilled in leveraging their money. Through leverage, I can easily buy a $1 million apartment building with only around $50-100k of my own money? The rest comes from the bank, and this means that my return on investment (ROI) is very, very high. One of the great reasons to invest in real estate is because my banker loves to lend me money for real estate. If I were to try asking my banker for a 30-year loan at 6.5 percent to buy mutual funds or stocks; they will laugh me out of their bank. Inflation protection: Also, by owning real estate I have a great protection against inflation, since I own actual property! It also increases over time, which in turns lets me raise rents, and thus increasing my revenue each month. Invest - 149 - Invest- 55 Assets That Grow Savings and Earn Passive Income Information: A real estate deal made with insufficient knowledge can be a disastrous one. As a beginner in real estate investment, I am required to research on the basic rules of investment. I can talk to property owners, investment advisors to know the pros and cons of real estate investment. Stable Investment: Real estate investment is the best investment I can make in my life. The value of land always goes up, at an industry average of 2% per year. Further, a building can last upto 50 years. And land will always increase in value. Further, as development come around the land, the land increases in value. Greatest Investment: For many people, their home is the single largest investment they will ever make. In fact, it is one of the most important parts of my portfolio because it serves a dual role as not only an investment but also a centerpiece to my daily life. Though a home is one of the largest investments the average investor will purchase, there are other types of real estate investments worth investing in. Tax breaks: One of the main reasons to invest in real estate is because the tax laws (loopholes) are written in favour of business owners who invest in real estate. Alternative Investment: In the context of portfolio investing, real estate is traditionally considered an ‘alternative’ investment class. That means it is a supplementary investment used to build on a primary portfolio of stocks, bonds and other securities. Tangible: One of the main differences between investing in a piece of real estate as compared to stocks or bonds is that real estate is an investment in the ‘bricks and mortar’ of a building and the land it is built upon. This makes real estate highly tangible, because unlike most stocks I can see and touch my property. This often creates substantial pride of ownership, but tangibility also has its downside because real estate requires hands-on management. I do not need to mow the lawn of a bond or unplug the toilet of a stock! Hybrid Returns: One of the beneficial features of real estate is that it produces relatively consistent total returns that are a hybrid of income and capital growth. In that sense, real estate has a coupon-paying bond-like component in that it pays a regular, steady income stream, and it has a stock-like component in that its value has a propensity to fluctuate. And, like all securities that I have a long position in, I would prefer the value to go up more often than it goes down! Backbone of Financial Sector: The financial fiber of the country runs on real estate. Real estate is the number one and most wanted security in capital acquisition through debt. Invest - 150 - Invest- 55 Assets That Grow Savings and Earn Passive Income Income Return Dependant On Full Occupancy: The income return from real estate is directly linked to the rent payments received from tenants, minus the costs of operating the property and outgoing mortgage/financing payments. So, it is to keep my property as full as possible. If I lose too many tenants, I will not have sufficient rents being paid by the other tenants to cover the building operating costs. My ability to keep the building full depends on the strength of the leasing market - that is, the supply and demand for space similar to the space I am trying to lease. In weaker markets with oversupply of vacancies or poor demand, I would have to charge less rent to keep my building full than in a strong leasing market. And unfortunately, if my rents are lower, my income returns are lower. Two Types of Returns: Real estate returns are generated in two ways. First, the income return comes from tenants' rent payments. The income return is a straightforward calculation because all I need to know is how much cash remains after all property expenses have been paid. The second type of return is the capital return, which is the increase or decrease in the value of the property due to changes in market demand and/or inflation. Appraisal of Returns: The capital return is more difficult to calculate, and requires the property to be valued or appraised. Capital appreciation of a property is determined by having the property appraised. An appraiser uses actual sale transactions that have occurred and other pieces of market data to estimate what my property would be worth if it were to be sold. If the appraiser thinks my property would sell for more than I bought it for, then I’ve achieved a positive capital return. Because the appraiser uses past transactions in judging values, capital returns are directly linked to the performance of the investment sales market. The investment sales market is affected largely by the supply and demand of investment product. If I want to determine the value of a real estate investment, the most accurate method is to sell the property and see how much money I get for it. Of course, the problem with this method is that I would no longer own that asset! In most cases I would want to determine the value without selling the asset, so I would approximate the value of the property based on the price that was actually achieved for other similar properties in the area of interest. The approximation process can be inexact and subjective. The real estate market does not have the convenience of a public market, such as that for stocks, where I can continuously value an asset. Also, it is rare for two real estate properties to be exactly the same - unlike two shares of stock in a company, which are exactly the same. A third factor contributing to the subjectivity of real estate valuation is that it does not trade very often, so it can be difficult to establish a market value- especially if substantial time has passed since the last comparable trade. All of the above noted valuation issues have given rise to a group of professional consultants referred to as appraisers. Invest - 151 - Invest- 55 Assets That Grow Savings and Earn Passive Income The task of an appraiser is to objectively assess the market value of a property by hypothesizing the most likely price of a trade between an arms-length buyer and seller. Appraisers have appropriate education and experience to perform property valuations, and typically are certified by a professional body which sets appraisal rules that must be followed by all of its members. If an appraiser is looking at a vacant building or land, they would use a third valuation method - the comparable sales approach. This approach assumes that if, for example, a vacant building sold for $100 per square foot, then the value of another similar vacant building would also be $100 per square foot. Land is also valued this way, with particular attention being paid to ensuring the benchmark land has equivalent zoning and density potential as the subject land. When choosing an appraiser to value my property, the most important consideration is that they have the appropriate experience and background to appraise my type of property. I do not want to hire a residential appraiser to value my commercial building unless they also have experience valuing commercial buildings. They also need to have experience appraising properties in my geographical area, because different locations have different market attributes. If my appraisal will be used by a third party, such as a mortgage lender, then I should be certain the lender will accept reports from my chosen appraiser. Last, the amount of the appraiser's fees should be a consideration. Mortgage Financing: The type and amount of mortgage financing is important to the performance of the property for two reasons. First, if my property has a closed mortgage in place that also happens to have poor terms (for example, a high interest rate or an undesirable loan to value or amortization period), then it can affect the value of the property. Therefore, it is important to consider the perception of the market when locking in my financing if there is a chance I will sell the property during the mortgage term. The second reason financing is important is because of the ongoing effects of leverage. Assuming I purchased a property for $1,000,000 one year ago without any financing. I just completed an appraisal that says the property is worth $1,200,000. So, my capital gain is $200,000, which results in a capital return of 20%. However, assuming I bought the same property but financed my purchase with a 50% loan to value, interest-only mortgage. After my purchase I therefore have $500,000 of my own cash invested and the bank has loaned I the other $500,000. One year later, I still owe the bank $500,000 because I used an interest-only mortgage. So when I get my $1,200,000 appraisal and subtract what I owe the bank, my equity in that property is worth $700,000. Since I have $500,000 invested, my capital gain is $200,000. My capital return, however, is 40% rather than the 20% I would have achieved if I did not use financing. This occurs because I still achieve a gain of $200,000, but I get it using only $500,000 of my own money instead of $1,000,000 of Invest - 152 - Invest- 55 Assets That Grow Savings and Earn Passive Income my own cash (but keep in mind that I would need to pay out interest payments to the bank). This is known as leverage, and it has a powerful impact on property returns. Volatility of Returns: The majority of the volatility in real estate returns comes from the capital appreciation component of returns. Income returns tend to be fairly stable, and capital returns fluctuate more. The volatility of total returns falls somewhere in between. No fixed maturity: Unlike a bond which has a fixed maturity date, an equity real estate investment does not normally mature. It is not uncommon for investors to hold property for over 100 years. This attribute of real estate allows an owner to buy a property, execute a business plan, then dispose of the property whenever appropriate. An exception to this characteristic is an investment in fixed-term debt; by definition a mortgage would have a fixed maturity. Tangible: Real estate is, well, real! I can visit my investment, speak with my tenants, and show it off to my family and friends. I can see it and touch it. A result of this attribute is that I have a certain degree of physical control over the investment - if something is wrong with it, I can try fixing it. I cannot do that with a stock or bond. Management: Because real estate is tangible, it needs to be managed in a handson manner. Tenant complaints must be addressed. Landscaping must be handled. And, when the building starts to age, it needs to be renovated. Inefficient Markets: An inefficient market is not necessarily a bad thing. It just means that information asymmetry exists among participants in the market, allowing greater profits to be made by those with special information, expertise or resources. In contrast, public stock markets are much more efficient information is efficiently disseminated among market participants, and those with material non-public information are not permitted to trade upon the information. In the real estate markets, information is king, and can allow an investor to see profit opportunities that might otherwise not have presented themselves. High Transaction Costs: Private real estate market has high purchase costs and sale costs. On purchases, there are real-estate-agent-related commissions, lawyers' fees, engineers' fees and many other costs that can raise the effective purchase price well beyond the price the seller will actually receive. On sales, a substantial brokerage fee is usually required for the property to be properly exposed to the market. Because of the high costs of ‘trading’ real estate, longer holding periods are common and speculative trading is rarer than for stocks. Invest - 153 - Invest- 55 Assets That Grow Savings and Earn Passive Income Lower Liquidity: With the exception of real estate securities, no public exchange exists for the trading of real estate. This makes real estate more difficult to sell because deals must be privately brokered. There can be a substantial lag between the time I decide to sell a property and when it actually is sold usually a couple months at least. Underlying Tenant Quality: When assessing an income-producing property, an important consideration is the quality of the underlying tenancy. This is important because when I purchase the property, I am buying two things: the physical real estate, and the income stream from the tenants. If the tenants are likely to default on their monthly obligation, the risk of the investment is greater. Variability among Regions: While it sounds cliché, location is the most important aspect of real estate investments; a piece of real estate can perform very differently among countries, regions, cities and even within the same city. These regional differences need to be considered when making an investment, because my selection of which market to invest in has as large an impact on my eventual returns as my choice of property within the market. ‫ق‬ Benefits $ Diversification Value - The positive aspects of diversifying my portfolio in terms of asset allocation are well documented. Real estate returns have relatively low correlations with other asset classes (traditional investment vehicles such as stocks and bonds), which adds to the diversification of my portfolio. $ Tax and Legal Advantages-Real estate generally has many tax and legal advantages. It also has the ability for one to take on great debt, have someone else (my tenants) pay off my debt while I keep the asset. $ Yield Enhancement - As part of a portfolio, real estate allows me to achieve higher returns for a given level of portfolio risk. Similarly, by adding real estate to a portfolio I could maintain my portfolio returns while decreasing risk. $ Inflation Hedge - Real estate returns are directly linked to the rents that are received from tenants. Some leases contain provisions for rent increases to be indexed to inflation. In other cases, rental rates are increased whenever a lease term expires and the tenant is renewed. Either way, real estate income tends to increase faster in inflationary environments, allowing an investor to maintain its real returns. Invest - 154 - Invest- 55 Assets That Grow Savings and Earn Passive Income $ Ability to Influence Performance - Real estate is a tangible asset. As a result, an investor can do things to a property to increase its value or improve its performance. Examples of such activities include: replacing a leaky roof, improving the exterior and re-tenanting the building with higher quality tenants. An investor has a greater degree of control over the performance of a real estate investment than other types of investments. ‫ق‬ Risks $ Costly to Buy, Sell and Operate - For transactions in the private real estate market, transaction costs are significant when compared to other investment classes. It is usually more efficient to purchase larger real estate assets because I can spread the transaction costs over a larger asset base. Real estate is also costly to operate because it is tangible and requires ongoing maintenance. $ Management - With some exceptions, real estate requires ongoing management at two levels. First, I require property management to deal with the day-to-day operation of the property. Second, I need strategic management of the property to consider the longer term market position of the investment. Sometimes the management functions are combined and handled by one group. Management comes at a cost; even if it is handled by the owner, it will require time and resources. $ Difficult to Acquire - It can be a challenge to build a meaningful, diversified real estate portfolio. Purchases need to be made in a variety of geographical locations and across asset classes, which can be out of reach for many investors. I can, however, purchase units in a private pool or a public security, and these units are typically backed by a diverse portfolio. $ Cyclical (Leasing Market) - Not unlike other asset classes, real estate is cyclical. Real estate has two cycles: the leasing market cycle and the investment market cycle. The leasing market consists of the market for space in real estate properties. As with most markets, conditions of the leasing market are dictated by the supply side, which is the amount of space available (or, vacancies), and the demand side, which is the amount of space required by tenants. If demand for space increases, then vacancies will decrease, and the resulting scarcity of space will cause an increase in market rents. Once rents reach economic levels, it becomes profitable for developers to construct additional space so that supply can meet demand. Invest - 155 - Invest- 55 Assets That Grow Savings and Earn Passive Income $ Cyclical (Investment Market) - The real estate investment market moves in a different cycle than the leasing market. On the demand side of the investment market are investors who have capital to invest in real estate. The supply side consists of properties that are brought to market by their owners. If the supply of capital seeking real estate investments is plentiful, then property prices increase. As prices increase, additional properties are brought to market to meet demand. Although the leasing and investment market have independent cycles, one does tend to influence the other. For instance, if the leasing market is in decline, then growth in rents should decrease. Faced with decreasing rental growth, real estate investors might view real estate prices as being too high and might therefore stop making additional purchases. If capital seeking real estate decreases, then prices decrease to force equilibrium. Although timing the market is not advisable, I should be aware of the stage of the market when I am making my purchase and consider how the property will perform as it moves through the cycles. $ Performance Measurement - In the private market there is no high quality benchmark to which I can compare my portfolio results. Similarly, it is difficult to measure risk relative to the market. Risk and return are easy to determine in the stock market but measuring real estate performance is much more challenging. ‫ق‬ The 4 Types of Real Estate All these real estate investments (direct property ownership, mortgages, and debt or equity securities) have in common one or more tangible real estate properties underlying each investment. That means when I make an investment, it is important to consider the characteristics of the underlying real estate because the performance of those properties will impact the performance of my investment. When I am looking at the underlying real estate, one of the most important criteria (aside from location, location, location!) is the type of property. When considering a purchase, I need to ask my self whether the underlying properties are, for example, residential homes, shopping malls, warehouses, office towers or a combination of any of these. Each type of real estate has a different set of drivers influencing its performance. I cannot simply assume one type of property will perform well in a market where a different type is performing well. Likewise, I cannot assume one type of property will continue to be a good investment simply because it has performed well in the past. Invest - 156 - Invest- 55 Assets That Grow Savings and Earn Passive Income $ Commercial Property Offices are the ‘flagship’ investment for many real estate owners. They are, on average, the largest and highest profile property type because of their typical location in downtown cores and sprawling suburban office parks. At its most fundamental level, the demand for office space is tied to companies' requirement for office workers, and the average space per office worker. The typical office worker is involved in things like finance, accounting, insurance, real estate, services, management and administration. As these ‘white-collar’ jobs grow, there is greater demand for office spaces. Returns from office properties can be highly variable because the market tends to be sensitive to economic performance. One downside is that office buildings have high operating costs, so if I lose a tenant it can have a substantial impact on the returns for the property. However, in times of prosperity, offices tend to perform extremely well, because demand for space causes rental rates to increase and an extended time period is required to build an office tower to relieve the pressure on the market and rents. $ Retail Property There is a wide variety of retail properties, ranging from large enclosed shopping malls to single tenant buildings in pedestrian zones. At the present time, the Power Center format is in favor, with retailers occupying larger premises than in the enclosed mall format, and having greater visibility and access from adjacent roadways. Many retail properties have an anchor, which is a large, well-known retailer that acts as a draw to the center. An example of a well-known anchor is a huge supermarket. If a retail property has a food store as an anchor, it is said to be food-anchored or grocery-anchored; such anchors would typically enhance the fundamentals of a property and make it more desirable for investment. Often, a retail center has one or more ancillary multi-bay buildings containing smaller tenants. One of these small units is termed a Commercial Retail Unit (CRU). The demand for retail space has many drivers. Among them are: location, visibility, population density, population growth and relative income levels. From an economic perspective, retails tend to perform best in growing economies and when retail sales growth is high. Returns from Retails tend to be more stable than Offices, in part because retail leases are generally longer and retailers are less inclined to relocate as compared to office tenants. $ Industrial Property Invest - 157 - Invest- 55 Assets That Grow Savings and Earn Passive Income Industrials are often considered the ‘staple’ of the average real estate investor. Generally, they require smaller average investments, are less management intensive and have lower operating costs than their office and retail counterparts. There are varying types of industrials depending on the use of the building. For example, buildings could be used for warehousing, manufacturing, research and development, or distribution. Some industrials can even have partial or full office build-outs. Some important factors to consider in an industrial property would be functionality (for example, ceiling height), location relative to major transport routes (including rail or sea), building configuration, loading and the degree of specialization in the space (such as whether it has cranes or freezers). For some uses, the presence of outdoor or covered yard space is important. $ Residential Property Residential property generally delivers the most stable returns, because no matter what the economic cycle, people always need a place to live. The result is that in normal markets, residential occupancy tends to stay reasonably high. Another factor contributing to the stability of residential property is that the loss of a single tenant has a minimal impact on the bottom line, whereas if I lose a tenant in any other type of property the negative effects can be much more significant. For most commercial property types, tenant leases are either net or partially net, meaning that most operating expenses can be passed along to tenants. However, residential properties typically do not have this attribute, meaning that the risk of increases in building operating costs is borne by the property owner for the duration of the lease. A positive aspect of residential properties is that in some countries, government-insured financing is available. At the expense of a small premium, insured financing lowers the interest rate on mortgages, thereby enhancing potential returns from the investment. ‫ق‬ How to Invest in Real Estate (4 Options) Real estate investments fall into one of the four following categories: private equity, public equity, private debt and public debt. My choice of which one to invest in depends on the type of exposure I am seeking for my portfolio. $ Public & Private Equity An equity investment represents a residual interest in the property. When I am an equity investor, I am essentially the owner of the property. I stand to gain a lot when the property value increases or if I am able to get more rent for my building. However, if things should go wrong (for example, all my tenants vacate and I cannot make my mortgage payment) then the mortgagee, who has a priority interest in my property, may foreclose and I must forfeit my Invest - 158 - Invest- 55 Assets That Grow Savings and Earn Passive Income equity position to satisfy their security. In that sense, the risks of an equity position in real estate is much like that of owning stock. The choice of whether I want to invest in equity or debt will depend upon my risk tolerance and my return expectations. The riskier choice is investing in equity, but I can also make a lot more money! As the greater the risk, the greater the reward. Public equity is made up of real estate securities such as standard equity REITs or publicly traded real estate operating companies. Because investments are traded on a stock exchange, they tend to exhibit return patterns that are similar to equities, even though the underlying assets are real estate. These public securities trade at a discount or a premium to their net asset values (NAVs), meaning that the value of the company is different than the sum of the underlying real estate values. This occurs as a result of the stock market valuation of these securities, which incorporates things like investor sentiment and psychology. It is important to be aware of this characteristic when making an investment in a real estate security because such investments can perform very differently than the underlying real estate that these public companies own. One of the benefits of buying a security is the relative ease of acquisition. I buy it in the same manner as I would buy a stock - phone my broker, make the order and pay the relevant commission. I also achieve good liquidity with these investments, because they can be sold on short notice into the market with none of the usual delays that take place in the private market. Private equity real estate investing is the traditional ownership method. If I own a home, I have participated in this market. There are a number of things to keep in mind when looking for deals: £ £ £ £ Information Networks: The key to locating investment opportunities is to be in touch with the various deal sources. I should get to know various real estate brokers and dealers. It also helps to have a network of other real estate owners, so I can keep up with an ever-changing market. I can find deals in unexpected places, such as my banker, lawyer, mortgage broker or through foreclosure records. Reputation: Over time, my reputation becomes very important in maintaining a reliable flow of investment opportunities. If I am a person that people want to deal with, opportunities will come to me more easily and frequently. No Hurry: I should take my time to find the investment that meets my desired characteristics. I will be better off waiting for the right investment than rushing into a questionable one. Fundamentals: I should look for positive fundamentals in all of my investments. I will always ask my self what drives tenants to want to be in the building I am considering, and what could happen in the future to affect the desirability of the property. I should consider things such as quality of tenants, building configuration, location, condition and ability to finance. Invest - 159 - Invest- 55 Assets That Grow Savings and Earn Passive Income £ £ £ Financial Analysis: When I find the right deal, I should always complete a financial analysis to make sure the returns meet my investment criteria. If I need financing, I will speak to a lender or a mortgage broker to determine what type of mortgage is available, and then include the financing in my financial model. Due Diligence: It is also worthwhile to complete a thorough due diligence on my prospective investment. This process can include having reports completed on the physical and environmental condition of the property, and having an appraisal performed. My lawyer will be able to obtain a variety of search results and will assist in examining the title. Depending on the complexity of the purchase, there are many other tasks that may be required. There are many costs related to due diligence and the purchasing process, so I will be sure these costs become part of my financial analysis. Some typical costs include lawyer's fees, financing fees, appraisal costs and other administrative fees. Management: I should determine how I am going to manage the investment. Will I do it myself or hire a manager? Cost accounting will be required. Tenant relationships are critical, so the manager must respect their requirements and maintain a working business relationship with them. It is up to me to ensure the long-term viability of the investment and to instruct the property manager with respect to strategy, such as redeveloping or selling the property. $ Public & Private Debt When I invest in debt, I am lending funds to an owner or purchaser of real estate. I receive periodic interest payments from the owner and a security charge against the property in the form of a mortgage. At the end of the mortgage term, I get back the balance of my mortgage principal. This type of real estate investing is quite like that of bonds. A common example of public debt is a Commercial Mortgage-Backed Security (CMBS). A CMBS is a pool of mortgage loans that are assembled by a lender, and then sold in tranches to the public market. As borrowers make their regular mortgage payments, the proceeds are pooled together and then are paid to the owners of the debt securities in a priority dictated by the rating of the security. The security's rating is determined by a third party rating service such as Moody's, Fitch, Standard & Poor's and Dominion Bond Rating Service. The rating process involves the agency reviewing the pool of mortgage loans, including an examination of the underlying collateral assets, to determine the quality of cash flow that is likely to be derived from those loans. If the loans are of a very high credit quality, a larger proportion of the mortgage pool will be assigned an AAA rating. The rating categories are consistent with bond rating categories, so for instance the A tranche is subordinate to the Invest - 160 - Invest- 55 Assets That Grow Savings and Earn Passive Income AAA tranche, and the buyer of the B-piece will be subordinate to all of the more senior tranches. Usually, all the holders of the more senior securities must receive their principal and interest payments before the subordinate pieces receive theirs. As such, tranches with lower credit quality are riskier, but have higher return potential. Private debt is not so much purchased as it is issued. That is, if I would like to invest in private debt, I should provide mortgage financing to an owner of real estate. In return for my mortgage loan, I will receive a fixed or floating interest rate, and a priority claim on the real estate assets in the event of default on the loan. A common example of investing in private debt is a Vendor TakeBack Mortgage (VTB). If I own a commercial property and sell it to a purchaser, I could choose to accept all or part of the payment over time. Just like a conventional mortgage received from a financial institution, the purchaser would pay interest on the borrowed funds over the length of the term, and I would register my claim to receive the payments on the title to the property. Another alternative is to make a contribution into a private mortgage pool, which is a pool of capital that is invested in a variety of mortgages. Such an investment would require diligence to determine its risk, because there is no third party rating agency to depend upon. A benefit of a mortgage pool versus a VTB is that a default of one mortgage will have less of an impact on my investment if it is combined with other mortgages to balance the risk. To purchase units in a private mortgage pool, I should contact an investment manager who assembles such pools, or a broker involved in the private mortgage market. Invest - 161 - Invest- 55 Assets That Grow Savings and Earn Passive Income $ The Investment Selection Matrix Once I select my market and decide whether debt or equity investing is appropriate, it becomes apparent what type of security to buy or investment to make. $ $ $ $ ‫ق‬ If I choose quadrant A, Public Equity, I should purchase real estate securities such as standard equity REITs or publicly traded real estate operating companies. If I select quadrant B, Private Equity, I should buy direct, ownership interests in real estate properties. If I choose quadrant C, Public Debt, I would purchase a mortgage REIT, a mortgage-backed securities (MBS) or (Commercial Mortgage-Backed Securities (CMBS). If quadrant D, Private Debt, is most appropriate, then I would lend money to purchasers of real estate, thereby investing in mortgages. Understanding Land Zoning & Land Use Regulation Zoning is the way the governments control the physical development of land and the kinds of uses to which each individual property may be put. Zoning is a purely a county, city, or municipal function. However, most communities administer zoning issues through their Community Development Director and a number of boards and commissions. It is usually risky to ignore zoning rules since the ramifications for zoning violations can be brutal. A zone is created and only certain types of property, or certain uses of properties, are allowed in the zone. For instance, in a an area zoned Residential/4 Units, only residential structures, such as homes or condominiums can be constructed, with a limit of four units per lot or acre. I cannot utilize a structure in this zone as a commercial storefront. There are four (4) most frequently-used zoning groups namely; $ Commercial, $ Industrial, Invest - 162 - Invest- 55 Assets That Grow Savings and Earn Passive Income $ Residential $ Agricultural. Further, within each of the general categories are more narrowly defined divisions. For example, a residential zone might be segregated into separate zones for single-family homes on one acre, single family homes on a half acre, hotels, boardinghouses, mobile homes, low-rise apartment complexes, highrise apartment complexes, or institutional housing. An industrial zone may be zoned ‘heavy’, ‘light’, or ‘research’. A commercial zone can be divided into small stores, shopping centers, gas stations, restaurants, drive-in facilities, adult-entertainment districts, and warehouses. Through zoning, property values are sustainable for longer periods and also reduces the number of speculative buyers. Developers also stick to stipulated architectural designs thereby preserving the landscape. The real estate adage that property values are determined by ‘location, location, location’ ... is true; in part because location usually determines the likely zoning. Further, in a crime infested location, people do not pay rent, people do not rent, and as sure as hell, people do not move in, hence property values go down. On the same breadth, in a jobless area, people move out, people default, and peopled onto move in, hence, no returns. “location, location, location.” On the other hand, property values also plummet when industries start operating from residential zones. ‘zoning always affects value’. The highest and best use that a property can have is a factor of how it is zoned. Zoning does affect the industry positively even though there has never been rigorous implementation by the local authority. It guides the planning policy, enhances appreciation of property values and many other aspects that one would want in a secluded area. The philosophy of zoning is to eliminate non-conforming uses; hardship notwithstanding. Thus ‘zoning is a double-edged sword for real estate investors’. If I contemplate the purchase of any questionable real estate, it is imperative that I get a written guarantee that the local government will continue to allow the non-conforming use and allow the property to be sold as non-conforming in the future. I should also personally check city zoning maps and ordinances. Invest - 163 - Invest- 55 Assets That Grow Savings and Earn Passive Income I can also request a certification as to the zoning status of a particular parcel. If there is any doubt about zoning or use restrictions, it will be money well spent. Zoning is determined by the housing trends and demand over a certain period. This is what makes some high-end markets being transformed into middle income areas. Violating zoning laws can be costly and time consuming and investors should strive to observe zoning standards. If I invest in real estate that is rental property, my tenants may cause zoning problems. Tenants who run a business from their home may unknowingly violate zoning laws, so it is very important to have a clause in my lease agreement stating what can and can not be done on my rental premises. Most home based businesses are not a problem, but if the tenant has customers coming to the property, there may be complaints about noise or traffic which can cause problems. Another way that zoning laws may affect my real estate investment is when zoning is changed from one class to another. This is called ‘Rezoning‘. Municipalities are not required to change a property’s zoning (absent a law or court order), so rezoning a property is not a slam dunk. If the zoning is changed from residential to another class this can mean a higher property value, which means more value for my investment. If the class is changed to residential then the property value may drop, causing me to lose money on my investment. Sometimes there is a conditional zoning requirement. One case may be where a residence has existed on a property for years. If the zoning laws change the area from residential to commercial, the city can not force the owner to sell or tear down the residence. But if the home is destroyed in a natural disaster or fire it can not be rebuilt, and only commercial buildings can be built on the land. A variance, on the other hand, is relief from some zoning requirement. It modifies an ordinance provision as it applies to a specific property for a specific reason, but it does not change the underlying zoning classification of that property. To get a variance I would have to show the municipal zoning board that an unreasonable hardship (one I did not create in the first place) would result if it were not granted. I will not get it, however, if my only argument is that I will lose money, because the hardship has to be something other than economic. ‫ق‬ Understanding Cash Flow The first and foremost step is to understand the concept of cash flow. In simpler terms, cash flow is calculated by subtracting the housing expenses (mortgage payment and property tax) from the money that is received from the tenants per month. Positive cash flow is when the received money is more than the housing expenses; whereas, if the expenses are higher than the generated Invest - 164 - Invest- 55 Assets That Grow Savings and Earn Passive Income income from the property, it is called a negative cash flow. If negative cash flow continues, then saving money is impossible, rather it may affect the personal income of the investor. I will remember the advice of Kiyosaki, ‘real estate investment is a business’ Hence, I have no interest in the underlying business, which is, farming, rental, office space, hotel, etc, I should not invest in real estate. And if I do, I will not understand the cash flow, and I will lose my money because of lack of financial intelligence. And if I understand, and like the business, then as Kiyosaki says, ‘the business will buy the real estate.’ ‫ق‬ Rules and Regulations Before I start any investment, I should read the rules and regulations of investing in rental properties. There are certain liabilities and responsibilities of real estate investments, which are specified in the country's jurisdiction. To know more about real estate investment tips, property deals, rules and regulations, I can talk to a lawyer, or do my own research. This will help me in knowing which properties are on sale, and the ones worth buying. ‫ق‬ Choosing Rental Property This is the most crucial part of investing in rental property. I can opt for single or multi-family unit or a vacation home. While searching for properties, I should make sure I consider locations which are in demand, so that I can find tenant easily. Such locations include areas near colleges, universities, corporate offices and good residential sites. This way, I will benefit in ways, getting tenants and high rent charges. A property in a suitable location is also easy to sell, without incurring losses. Hence, take quality time and check for the future income potential before finalizing the properties. In choosing rental property, I will remember the, ‘Infidelity Rule! ‘Do not fall in love with one house; fall in love with four houses.’ Invest - 165 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Value the Property: Even if I get a good property deal in a good location, I should not forget to evaluate the property. I can consult a professional or a real estate agent to calculate the real estate value. To get a better idea about rental property tax, I can seek advice from a tax advisor or a tax professional. Always discuss with a lawyer to avoid any legal issues of rental property investments. While purchasing a rental property, I will make sure I buy renters’ insurance. I will recall that in investing in property, it is not about the number of houses rather, the value of each house, being, where it is located, and its proximity to service areas. “Location is the key.” ‫ق‬ Choosing Tenants: After I purchase a rental property, I can start advertising, in order to find tenants as soon as possible. However, I will not make haste, and also I will choose the tenants carefully. I will make sure I analyze the creditability of the tenants for my property. Before proceeding with the formalities of renting, I can run credit checks and screen tenants, so as to minimize future problems. I should discuss the mode of transaction and also gain vital information like their background, references and permanent address. It is always advisable to collect security money from the tenants. ‫ق‬ Selling Rental Property: Before I purchase the investment properties, I should also decide how long I want to own them. Both short-term and long-term possession have their own pros and cons. A long possession will require investment in repairing and maintaining the properties. However, for those who own a few properties, long-term possession is beneficial. In case of negative cash flow sell the home or property, instead of incurring loses. With this money, I can take possession of a better property. Further, not all my properties will be occupied in the first months of investment. Hence, I should not panic, if I earn less income in the beginning. I should make sure that I check the cash flow and keep myself updated about other investment options that may provide me higher returns. A major advantage of real estate investment is that it will continue to boom, as the population is increasing day-by-day and obviously, people require homes to stay. Invest - 166 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Real Estate Markets When I am planning my real estate investments, one of my first tasks is to decide what kind of exposure to the real estate market is appropriate for my situation. Different exposures produce varying levels of risk and return. My choice will also influence the means by which I will acquire the real estate. Real estate markets in most countries are not as organized or efficient as markets for other, more liquid investment instruments. Individual properties are unique to themselves and not directly interchangeable, which presents a major challenge to an investor seeking to evaluate prices and investment opportunities. For this reason, locating properties in which to invest can involve substantial work and competition among investors to purchase individual properties may be highly variable depending on knowledge of availability. Information asymmetries are commonplace in real estate markets. This increases transactional risk, but also provides many opportunities for investors to obtain properties at bargain prices. ‫ق‬ Private vs Public Markets The first type of market I could participate in is the private market. In the private market, I would be purchasing a direct interest in one or more real estate properties. I would own and operate the piece of real estate my self (or through a property manager), and I would receive the rent payments and value changes from that investment. For example, if I were to purchase an industrial building that was leased to one or more tenants who pay I rent, I would be participating in the private real estate market. I could also participate in this market by purchasing properties with any number of partners - this is known as a pool or syndicate. Alternatively, I could choose to invest in the public real estate market. I would be participating in the public market if I purchased a share or unit in a publicly traded real estate company, such as a real estate investment trust (REIT). If I buy a real estate security, I am investing in a company that owns real estate and manages it on behalf of the shareholders/unit-holders of the company. As a result, my exposure to the real estate market is more indirect. A real estate security usually pays a dividend or distribution in order to send the rent payments that it receives from tenants to its shareholders/unit-holders. Any price appreciation or depreciation in the assets owned by the company is reflected in its share or unit price. ‫ق‬ Real Estate Market Players Invest - 167 - Invest- 55 Assets That Grow Savings and Earn Passive Income $ Market Regulators The real estate market is regulated by various bodies. There are both state regulations, backed by law and threat of section, and self-regulation by associations. The government regulators are the line ministry, which is in charge of registering titles, and also provides search services to confirm registered owners of property. The market is also regulated by professional associations, which are member based and controlled, and include the following: £ £ £ £ Association Association Association Association of of of of land surveyors real estate valuers real estate agents architects $ Market Participants The real estate market also has market participants, as below: ‫ق‬ Real Estate Brokers These are the professionals who do match making between investors who want to sell or lease their property, and the market who want to buy or rent property. ‫ق‬ Real Estate Agents These are the professionals who manage property on behalf of the property owners. ‫ق‬ Appraisers They investigate and calculate the value of a property, and determine the capital gain. Invest - 168 - Invest- 55 Assets That Grow Savings and Earn Passive Income REAL ESTATE INVESTMENT PRODUCTS ¥ Real Estate Investment Groups Real Estate Investment Groups are similar to small mutual funds. for rental properties. While an investor may own one or professionally managed company acquires, builds, maintains the units on the properties in exchange for a percentage of the ¥ They are set up more units, a and lets out all monthly rent. Rental I can opt for real estate investment with an aim to rent the property out to a tenant. As the owner (landlord) I earn a continuous stream of rent from the tenant, but I am responsible for paying the mortgage, taxes and any costs associated with maintaining the property. I also benefit from capital appreciation (a rise in the value of the property over time). However, I run the risk of not finding a tenant and could suffer negative monthly cash flows, with mortgage payments and maintenance expenses still to be borne. As compared to owning stocks and bonds, rental real estate requires a significant amount time and effort to be devoted by me, the landlord. To recover the investment in real estate through rental fees, it is advisable to charge at least 1% of the value of the property as monthly fees. For instance, if the property is worth USD. 5 million, then, the monthly rent should be 1% of USD. 5 million, that is, USD. 50,000, and target at most 8 years as break even time point. ¥ Real Estate Trading Instead of buying land to hold (land banking), real estate traders hold properties for only a short span of time (less than four months), aiming to sell them at a profit. This process is called flipping properties. In true investor vocabulary, flipping is known as speculating or trading. Some people call it gambling. While flipping is one method of investing, there are many, more sophisticated, less risky ways to do well with real estate. As a real estate trader, I aim at purchasing significantly undervalued or very hot properties. I may or may not invest money into improving the property before putting it back on sale. A bear market could result in substantial losses for a real estate trader, since the investment is large. I will teach myself to negotiate hard in this industry, for the saying is right, ‘a house is worth whatever it sells for.’ Invest - 169 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Real Estate Investment Trusts (REITs) A real estate investment trust (REIT) is a corporation that invests in real estate. REITs trade on major exchanges. A REIT uses investors' money to acquire and operate properties. The benefits of REITs are: $ $ $ $ $ REITs provide fairly regular income. Investors gain exposure to non-residential investments (like malls and office buildings). They are tax sheltered, with 3-5% tax deducted on the income, unlike the average 30% tax on shares and corporate taxes. REITs are highly liquid. REITs are required by law to distribute 90% of their taxable income in the form of dividends to shareholders. Before making a choice regarding the kind of real estate participation, an investor must evaluate his/her investment capacity and risk appetite. Invest - 170 - Invest- 55 Assets That Grow Savings and Earn Passive Income 2. INSURANCE INVESTMENT INTRODUCTION TO INSURANCE ¥ What is Insurance? Insurance is the financial protection against a loss arising out of happening of an uncertain event or emergency. In life, there are three types of emergency, and they involve my property; my life; and my health. It is an agreement that the insurance company will pay me an amount as compensation if any unexpected event occurs (like theft); or after the expiry of a certain period (like 20 years, or upon death). The party bearing the risk, or selling the insurance, is known as the 'insurer' or 'assurer' and the party whose risk is covered is known as the 'insured' or 'assured' or ‘policy holder’. For more reading on insurance as a protection against emergencies, I should read Ojijo’s Making My Child Financially Intelligent: Money Lessons by Age Group (from 3-13years). However, despite insurance being a contract, certain types of insurance are compulsory. In many countries it is compulsory to have vehicle insurance before using or keeping a motor vehicle on public roads. Its primary use is to provide protection against physical damage resulting from traffic collisions and against liability that could also arise therefrom. ¥ What is Insurance Investment? Whereas the insurance industry is for risk management, can also serve as an investment. ¥ Insurance Markets Insurance markets deal with the buying and selling of insurance. The insurance market conventionally focused around life insurance until recently, a various range of other insurance policies covering sectors like medical, automobile, health and other classes falling under general insurance came up, generally provided by the private companies. ‫ق‬ Insurance Market Regulators Every country either has an Insurance Commission, or Insurance Regulatory Authority, which regulates all entities carrying out insurance business. There are also elf regulatory bodies, including the following: Invest - 171 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ ‫و‬ Association of Insurers ‫و‬ This is an association of companies providing insurance services. ‫و‬ Association of Insurance Brokers ‫و‬ Association of Insurance Agents Insurance Market Players The following are the participants in the insurance market. ‫و‬ Life Insurance Companies ‫و‬ Health Insurance Companies ‫و‬ Property Insurance Companies ‫و‬ Motor Vehicle Insurance Companies Invest - 172 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ How to Invest in Insurance Insurance companies are engaged in two primary revenue streams: the assumption of other people’s risk in exchange for money/premiums (risk management) and the management of such premiums (asset management). An insurance company makes money by making more in revenue (insurance premium sales + investment income) than expenses (premiums paid out + general operating expenses). Beside the traditional metrics of investing stocks, I should look at the following fundamentals. $ Premium Growth. In plain English, how many premiums is it selling? This is the life-blood of any insurer’s growth. Stop selling premiums and the company will shrink since it has expenses (premiums to pay out) without corresponding revenue other than investing income. Premium growth is so important that commissions paid are generally the largest expense after premiums paid. I should also look for sources of premium growth- ideally, an insurance company should be growth among many product lines. Most companies highlight premium growth in their discussion to the financial statements. $ Combined Ratio. This tells me if the premiums are making money. This is calculated by expenses and losses/revenue from premiums. If the ratio is more than 100, the company is paying out more than it is taking in. If the ratio is less than 100, the company is making money. Most insurance companies do not disclose this ratio. It has to be calculated manually or analysts will calculate it in a research report. $ Investment Income. In some insurance sectors, insurance premiums are close to, or are, loss leaders. Money is made mostly through investment income. There’s two factors to look at: (i) what is the total of investment income over all revenue; if it is really high, the insurance company either is not selling a lot of premiums or has become purely an asset management company addicted to trading revenue to be profitable; neither are positive developments for an investor; (ii) what is the company invested in? Hopefully, their trading strategy is prudent. Most insurance companies will disclose what they are investing in and whether they are engaging in hedging strategies. $ Capital Adequacy. Similar to a bank, an insurance company has to put aside enough money in reserves (which does not show up in earnings until the transfer of risk has expired) to pay for future claims. This is disclosed by all insurance companies. The higher the ratio the safer the company is but too high of a ratio means either: (i) risk payout is anticipated to be quite high in the future; or (ii) the company is not expanding since it is putting so much money in reserves and not to expansion. Invest - 173 - Invest- 55 Assets That Grow Savings and Earn Passive Income $ Credit Rating. As a payer of policies, all insurance companies have a credit rating which reflects a third parties assessment of their ability to pay policies as they become due. The higher the credit rating the better (i.e. AAA is ideal). This is always stated by insurers. Invest - 174 - Invest- 55 Assets That Grow Savings and Earn Passive Income INSURANCE INVESTMENT PRODUCTS Investment through insurance products is carried out using the following avenues. ¥ Insurance Bond/Investment Bond ‫ق‬ Definition An insurance bond (or investment bond) is a single premium life assurance policy for the purposes of investment. Traditionally insurance bonds were withprofits policies and were often called with-profit(s) bonds. Since the introduction of unitised insurance funds they have often been marketed as unit-linked bonds or investment bonds. An investment-linked insurance plan is a life insurance that combines investment and protection. My premiums will buy life insurance protection as well as units in a fund of my choice; managed by the insurance company i.e. I choose how to allocate my insurance premiums towards protection and investment. Unitised Insurance Funds or Unit-Linked Insurance Funds are a form of collective investment offered through life assurance policies. An insurance company's contract may offer a choice of unit-linked funds to invest in. All types of life assurance and insurers pension plans, both single premium and regular premium policies offer these funds. They facilitate access to wide range and types of assets for different types of investors. ‫ق‬ Characteristics When an investment bond is taken out, a life to be insured and a beneficiary are nominated, and if the life insured dies, the full surrender value is paid to either the policy owner (if different from life insured) or to nominated beneficiaries (if the policy owner is the same as the life insured). In the event that the life insured dies, there will be no tax liability for the beneficiary. It is offered by life insurance companies. The investment is provided in the form of a single premium life insurance policy. Insurance bonds are very simple investments that allow investors to save for the long term. Investors who hold their bonds for longer period of time, mostly more than 10 years without making any withdrawals in that time are able to receive their earnings tax free. Invest - 175 - Invest- 55 Assets That Grow Savings and Earn Passive Income Investing in these bonds can be profitable because they offer income or growth and facilitate investors with the access to a variety of investment funds. They are normally designed to produce long term capital growth, but can also be used to generate an income. The range of fund choice for investment has grown significantly in recent years with the increased trend to provide unit-linked alternatives to popular unit trust and OEIC funds styled as externally managed funds as opposed to the life assurance companies internally managed funds. Typically the externally managed fund links have higher charges; this is tolerated as the expectation is for better returns. Nature of funds: The funds are open-ended investments made available through life assurance companies. Unlike most collective investments there is no independent body tasked with safeguarding the assets. The company may manage, promote and hold the assets on behalf of the policyholders. The policyholders have rights to the assets but do not own the units, nor are they readily redeemable. Unit-Linked Insurance Plan (ULIP) is a type of life insurance where the cash value of a policy varies according to the current net asset value of the underlying investment assets. It allows protection and flexibility in investment, which are not present in other types of life insurance such as whole life policies. The premium paid is used to purchase units in investment assets chosen by the policyholder. ULIP provides solutions for insurance planning, financial needs, and many types of financial planning including children’s marriage planning. The policyholder purchases units at their Net Asset Values (NAV) and also makes contributions toward another investment vehicle. Unit linked insurance plans allow for the coverage of an insurance policy, and provide the option to invest in any number of qualified investments, such as stock, bonds or mutual funds. A unit linked insurance plan acts just like a savings vehicle, but also has the benefits of an insurance contract. When an investor purchases units in a ULIP, I am purchasing units along with a larger number of investors, just like an investor would purchase units in a mutual fund. Different ULIPs offer different qualified investments. The most important benefit of ULIP as opposed to conventional plans is the flexibility they give the investor to choose the premium amount and also choosing the underlying fund in which this money is to be invested. ULIPs also come with an option of lifecycle-based portfolio strategy that redistributes my money across various asset classes (Automatic Asset Allocation) based on my life stage and risk tolerance. Thus, with this plan, I can look forward to a great start to realize all my aspirations. Invest - 176 - Invest- 55 Assets That Grow Savings and Earn Passive Income Like endowment plans, the benefits are paid to me or my nominee at the end of a specific period, on maturity, on surrender, if I suffer total permanent disability and/or upon my demise. The value for the policyholder is derived, not from an actual claim event, rather it is the value derived from the 'peace of mind' experienced by the policyholder, due to the negating of adverse financial consequences caused by the death of the Life Assured. Life policies are legal contracts and the terms of the contract describe the limitations of the insured events. ‫ق‬ Why Invest In An Insurance Bond? There are many reasons why bonds would provide a suitable investment vehicle for my money, though Unit Trusts are more tax-efficient. Useful features of Bonds for more specialist planning scenarios include the tax deferred status, the ability to write the investment in trust and reduce the inheritance tax liability on an estate, and exclusive access to expensive investment links like guaranteed or protected profits funds, to name a few. Bonds can provide income or growth and when income is required there are now bonds that can offer a set minimum guaranteed income for life of the plan holder. Nowadays almost all of the investment funds offered within investment bonds can be bought directly as Unit Trusts or OEICs. But increased annual charges on unit trusts and OEICs mean they are not always cheaper than investment bonds over the long term. But they are much more flexible. I can take my money out of a unit trust or OEIC at any time without penalty. The other advantage is that no capital gains tax is paid by the fund managers. ‫ق‬ Two (2) Categories of ULIP Funds Life-based contracts tend to fall into two major categories: £ Protection policies - designed to provide a benefit in the event of specified event, typically a lump sum payment. A common form of this design is term insurance. £ Investment policies - where the main objective is to facilitate the growth of capital by regular or single premiums. Common forms are whole life, universal life and variable life policies. $ Whole Life Assurance Invest - 177 - Invest- 55 Assets That Grow Savings and Earn Passive Income Whole Life Assurance is a permanent life insurance and therefore applies for a lifetime. Generally, the life insurance premiums remain fixed for the entire span of the policy or limited term. Whole Life Assurance has investment benefits for the insurer since it has a cash value component, which can be made accessible through policy loans or surrenders. This is Life-long protection cover. Hence, premiums are paid throughout your life or for a limited term, and the money including bonuses will be paid when I pass away or suffer total and permanent disability. Whole life cover can also be Single Premium Whole Life or Limited Pay Whole Life. ‫و‬ Limited Pay Whole Life In a Limited Pay Whole Life, the policy itself continues for the life of the insured but instead of paying annual premiums for life, they are only due for a certain number of years, such as 10. The policy may also be set up to be fully paid up at a certain age, such as 55 or 75. ‫و‬ Single Premium Whole Life A Single Premium Whole Life is a form of limited pay, where the premium pay period is a single large payment up-front. $ Variable Universal Life Insurance Variable Universal Life Insurance (often shortened to VUL) is a type of life insurance that builds cash value. In a VUL, the cash value can be invested in a wide variety of separate accounts, similar to mutual funds, and the choice of which of the available separate accounts to use is entirely up to the contract owner. The 'variable' component in the name refers to this ability to invest in separate accounts whose values vary—they vary because they are invested in stock and/or bond markets. The 'universal' component in the name refers to the flexibility the owner has in making premium payments. The premiums can vary from nothing in a given month up to maximums defined by the regulators of life insurance. This flexibility is in contrast to whole life insurance that has fixed premium payments that typically cannot be missed without lapsing the policy. It protects the policyholder until death—however long that may be. Also like whole life insurance, universal life insurance accrues cash value over time. Unlike whole life insurance, universal life insurance breaks the death benefit and cash value accumulation into separate components. This allows the policy holder to make changes in the policy. For example, if the policyholder wants to increase the death benefit, he or she puts more of the premium money into the insurance account and less into the cash value account. The reverse is also true. The policyholder can decrease the death Invest - 178 - Invest- 55 Assets That Grow Savings and Earn Passive Income benefit and increase the cash value contribution. To reduce premiums, the policyholder can pay only the insurance portion. Once the cash value has accumulated, the policyholder can withdraw the money. The money must be paid back, or else the death benefit will be decreased. Some people use the universal life insurance policy as a savings account to draw on as they get older. Others use the accumulating cash value to increase the death benefit so they have more to leave their loved ones. Universal life allows these choices and decisions to be made throughout my lifetime. With most if not all VULs, unlike whole life, there is no endowment age (which for whole life is typically 100). This is yet another key advantage of VUL over Whole Life. With a typical whole life policy, the death benefit is limited to the face amount specified in the policy, and at endowment age, the face amount is all that is paid out. Thus with either death or endowment, the insurance company keeps any cash value built up over the years. However, some participating whole life policies offer riders which specify that any dividends paid on the policy be used to purchase ‘paid up additions’ to the policy which increase both the cash value and the death benefit over time. If investments made in the separate accounts out-perform the general account of the insurance company, a higher rate-of-return can occur than the fixed rates-of-return typical for whole life. The combination over the years of no endowment age, continually increasing death benefit, and if a high rate-ofreturn is earned in the separate accounts of a VUL policy, this could result in higher value to the owner or beneficiary than that of a whole life policy with the same amounts of money paid in as premiums. ‫ق‬ Value Added Term (VAT) Assurance This is a plan that offers both protection and savings, but for a fixed term, mainly 15 years. In a Value Added Term (VAT) Assurance there is more than protection. VAT combines both cash value and a tax-sheltered savings plan. Therefore, my premium payments are applied both for protection and savings. If I survive the term and no claim arises during the full term of the VAT Assurance, all premiums (100%) I paid to the insurance company will be refunded. In order to build these refunds, the premiums charged on VAT are higher than for other term covers. This cover is suitable for those people who often wonder why they should insure their lives while the benefit will end up in the hands of beneficiaries in the unfortunate event of death, since it build these refunds. Invest - 179 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Value Added Mortgage (VAM) Protection Assurance In a Value Added Mortgage (VAM) Protection Assurance combines both protection and cash value. Therefore, my premium payments are applied both for protection and guaranteed return of premiums paid at the end of the term. If the life assured survives the term and no claim arises during the full term of the VAM Life cover, all premiums (100%) paid by the life assured and received by the company will be refunded. In order to build these refunds, the premiums charged on VAM protection assurance are higher than normal Mortgage protection premiums. ‫ق‬ Different funds offered by ULIP General Description Nature of investments Risk Category Equity funds Investing in companies stock. Medium to high Income, fixed deposits & bond funds Investing in Government securities & in corporate bonds. Medium Cash Funds Investing in cash, bank deposits & money market Low Balanced Funds Combination of equity investment & fixed interest instruments Medium ‫ق‬ Difference between Traditional Endowment And ULIP The main difference between traditional endowment and ULIP is that ULIP: ¥ ¥ Payments will depend on the price of the units at the time of claim. Being Investment-linked and like other types of investments, are exposed to investment risk. The unit price of an investment fund is linked to the total value of the plan, which fluctuates with the movements in the unit price. Hence, I may realize a gain or loss when I sell my units, and may even get less than what I invested. Past-performance of an investmentlinked fund's track record is only a guide to future performance. Invest - 180 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ ¥ ¥ ‫ق‬ Give me flexibility and leverage to choose my own level of protection and investment, to increase your premiums and coverage when your finances improve in the future and to choose the type of funds or portfolio (Equity Fund, Money Fund, Growth Fund and Bond Fund), based on your risk appetite. And as Robert Kiyosaki said, ‘Leverage is the reason some people become rich and others do not become rich.’ Allows me to periodically vary the amount of my premium payments (either in single or regular-premium as well as periodic premium injections) or coverage based on my own personal financial situation. The single premium allows me to immediately invest more to generate returns. Allows me to switch funds after periodically evaluating my options carefully to find the right plan with the right fund to suit my changing needs. Basic Charges on ULIP’S ¥ Premium Allocation Charges- It normally includes initial & renewal expenses apart from commission expenses. ¥ Mortality Charges- This charge is provided for the Cost of Insurance Coverage under the plan. A lot of factors are responsible for mortality charge like age, amount of cover etc. ¥ Fund Management Fees- These are fees levied for management of the fund(s) and are deducted before arriving at the Net Asset Value (NAV). They usually range from 1.5 % to 3%. ¥ Policy/Administration Charges- These are the fees for administration of the plan and levied by cancellation of units. This could be flat throughout the policy term or vary at a pre-determined rate. ¥ Surrender Value- A surrender charge may be deducted for premature partial or full encashment of units wherever applicable, as mentioned in the policy conditions. ¥ Fund Switching Charges- Limited fund switching charges may be allowed every year. ¥ Service Tax Deduction- Before allotment of the units the applicable service tax is deducted from the risk portion of the premium. ‫ق‬ Tips for Investing in ULIP Things to remember before going for a ULIP ¥ Invest for a long term- A long term investment will give me good results. ¥ Be sure about the charges- Make sure about the charges that the company will take from me. There should not be any hidden cost. ¥ Invest at my own risk- Investing in ULIP is also risky, I should check the risk appetite before investing. Invest - 181 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Advantages of ULIP $ $ $ $ Provide life cover. Tax saving. It also gives me opportunity to invest in stock market. Gives me the option of long term investment. $ Variable universal life insurance receives special tax advantages $ VUL policies have a great deal of flexibility in choosing how much premiums to pay for a given death benefit. Financial Protection - As with all life insurance programs, VULs can be used to protect a family in the case of a premature death. $ Tax Advantages - Because of its tax-deferred feature, the VUL may offer an attractive tax advantage, especially to those in higher tax brackets. To attain them, the policy must be highly funded, for the tax advantages to offset the cost of insurance. These tax advantages can be used for either: ¥ Education Planning - The cash value of a VUL can be used to help fund children's education, as long as the policy is started very early. ¥ Retirement Planning - Because of its tax-free policy loan feature, the VUL can also be used as tax-advantaged income source in retirement, assuming retirement is not in the near future and the policy is not a modified endowment contract. Again, the policy must be properly funded for this strategy to work. $ Estate Planning - Those with a large estate can sometimes use a VUL as part of their estate planning strategy to reduce or avoid estate taxes by setting up a Life Insurance Trust. $ ‫ق‬ Disadvantages $ Cost of Insurance - The cost of insurance for VULs is generally based on term rates and as the insured ages, the risk of mortality increases, increasing the cost of insurance. If not monitored properly the cost of insurance may eventually exceed the cash outlay depleting savings. If this continues long term the savings will be depleted and insured will be given an option to increase the cash outlay to cover the higher cost of insurance or cancel the policy leaving them with no savings and either no insurance, or very expensive insurance. $ Cash Outlay - The cash needed to effectively use a VUL is generally much higher than other types of insurance policies. If a policy does not have the right amount of funding, it may lapse. $ Investment Risk - Because the sub accounts in the VUL may be invested in stocks and bonds, the insured now takes on the investment risk rather than the insurance company. Invest - 182 - Invest- 55 Assets That Grow Savings and Earn Passive Income $ Complexity - The VUL is a complex product, and can easily be used (or sold) inappropriately because of this. Proper funding, investing, and planning are usually required in order for the VUL to work as expected. Rights Offering: Issuance of “rights” to current shareholders allowing them to purchase additional shares, usually at a discount to market price. Shareholders who do not exercise these rights are usually diluted by the offering. Rights are often transferable, allowing the holder to sell them on the open market to others who may wish to exercise them. Rights offerings are particularly common to closed-end funds, which cannot otherwise issue additional ordinary shares. Risk: The chance of loss on an investment due to many factors, including inflation, interest rates, default, politics, foreign exchange, call provisions, etc. In Private Equity, risks are outlined in the Risk Factors section of the Placement Memorandum. Shell Corporation: A corporation with no assets and no business. Typically, shell corporations are designed for the purpose of going public and later acquiring existing businesses. Also known as Specified Purpose Acquisition Companies (SPACs). Staggered Board: This is an anti-takeover measure in which the election of the directors is split in separate periods so that only a percentage (e.g., one-third) of the total number of directors come up for election in a given year. It is designed to make taking control of the board of directors more difficult. Statutory Voting : A method of voting for members of the Board of Directors of a corporation. Under this method, a shareholder receives one vote for each share and may cast those votes for each of the directorships. For example: An individual owning 100 shares of stock of a corporation that is electing six directors could cast 100 votes for each of the six candidates. This method tends to favor the larger shareholders. Invest - 183 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Endowment Plans ‫ق‬ Definition Endowment Plan is a type of Life Insurance policy where the premium paid is partly divided to secure my life and partly for investment purpose to generate revenues. ‫ق‬ Characteristics Wealth Creation Tools: Endowments are wealth creation plans which give me-the policyholder-the dual benefit of protection along with the potentially higher returns in the form of bonuses. Hence, endowment products combine protection and savings. The benefits are either paid at the end of a specific period, on maturity, on surrender, and if I suffer total permanent disability and/or upon my demise. Investment: The insurance companies in this reference act like brokers to me; they invest my money in the market and share the returns with me. Insurance companies generally invest money in virtually risk-free government debt, which is a safe bet but earns meager returns. Each year the insurance companies declare bonuses and these bonuses are nothing but the profit earned on investments made after deducting the administrative expenses of the insurance companies. Long term: Such types of plans are long term plans which cover life. I am bound to pay the premium until its maturity and the premiums payable for such plans are obviously expensive than other term plans. Endowment plans are for the long term. Terminating one before maturity can incur great cost to my future financial position. Transparency: The investments made by the insurance companies lack transparency and I have no control over the investment made by the companies. I have no idea where the money is being invested and how much and so on. So basically I have to accept whatever the insurance company offers to pay. Thus this is one reason for the plan to have lost its popularity. The plan has a competition now; the Unit Linked Plan has been introduced. It allows more flexibility and transparency. The premium for Endowment Plan is significantly higher than any other type of Term Life Insurance Plans for the same amount of sum assured because it is insurance plus investment plan clubbed together offering a wider option to the consumers. Bonuses: On all endowments, insurance companies provide extra cash or accrued bonuses at maturity. Each year, the companies also allocate a bonus which is paid on maturity of the policy. Bonuses vary and depend on the profits of the portfolio, but are paid on the full face amount of the policy. Since it is an endowment plan, in case I survive the tenure of the policy, an Invest - 184 - Invest- 55 Assets That Grow Savings and Earn Passive Income amount equivalent to the sum insured plus the accumulated bonuses is payable to me. If I expire during the tenure of the policy, the sum insured plus the accumulated bonuses is payable to the nominee or beneficiary. Special feature of the plan is that even on survival the policy holder is payable by the insurance company. This means that the plan is beneficial in both ways which is not the case in any other term policies. There are two types of bonuses: ¥ Annual (Reversionary) Bonuses: These bonuses are declared annually as cash values computed as percentages of the basic sum assured. Once granted, these bonuses are guaranteed and cannot be withdrawn. ¥ Accrued (Final or Terminal) Bonuses: The company grants an additional bonus at the end of the life of a policy, designed to encourage the policyholder to keep the policy in force until the maturity date. The size of the terminal bonus is dependent upon the investment conditions prevailing at the time of maturity, as well as upon investment performance. Accrued bonuses are not guaranteed. Endowment Plans are best for people who satisfy the following criteria: ¥ ¥ ¥ ¥ ¥ ‫ق‬ Young Have a lack of discipline to save regularly Prefer simplicity in terms of protection and investment Risk Averse Prefers to know the minimum guaranteed returns than dreaming about potential upsides Types of Endowment Plans There are two types of endowment plans, as below: ‫ ق‬Ordinary Endowment Assurance: In this case, the sum assured is paid to the assured when the policy matures and this happens whether I survive my policy or to my beneficiaries if I die. ‫ ق‬Anticipated Endowment Assurance: This provides for part payment of the benefits within a specified period of time, for instance, payment of 20% the first five years, and the rest, 80%, on maturity of the policy. Invest - 185 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Child Education Plan ‫ق‬ Definition This is a savings and protection tool to provide the money my child needs and ensure that money is made available at crucial junctures in my child's schooling years - nursery, primary, secondary, tertiary, graduate and postgraduate levels - to fund crucial education investments for my child's future. Under this policy, the child is the beneficiary, while as the parent/legal guardian, I am the policy owner. ‫ق‬ Characteristics A death benefit equals to a guaranteed 100% sum assured, plus accrued policy bonuses (when declared) will be paid to the child or nominated beneficiary (ies). ‫ق‬ Why Do I Need A Child Education Policy? One of my most important responsibilities as a parent or guardian is to ensure that my child gets the best possible education that can be provided. Yet, the cost of higher education is ever increasing and has put a financial strain on many families. That is why it is important to start planning for my child's education as soon as possible, because the earlier I begin, the more time it allows my money to grow. The child education policy will provide the funds needed by my child to pursue further education and assures that whatever happens in the future, my child will still have the means to pursue some of his/her goals in life and my child's education continues unhampered.. Hence, the Education Plan paves the way for success to my beloved child by offering guaranteed education fund at the selected policy anniversary. ‫ق‬ Choosing an Education Plan ¥ ¥ ¥ ¥ Consider how much money I want to set aside for my child’s education. Make sure that the premium is affordable. Choose a policy that gives me flexibility so I can gradually increase the savings in the future. Ensure that I opt for the Policy Owner benefit rider. Invest - 186 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ How Much Cover My Child Needs I should have a goal in mind. What are my goals for my child's education? The following are some of the factors I may need to consider in determining the level of coverage: ¥ ¥ ¥ ‫ق‬ Place of Study: Studying locally or abroad? If abroad, is there a likelihood that it would cost more? Where would that be? University of Choice: A top-notch university will cost more; Length of Study: The longer duration, the higher the incidental expenses. Education Investment Guide Working through the above factors will help me figure out the expected education costs and investment. As a guide, I may try to calculate an example of how much I will need. ¥ ¥ ¥ ¥ Take current annual fees. Expected living expenses. Plus number of years of study. Since the education costs will be incurred in the future, I need to also account for inflation. I may end up with an amount I find difficult to afford. However, the good news is that by wisely putting my money to work for me through a savings or investment plan, the returns from such investment or savings can be accumulated over the years to help me cover the costs. ‫ق‬ Some Benefits The Child Education Assurance plan has various advantages, depending on the insurance company, including:  Waiver of premium: This is done where the parent for some time has lost source of income, due to sickness, retrenchment, or disability.  Child Income Benefits: This is possible to a percentage, usually between 1015% of the amount insured, and this is paid to the child if the parent dies, until the maturity of the policy, at which time, the child gets the entire sum remaining.  Child Disability Benefits: An insurance company will pay the child a lump sum if he gets injured, or disabled, or suffers terminal illness that causes disability. Invest - 187 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Personal Pension Plan ‫ق‬ Definition A Personal Pension Plan is about making the most of my retirement future. It is essentially a tax deductible investment vehicle that that allows for the tax-free accumulation of a fund for later use as an income on retirement. A pension plan is also called a retirement plan or superannuation. ‫ق‬ Characteristics Retirement plans may be set up by employers, insurance companies, the government or other institutions such as employer associations or trade unions. Called retirement plans in the USA, they are known as pension schemes in the UK and Ireland and superannuation plans or super in Australia and New Zealand. Retirement pensions are typically in the form of a guaranteed life annuity, thus insuring against the risk of longevity. The money contributed by the contact holder is invested and the fund accumulates with interest. A pension fund will be built up throughout my working life. When I retire, the pension will become in payment, and at some stage I, the pensioner, will buy an annuity contract, which will guarantee a certain pay-out each month until death. The amount of pension when I retire is dependent upon the following: $ $ $ The amount of regular or single contributions. Performance of the investment funds. The annuity rate – the factor used to convert the accumulated pension fund into an annuity - at the date of retirement. Currently, the entry age is 18 years and the minimum retirement age differs by country. When I retire, I can opt to take a lumpsum or part lumpsum, and use the balance to buy a life annuity. If I die, my residual fund can be allocated to provide a survivor pension for my surviving dependants. For an extensive analysis of how I can plan for my retirement, I should read Ojijo’s Retire Happy: 21 Questions to Plan My Retirement. Invest - 188 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Provident Fund ‫ق‬ definition Provident fund, like a pension fund, is collective investment scheme which provides employees with a lump sum benefit at retirement. Provident Fund scheme is mainly used for three reasons: 1. encourage savings; 2. promote investments; and 3. provide tax benefits. The purpose of provident funds, like pension funds, is to provide social security, that is, public measures, against the economic and social distress that otherwise would be caused by the stoppage or substantial reduction of earnings resulting from sickness, maternity, employment injury, unemployment, invalidity, old age and death; the provision of medical care; and the provision of subsidies for families with children. Whereas socials security is provided for in Article 22 of the Universal Declaration of Human Rights (1948) which states that: “Everyone, as a member of society, has the right to social security”. It is also included in Declaration of Philadelphia (1944) and International Covenant on Economic and Social Rights (1966, 1976). However, while it exists in the constitution of Uganda in terms of what the government considers important, it is not in the main body of the constitution. The nine fundamental social security rights are: 1. 2. 3. 4. 5. 6. 7. 8. 9. ‫ق‬ Medical care Old-age benefit Invalidity benefit Survivors’ benefit Sickness benefit Maternity benefit Employment injury benefit Unemployment benefit Family benefit characteristics Invest - 189 - Invest- 55 Assets That Grow Savings and Earn Passive Income Unlike traditional pension fund which is to some extent compulsory, provident fund is mostly voluntarily between employers and employees, except in some jurisdictions which make it mandatory. In such jurisdictions where it is mandatory, non profit making organisations, charitable institutions, and wholly owned and run family businesses are also exempt from mandatory. The main difference between a pension and provident fund concerns taxation benefits, and withdrawal amounts at retirement. Under a pension fund, a maximum of one-third of the final benefit may be taken as cash and at least two-thirds of the final benefit must be paid as a pension for the rest of the pensioner's life. Pension fund members must buy an annuity with at least two-thirds of their retirement fund. Under a provident fund, on the other hand, the full amount of the benefit available at retirement may be taken as a lump sum cash payment, irrespective of whether the benefit is calculated on a defined benefit or a defined contribution basis. A provident fund is thus more flexible, as employees can still purchase an annuity with their fund. Further, the tax concessions for employers and members in respect of the two types of funds also differ. The employer may deduct up to a given percentage of the member's salary for tax purposes under both pension and provident funds. In a pension fund up to 7,5% of members salary is tax deductible, while there is no tax deductible benefit for the members contribution in a provident fund. In case of lack of workplace provident fund, the employees can themselves start a provident fund, and operate it as an investment club, without the benefit of contributions from the employer. Asset of the fund consists of money contributed by both employers and employees. This means employees are not alone in saving the money; employer helps them at the same time. The contribution to be made by employer will always equal or exceeding that contributed by employees. Members saving could increase over time as there is a monthly contribution from both employer and employee, as well as incurred benefit from the investment of the fund. However, the fund will not pay interest or dividend to members as it is designed to accumulate into a large amount and pay to members upon their termination of membership. Moreover, members are not entitled to withdraw part of their saving before termination of membership since it is not in accordance with the objective of saving for retirement. Upon termination of membership from the fund, members will receive all of their contribution and its incurred benefits, and will receive a certain amount of employer's contribution and its incurred benefits according to the fund article. If I resign from the fund before retirement, I may not entitle to some part of the employer’s contribution. Moreover, the amount received from employer’s contribution and all incurred benefits will be taxable. Invest - 190 - Invest- 55 Assets That Grow Savings and Earn Passive Income Employer will deduct a certain amount of money from my salary. I have the responsibility to check the correctness of the amount of the contribution by checking from payroll slip. This slip should also be kept for checking with the biannual report. The asset management company will send a report showing the amount of employer’s and employee’s contribution to all members. (Biannual report) The members own assets in the fund in units, each unit representing a given cash value. An increase in unit value means the fund performance has been better. On the other hand, a decrease in value means the fund performance has been deteriorated. Termination of membership can be either a result of employee’s retirement from job, resignation or transfer to another fund. Members should pay attention to the types of payment because they can vary in each fund. Normally, the asset management company will pay in the form of cheque, either to the member leaving the fund, or to the new employer. Money flows into and out of the provident fund can be divided into three streams: contributions, returns on investment and benefit payout. Different jurisdictions employ different tax policies pertaining to these streams. Some apply the Taxation-Exemption-Exemption (TEE) system where contributions are subject to taxation while the other two flows are not. Others may choose the EET system where only benefit payout is tax levied. Other governments opt for tax exemption on all of the three streams, i.e., the EEE system, to offer a full incentive for earning retirement savings through provident funds. Under the EEE system, employee contribution is exempted to a given sum, while the employer contribution is deductible as expense; return on investment is tax-exempted; and benefit payout is tax-exempted upon condition that the member reaches his or her retirement age and has maintained a continued membership for not less than five years. The total benefit is included in the taxable income: Total benefit = the employer’s contribution + returns on investment from the employee’s the employer’s contribution + returns on investment from contribution The fund-governing rules must include provisions regarding the payment of benefits to employees upon membership termination. Under all circumstances, members are always entitled to the whole sum of their contributions and accrued benefits attributable to their own contributions. However, entitlement to the employers' contributions and benefits derived from this part is determined as stated in the fund article. This is called "the vesting rule". In case of no specific requirements, member have the right to receive the whole sum. Invest - 191 - Invest- 55 Assets That Grow Savings and Earn Passive Income The fund article contains the vesting rule which may be based on the employment period or the membership period. Example: Employment Period Less than 1 year 1 - 5 year More than 5 year Entitlement To The Employer's Contributions And Benefits 10% 50% 100% The specified period should not be prolong in such a way that may impede members' attainment to the full amount. Unreasonable period extension may be viewed as an intention of employee exploitation. Almost 100% of provident funds require a period of 10 years or less for members to obtain the full amount of the employer’s contribution and its benefits regardless of period of employment or membership. The fund-governing rules may specify causes for deprivation of rights on the employer’s contribution and benefits on the grounds of frauds, disciplinary violations, and critical negligence and etc. The fund-governing rules may also prescribe a specific period in which members can take the whole sum of benefit payout. However, it is not allowed to prescribe in the fund article that the unpaid amount will be transferred to any person. ‫ق‬ benefits $ employee retention: The employer contributes to match up employees’ contribution, and hence, set up of provident fund as a benefit motivates employees to work with employer. saving tool: Provident fund not only provides a tool for employees to save consistently with the employer's assistance, asset of the fund is further managed by a professional called "Asset Management Company" The benefit derives from management is distributed to member of the fund proportionately. Professional investment advise: the contributions are given to an asset management company to invest on behalf of the scheme, and hence, the fund owners are getting professional advise and management of their money. temporary custody of money between jobs: In case of resignation, members can choose to temporarily keep their money within the former fund before transferring it to the provident fund of their new employers. This will allow members to seamlessly maintain their retirement savings in the provident $ $ $ Invest - 192 - Invest- 55 Assets That Grow Savings and Earn Passive Income $ fund system. As a result, member will have enough savings when they reach a retirement age and have a good quality of life after retirement. tax exemption: Money received from a provident fund upon retirement is tax exempted. The provident fund is set up to provide adequate saving after retirement and the tax incentive scheme is granted to support such purpose. For those who do not maintain membership until retirement, therefore, will not gain full tax benefits or not at all. Invest - 193 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Annuity ‫ق‬ Definition Annuity is a financial product sold by insurance companies that is designed to accept and grow funds from an individual and then, upon annuitization, pay out a stream of payments to the individual at a later point in time. ‫ق‬ Characteristics Purpose: Annuities are primarily used as a means of securing a steady cash flow for an individual during their retirement years. An annuity as another way of saying ‘annual payments’. Withdrawal: Earnings cannot be withdrawn without penalty until a specified age and are taxed only at the time of withdrawal. Safety: Annuities are relatively safe, low-yielding investments. Structuring: Annuities can be structured according to a wide array of details and factors, such as the duration of time that payments from the annuity can be guaranteed to continue. Annuities can be created so, upon annuitization, payments will continue so long as either the annuitant or their spouse is alive. Alternatively, annuities can be structured to pay out funds for a fixed amount of time, such as 20 years, regardless of how long the annuitant lives. ‫ق‬ Advantages $ $ ‫ق‬ Deferred annuities allow all interest, dividends and capital gains to appreciate tax-free until I decide to annuitize (start receiving payments). The risk of losing my principal is very low - annuities are considered very safe. Disadvantages $ $ $ Fixed annuities are susceptible to inflation risk because there is no adjustment for runaway inflation. Variable annuities that invest in stocks or bonds provide some inflation protection. If I die early, then I will not get back the full value of my investment. Annuity investments are notorious for their lack of liquidity. They are designed for the purpose of creating an income stream in most cases and as a result it becomes virtually, if not actually, impossible to remove the Invest - 194 - Invest- 55 Assets That Grow Savings and Earn Passive Income lump sum or a portion of it once it has been invested. The volatility aspect depends on the specific annuity since many of them contain both stock and/or money markets in their portfolio. $ ‫ق‬ Risks: Annuities are advantageous for those looking for a relatively lowrisk investment with a decent rate of capital appreciation. The risks involved with annuities are fairly small compared to those of other investments because my investment is heavily regulated by the government. It is a good idea to ask the company from which I purchase an annuity if the company is insured - not all of them are. One precaution: annuities allow me to withdraw my principal, but I may be subject to stiff penalties. Types of Annuities There are several distinct types of annuities: $ Fixed Annuity This means the insurance company makes fixed payments to the annuity holder for the term of the contract. This is usually until the annuitant dies. The insurance company guarantees both earnings and principal. This is a fairly good financial instrument for those looking to receive a fixed investment income. $ Deferred Annuity A ’deferred’ annuity means that the series of annual payments will not begin until a later date. This is popular with retirees because they can defer taxes until annual payments are received. It delays payments of income, installments or a lump sum until the investor elects to receive them. This type of annuity has two main phases, the savings phase in which I invest money into the account, and the income phase in which the plan is converted into an annuity and payments are received. A deferred annuity can be either variable or fixed. Earnings on a deferred annuity account are taxed only upon withdrawal, providing the annuity with a tax benefit. This type of annuity also provides a death benefit, so that the beneficiary of the annuity is guaranteed the principal and the investment earnings. Deferred annuities allow me to enjoy the benefits of compounding without worrying about the tax implications. Invest - 195 - Invest- 55 Assets That Grow Savings and Earn Passive Income $ Variable Annuity This means that at the end of the accumulation phase the insurance company guarantees a minimum payment, and the remaining income payments can vary depending on the performance of my annuity investment portfolio. This annuity allows me to invest in a managed portfolio of stocks, bonds, money market funds, or any combination thereof. The performance of this portfolio determines the annual payment I will receive. $ Hybrid Annuity An insurance contract that allows buyers to allocate funds to both fixed and variable annuity components. Most hybrid annuities allow the investor to choose the amount of assets to allocate to the more conservative, fixed return investments, which offer a lower but guaranteed rate of return, and what amount to allocate toward more volatile variable annuity investments, which offer the potential for higher returns. Hybrid annuities can be useful for those who have longer time horizons and wish to participate in the stock and bond markets. Also, investors should make themselves aware of the fees for both the fixed and variable portions of a hybrid annuity. $ Income Annuity Annuities designed to start paying income as soon as the policy is initiated. The income annuity is annuitized immediately, although the underlying income units may be in either fixed or variable investments. As such, the income payments may fluctuate over time. An income annuity is typically purchased with a lump sum payment, often by people who are at or near retirement. Also known as an ‘immediate annuity’. Investors seeking income annuities should have clear picture of how much income will be received and for how long. Although the insurance product may be annuitized immediately, variable investments can allow for some principal protection by participating in equity markets. Even if all income units are in fixed investments, there may be a provision allowing for a higher return if a specific benchmark index performs extremely well. $ No-Load Annuity A type of variable annuity that charges much lower fees and expenses than traditional annuity contracts. No-load annuities are seldom if ever sold by brokers or commission-based planners because they do not pay a commission to the salesperson. These contracts usually have little or no back-end surrender charge associated with them. No-load annuities are generally marketed directly by the issuing insurance company or through fee-based financial advisors. Investors who purchase these contracts directly from a carrier can generally expect a fairly low level of customer service. For this reason, they are probably most appropriate for experienced investors who understand the characteristics and use of annuities, and can allocate their assets among the subaccounts themselves. Invest - 196 - Invest- 55 Assets That Grow Savings and Earn Passive Income $ Stretch Annuity An annuity option where tax-deferred allowances are passed on to the beneficiaries, offering the beneficiaries more flexibility and control over maintaining the investment. Therefore, the beneficiary has less restraint on wealth transfer, and he is likely to receive a larger sum of benefits stretched over a longer period of time. Legacy annuities or stretch annuities are not offered by many insurers, unfortunately. This type of annuity is very advantageous because the beneficiary is not burdened with paying a huge tax bill on his or her gains. This often can be stressful for a family that has just dealt with the loss of a loved one. $ Life Annuity An insurance product that features a predetermined periodic payout amount until the death of the annuitant. These products are most frequently used to help retirees budget their money after retirement. Typically, the annuitant pays into the annuity on a periodic basis when he is still working. However, annuitants may also buy the annuity product in one large purchase. When the annuitant retires, the annuity makes periodic (usually monthly) payouts to the annuitant, providing a reliable source of income. When a triggering event (such as death) occurs, the periodic payments from the annuity usually cease. Because of the complex nature of annuity products and their implications for the annuitant's standard of living, people are well advised to consult a reputable professional before purchasing any annuity product. Due to the tax-preferred nature of annuities, very wealthy investors or above-average income earners often use these life insurance products to transfer large sums of money or to mitigate the effects of taxes on their annual income. ‫ق‬ How to Invest Annuities are often forgotten by individual investors, partly because people are unaware of their benefits. Annuities are offered by most insurance companies, banks and brokers. The minimum investment for an annuity is typically $1,000 plus purchase fees. These fees can range from a load to an annual management fee that can be a between 1.5% - 3% of my total investment. Invest - 197 - Invest- 55 Assets That Grow Savings and Earn Passive Income 3. FOREX INVESTMENT INTRODUCTION TO FOREX ¥ What is Forex? Forex trading is professional exercise. Becoming a successful Forex trader is a serious enterprise. I must become accustomed to the market trends and have an understanding of the economy. While it is possible to jump right in there and get lucky – this luck will not hold. As the old adage goes, ‘bullshit will take you up, but it will not keep you there for long.’ Forex is a sort of system that must be learned. The more I understand, the better I will be able to capitalize on market trends. In Buffett’s view, “investors’ financial success is correlated to the degree in which they understand their investment.” ¥ What is Forex Investment? The Forex is full of different types of investors. There are investors who are looking for more long term investments while there are other short time investors seek to capitalize on temporary market trends. There are basically market opportunities for every type of investor. ‫ق‬ Tips for Forex Investing $ Technical Analysis (forex) As a rule of thumb, most small to medium investors will use technical analysis as their investment strategy. This strategy assumes that all market information and a specific currencies future can be found in the actual price chain – every single factor which effects the currency’s price have been taken into account by the market which the price thus reflects. The investor will then place their investment on three suppositions: $ The market movement considers all factors, $ The price movement of currency is related to and in fact directly tied to the price itself $ History always repeats itself. When I follow technical analysis, I will take a look at both the high’s and lows of the currency’s prices, all opening and closing prices of the currency, and the total volume of the currency’s transactions. Basically, I will play it safe and not try to outsmart the currency market. No long term trending or predictions are considered, but just the recent past which can be used to predict short Invest - 198 - Invest- 55 Assets That Grow Savings and Earn Passive Income term trends. If I want to know how to invest in Forex, understanding these three strategies is fundamental to my success. $ Fundamental Analysis (forex) Many traders in the Forex market use Forex trading fundamental analysis techniques to predict long-term economic trends that will affect a currency pair and believe that it is not a technique that suits short-term Forex traders. Majority of Forex traders conduct deals frequently in the market since they believe that conducting trades in the market a lot will keep them on track to the big hit. The other type of market strategy is to look at all the current situations occurring in country like political situations, economy, and various rumors that occur. The figures of an economy always depend on things I can measure such as the central bank interest rate, national unemployment levels, fiscal policies, the current rate of inflation, level of taxes, etc. These are used to predict possible long term and short term trends. The other things that can be looked at are less tangible such as political factors, or other such unquantifiable events that may influence the quantifiable things in the economy. Invest - 199 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Why Forex Investing $ Universal Forex trading is a universally accepted platform of foreign currency market. In a foreign exchange market currencies from around the world are bought and sold. $ Biuggest Market Forex trading is the biggest trading market in the world with trillions of dollars being traded on a daily basis. $ More profitable The Foreign Exchange or Forex Market is potentially more profitable and easier to trade than the stock market, yet few people take the time to learn about Forex trading principles. As the saying goes, “The investor is the asset or liability, not the investment.” $ No or Reduced Fees I do not have to worry about all the fees I may have to pay to my broker. There are also none of the usual fees to which futures and equity traders are accustomed to pay; no exchange or clearing fees, no NFA or SEC fees. $ Low Costs The main advantage of online Forex trading is the low costs involved because I do not have to pay commissions or transaction fees for trades. $ No time limitations An advantage of online trading Forex currencies is that I do not even have to be connected all day long. $ No commissions One of the most important things about online Forex trading is that I can make as many transactions as I wish without giving any commissions. $ Liquidity Because of the large volume of active Forex currency trading that takes place each day between more than one hundred fifty countries, it is also considered as the most liquid trade market. As the name of the game with FOREX trading is VOLATILITY and 80% of all trades do not last more than 2-3 days, with the vast majority of them being daytrades, it is easy to accept that conditions can and will change in a heartbeat, rendering most trade plans obsolete. Invest - 200 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Forex Markets The Forex market is truly unique for a variety of reasons. First, it is one of the very few markets which do not have any sort of external control – It is impossible to be manipulated. The Forex is also the largest financial market in the world. Trades per day can reach over 2 trillion dollars! With this type of money free flowing in around the market, it is impossible for a single investor to manipulate or influence the trends. As investment markets go, Forex is one of the ‘safest’ markets because it is very resistant to external factors or manipulations. It is in every sense of the world a free market. ‫ق‬ ‫ق‬ Forex Market Regulators ‫و‬ Forex traders association ‫و‬ Central Bank Forex Market Players ‫و‬ Forex traders ‫و‬ Forex investors ‫و‬ Forex bureaus ‫و‬ Forex brokers Invest - 201 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Forex Trading: How Forex Works! ‫ق‬ Many Types of Orders In the FOREX market there are a variety of order types available for making trades. Due to the extremely high volume of trades in the FOREX market most transaction are executed almost immediately, this allows for better price control of my trades. However the market volume in the FOREX exchange is so immense it is impossible for any single factor to control the price of a currency for any length of time. ‫ق‬ Universal Transactions Foreign currency transactions are never centralized during an exchange. Rather, they happen all over the world at the same time through telecommunication technology. Forex trade is open 24-7 – meaning there are always investment opportunities no matter what time of the day. Deals around the world quote prices for all the major currencies. An investor chooses a currency to invest (through a dealer or online) and buys it hoping to sell it back on the market when/if the currency price rises, thus gaining a profit. ‫ق‬ Forex Trading Plan As a beginner, I simply cannot have the experience to ‘feel’ anything related to the market processes and therefore it is advisable to rely completely on the mechanisms of a trading plan. A trading plan is especially crucial in Forex trading to stay ‘in-control’ against the emotional stress in speculative situation. It is advisable that I should also know about the basics of forex trading, so that I can stand my ground in the huge and often confusing world of forex trading. ‫ق‬ Trading Account Investing in forex is probably not the best investment for the inexperienced trader. If I go for long term trading then I need to know how to pick long term trends. If I am wrong then I will lose a great deal of my investment account. The same logic goes for midterm investing. This is one reason investing in the forex market should be done by experienced traders. But a trader can get the experience by trading a demo account, offered by most brokers for free. ‫ق‬ Trading Modes There are different types of ways to do forex trading. Invest - 202 - Invest- 55 Assets That Grow Savings and Earn Passive Income $ $ $ ‫ق‬ I can trade by making all of my own trading decisions. I can trade as a group, sometimes called user groups; many times the group does not trade together but they help each other to learn how to trade. I can join a club and make my investing decision together but place the trades on my own. Trading groups and clubs can be fun ways to trade in the beginning when I am trying to learn to trade. Trading can be a lonely venture and this way I have a support system to help me understand the market and learn to deal with my emotions of fear and greed. Forex Trading Tips $ Get Forex Training Before I can learn how to make money in Forex trading or investing, I need to first know how Forex works. Understanding the nuances for the Forex market means I am better quipped for how to make money in Forex. More knowledge means I will be in a better position to know how to invest in Forex the right way. It is in my interest to do as much research as possible and to get the best Forex training as possible -- this can provide me with key competitive advantages. I need to make an effort to find the best Forex training possible, and spend some serious time understanding both the market and Forex techniques. This is the best way how to engage in Forex trading. $ Follow the Forex Trading Rules The forex market is not for the hobby investor. I need to be serious about trading or the market will take my money quickly. The successful traders will have a set of trading rules they have made up when they are not trading to be used when they are trading. I will need a trading plan and have the discipline to keep records of my trades. Discipline and money management are the keys. And the greatest rule is the mantra of trading, ‘follow the trend.’ Invest - 203 - Invest- 55 Assets That Grow Savings and Earn Passive Income FOREX INVESTMENT PRODUCTS There are various ways of investing in forex as below: ¥ Physical Delivery This is the most rudimentary and traditional method of investing in forex. It involves purchasing and keeping the foreign currency physically. I can keep it at home, or in a forex account at a bank. ¥ Currency Stocks I can also participate in forex investing by investing in companies that trade forex. ¥ Currency Funds, ETFs & ETCs I can also invest in funds that are specifically trading in currencies, and investing incurrence, or currency futures. Currency ETFs are funds tracking major currencies. The funds are total return products where the investor gets access to the FX spot change, local institutional interest rates and a collateral yield. ¥ Currency Futures I can also invest in forex by purchasing forex futures, directly. ‫ق‬ Definition A currency future, also FX future or foreign exchange future, is a futures contract to exchange one currency for another at a specified date in the future at a price (exchange rate) that is fixed on the purchase date. A transferable futures contract that specifies the price at which a currency can be bought or sold at a future date. Currency future contracts allow investors to hedge against foreign exchange risk. ‫ق‬ Characteristics Marked-To-Market: Because currency futures contracts are marked-to-market daily, investors can exit their obligation to buy or sell the currency prior to the contract's delivery date. This is done by closing out the position. Rich dad often said, “The reason most average investors lose money is because it is often easy to invest into an asset, but it is often difficult to get out. If you want to be a savvy investor you need to know how to exit an investment as well as how to get into the investment.” With currency futures, the price is determined when the contract is signed, just as it is in the forex market, only and the currency pair is exchanged on Invest - 204 - Invest- 55 Assets That Grow Savings and Earn Passive Income the delivery date, which is usually some time in the distant future. However, most participants in the futures markets are speculators who usually close out their positions before the date of settlement, so most contracts do not tend to last until the date of delivery. US Dollar: Typically, one of the currencies is the US dollar. The price of a future is then in terms of US dollars per unit of other currency. This can be different from the standard way of quoting in the spot foreign exchange markets. The trade unit of each contract is then a certain amount of other currency, for instance €125,000. Delivery: Most contracts have physical delivery, so for those held at the end of the last trading day, actual payments are made in each currency. However, most contracts are closed out before that. Investors can close out the contract at any time prior to the contract's delivery date. Hedging: Investors use these futures contracts to hedge against foreign exchange risk. If an investor will receive a cashflow denominated in a foreign currency on some future date, that investor can lock in the current exchange rate by entering into an offsetting currency futures position that expires on the date of the cashflow. For example, I am a US-based investor who will receive €1,000,000 on December 1. The current exchange rate implied by the futures is $1.2/€. I can lock in this exchange rate by selling €1,000,000 worth of futures contracts expiring on December 1. That way, I am guaranteed an exchange rate of $1.2/€ regardless of exchange rate fluctuations in the meantime. Speculation: Currency futures can also be used to speculate and, by incurring a risk, attempt to profit from rising or falling exchange rates. For example, I buy 10 September CME Euro FX Futures, at $1.2713/€. At the end of the day, the futures close at $1.2784/€. The change in price is $0.0071/€. As each contract is over €125,000, and I have10 contracts, my profit is $8,875. As with any future, this is paid to me immediately. More generally, each change of $0.0001/€ (the minimum Commodity tick size), is a profit or loss of $12.50 per contract. Invest - 205 - Invest- 55 Assets That Grow Savings and Earn Passive Income 4. COMMODITY INVESTMENT INTRODUCTION TO COMMODITY ¥ What Is A Commodity? Commodities are often referred to as the ‘fifth’ asset class, after the conventional investment asset classes of cash, fixed interest securities, equities and property. From the orange juice we drink to the gas we use to power our vehicles and heat our homes, commodities play important roles in our daily lives. Commodities are naturally occurring/raw/primary products, and include agricultural products, also called soft commodities (soya, grains, vegetables, etc); energy products (oil, gas, electricity and green energy); base metals (copper, aluminum, iron, etc); and precious minerals (gold, silver, diamond, uranium, palladium and platinum. ‫ق‬ Characteristics of commodities $ No cash flow and or interest The case for investing in stocks and bonds is relatively straightforward. Both types of securities deliver a stream of cash flows to investors; stocks generate free cash flow from their operations and make dividend payments, while bonds make interest payments and/or return principal upon maturity. Commodities are unique in that there is generally no cash flow associated with the underlying asset; a bar of gold will never generate cash or make a dividend payment, and a field of wheat will not ever make and coupon payment. $ Intensive Growth Commodities are capable of recording huge price increases over relatively short periods of time, meaning that those who time the market correctly can turn a nice profit. But for those not interested in speculating on short-term swings, the appeal of commodities lies in the ability of this asset class to both smooth overall portfolio volatility and hedge against certain undesirable economic environments. In recent times traders have realized that soft commodity trading can be at times more profitable than equities. $ Continuous Capital Gain One salient factor to be considered in trading commodities is that it will never become worthless. $ The weather! Soft commodities trading are also historically known to have been affected by seasonal changes, climate changes, diseases and water shortages among Invest - 206 - Invest- 55 Assets That Grow Savings and Earn Passive Income others. Rice, corn and wheat comprise 90% of all world consumption in grains. Since the growth of the demand for these grains have increased many times in recent years supplies are required to fill the need. This is the main reason why investments in grains and other soft commodities is profitable and will continue to be so in the future $ Inflation and Commodity Prices Inflation is a measure of the ratio between the increase in aggregate prices for goods and services and the growth of the overall economy. When inflation is high, meaning goods and services are becoming more expensive faster than the economy is growing, the purchasing power of a given amount of cash is eroding. While commodity price increases may not be a significant cause of inflation, they are positively correlated to inflation rates, which mean that when one is going up, so is the other one. And, on the other hand, commodities are negatively correlated with increases in the value of stocks and mutual funds. So, when stocks are going down, commodities are generally going up. And the value of cash, as we know, is continuously eroded by higher rates of inflation. Commodities and companies which are strongly based in commodities, tangible assets like real estate, and exchangetraded commodity funds are all very likely to increase in value faster than inflation can degrade them. $ The Equity Commodities Correlation The relationship between the two changes with time. Commodities rarely correlate with the equity market. As a matter of fact, most managed futures including indexes and currencies have outperformed the stock market severally. Commodities are contracts to buy and sell anything and everything and are classed into three categories. Hard commodities are those that are extracted through mining and soft commodities are those that are grown and energy commodities such as electricity gas and coal. Since it is very hard or rather not desired for traders to transport these heavy products, what is normally traded are commodity futures and options. These are agreements made between traders to trade the commodities at an agreed price on specific dates. The equity commodities correlation is decoupling. To trade in commodities, I must keep an eye on the equity commodities correlation. For instance if my interest is in gold or oil, make sure that I keep one eye on their movements in the commodities market while the other eye is on the equity markets. I should check the price movements and decide when the most appropriate time to trade is. Always validate how fast the market responds. However, since there is always a delayed impact of the correlation in the equity markets, there is the likelihood of a much broader movement in the commodity market compared to the equity market. Invest - 207 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ What Is Commodity Investment? Investing in commodities means that I invest money in resources that can be found on our lovely planet Earth. These range from Gold, Silver and other precious metals – to Oil, Gas and other Energy resources. Investing in commodities like these can be a very smart investment indeed – and one that most likely pay off big time. Investing directly in commodities, such as gold or oil, tends to be more difficult for investors than investing in stocks and bonds. A major reason for this is that stocks and bonds are readily transferable and easily accessible to the average investor. Traditionally, commodities have been more difficult to invest in due to the complex way in which they trade through the futures and options markets. In other words, an investor can't just buy a barrel of oil. Most financial professionals agree that obtaining a broadly diversified investment mix is a prudent strategy. But many investors are missing market exposure to one overlooked category: Commodities. Like stocks, bonds, and real estate, commodities are an important asset class. Commodities are tangible assets used to manufacture and produce goods. Products like agriculture raw materials, water, energy, livestock, metals, timber and textiles are examples of commodities. The agriculture segment, for instance, includes familiar commodities like cotton, corn, coffee, and wheat. ‫ق‬ Myths of Investing in Commodities Many investors are reluctant to trade commodities due to a variety of myths or misconceptions by the general public and even the investment community. These myths probably date back many decades and were likely created by frustrated, losing commodity traders or by those who view commodities as too difficult of an investment to understand. I may hear things like commodities are too volatile or I will have a truckload of soybeans dumped on my front lawn if I trade commodities. Or, a quick response by many unsuccessful traders is that nobody can make money from trading commodities. Well, obviously people do make money trading commodities. $ Myth #1: Too Much Leverage By far, leverage is the biggest problem when investing in commodities. Normally, I only have to put up about 3 to 15 percent of the total value of a futures contract in futures margin. That is far less than the 50 percent that is required for stocks. And, of course, many new commodity traders do not know how to handle their newfound gift of incredible leverage. In reality, commodities are no more volatile than stocks as an asset class if I remove the leverage factor. The problem with many commodity investors is that they will invest a $25,000 account as if were $250,000. For example, they might buy Invest - 208 - Invest- 55 Assets That Grow Savings and Earn Passive Income 10 futures contracts that have margin of $2,500 each and control $250,000 worth of commodities. Therefore, if the commodities move up a little in value, they made $25,000, doubling their investment. However, if the commodities move down a little in value, their investment is wiped out. To be successful, I should trade far less contracts than what the margin requirements allow. In the above example, I should only be trading 1 or 2 futures contracts at a time. Remove the extreme leverage factor that gets so many new commodity traders in trouble. $ Myth #2: Taking Delivery of Commodities This is something I really do not need to worry about. Only the commercial players are involved in taking and making delivery on commodities. As long as I close my futures contract before the first notice day, which usually occurs a few weeks before the contract expires, I should have absolutely no worries about this. If for some reason I forget about the first notice day, my broker will certainly catch it and contact me. $ Myth #3: I Do not Have Enough Money to Trade Commodities Many commodity brokers will allow me to open an account with $5,000, while some even start at $2,500. This money should be risk capital as commodities can be a risky investment. The problem with accounts of this size is that investors take on too much risk for their account size. They tend to roll the dice and bet it all on one trade. I should not fall into that trap. If I shoot for a respectable return of 25 percent a year, I will do much better in the long run as opposed to trying to hit a home run. $ Myth #4: Nobody Makes money from Trading Commodities The fact is that many people do lose when trading commodities. However, the losers are usually ill prepared investors who jump into the commodity markets and lose within six month, never to return again. As the saying goes, “a true investor is prepared for whatever happens.” Others get addicted to the markets, while trying again and again to make a killing with the same strategies and just keep losing. The good new is that commodity investing is a zero sum game, which means for every dollar lost, someone gains a dollar. Actually, I have to factor in transaction costs, so each person loses a little more than a dollar and the other party gains a little less than a dollar. So, who makes all the money? It is normally the professional commodity traders and money managers that consistently make money year after year. Also, amateur commodity traders who make money tend to trade for a long time – maybe 30 years. In that time, this trader has probably taken money from hundreds of commodity investors along the way. Successful amateur traders and professional traders usually trade larger amounts of money. A professional trader managing $1 million may make profits of $200,000 for the year. In reality, he took money from the equivalent of 40 losing traders who threw $5,000 into the markets. Successful traders have Invest - 209 - Invest- 55 Assets That Grow Savings and Earn Passive Income usually paid their dues to learn how to trade commodities properly and they follow a strict trading discipline, which most losing traders never adopt. I can make money from trading commodities whether I are a novice or very experienced investor. I will not tell me it is easy, but if I do my research and use a good trading strategy with sound money management skills I stand a much better chance of success. So, do not run from investing in commodities because I heard one of these myths that do not give me a true picture of investing in commodities. ¥ Why Invest In Commodities? $ Tax efficient ETCs are not shares and so trades are exempt from stamp duty. Furthermore, ETCs can be traded within ISA accounts, allowing me to shelter my profit from Capital Gains Tax. $ High Returns The most obvious reasons why I should take this form of investment into consideration are its diversity and to hedge against inflation. The interest in commodities investments outperforms traditional investment opportunities such as stocks. Since oil, minerals, and metals are something that the entire world needs, investing in them is almost risk-free-or at least as risk-free as investments can get. $ Hedging Against Inflation Historically, gold and silver has always been a safe investment because in our world, It is inevitable! After all, ever since we started printing money, what has happened is that the more we print, the less worth it becomes. Basic inflation operates daily. So, naturally, precious metals go up in value. This is because we can’t ‘print’ or re-create such commodities. Therefore, owning gold and silver will always be a smart investment. The same goes for oil and gas. As the world consumes more and more of it, it becomes more and more expensive. Investing in natural commodities like oil and gas will give me an inflation-shield to protect me, and keep my assets growing in value even through dark economic times. $ Huge Growth Potential Deriving from supply and demand, commodities offer a huge growth potential. Commodities have a strong link to economies, affecting transport costs, energy, manufacturing and high street prices. New economic powers like China, Russia, Brazil and India have already started creating enormous demand for infrastructure, creating interest in building materials, and thereby base metals. This in turn drives the prices and costs. Invest - 210 - Invest- 55 Assets That Grow Savings and Earn Passive Income $ Diversification Commodities offer investors the chance to diversify their investments across differing asset classes. ‫ق‬ Commodity Investment Tips $ Fundamental analysis Investors using fundamental analysis analyze the macroeconomic situation, which includes international economic indicators, such as GDP growth rates, inflation, interest rates, productivity and energy prices. They would also analyze the yearly global gold supply versus demand. While gold production is unlikely to change in the near future, supply and demand due to private ownership is highly liquid and subject to rapid changes. This makes gold very different from almost every other commodity. Identifiable investment demand for gold, which includes gold exchange-traded funds, bars and coins, was up 64 percent in 2008 over the year before. Gold is regarded by some as a store of value (without growth) whereas stocks are regarded as a return on value (i.e., growth from anticipated real price increase plus dividends). Stocks and bonds perform best in a stable political climate with strong property rights and little turmoil. As the saying goes, “Both return on investment and return of investment are important;’ both profit, and security of capital are important.” $ Technical analysis As with stocks, gold investors may base their investment decision partly on, or solely on, technical analysis. Typically, this involves analyzing chart patterns, moving averages, market trends and/or the economic cycle in order to speculate on the future price. $ Using leverage Bullish investors may choose to leverage their position by borrowing money against their existing assets and then purchasing gold on account with the loaned funds. Leverage is also an integral part of buying gold derivatives and unhedged gold mining company shares (see gold mining companies). Leverage or derivatives may increase investment gains but also increases the corresponding risk of capital loss if/when the trend reverses. $ Systematic Hedging Strategy There have been severe volatility levels in commodities trading in the last few years and investors need to assess the reward risk ratio when hedging against these instable price moves. Investors should follow a systematic hedging Invest - 211 - Invest- 55 Assets That Grow Savings and Earn Passive Income strategy and balance their hedge between vanilla instruments and exotic instruments. The important thing is not to try to pick the top or the bottom of the market because it can’t be done. The advantage with exotic constructions is that I get improved strike prices and many times better levels of entry. However, it may be that I may give up a lot on the upside or I may put my self at a greater risk on the downside. These are the risk reward ratios that need to be taken into consideration when considering a hedging strategy. These issues should be benchmarked against production costs and budgetary rates. Another issue an investor should consider is whether to move away from the traditional leveraged products to the non-leveraged products. Employing a leveraged product certainly gives the investor the ability for a better strike price and obtains improved values but it can increase the risk to. A less risky move is to transact non-leveraged constructions but the downside is that entry levels will be at market. The investor should always be thinking about reward and risk ratios rather than perhaps the pros and cons of construction. The decision should not be centered on whether we should be in vanilla or exotic products but more whether the decision is between non-leveraged or leveraged products. The one thing that investors should never consider is selling naked options. By buying a naked option all an investor is doing is getting some premium and limiting the upside. Selling options is in the long run pretty much a losing proposal so it’s not a strategy that is right. Even if the investor employs a collar where he can limit his downside selling options is not a recommended commodity strategy for producers as the risk reward ratio is not favorable. Invest - 212 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ How to Invest In Commodities! (Farm-2-Fork) There are various tools to use in investing in commodities. My goal is to invest with a tool that suits my own preferences best. ‫ق‬ Futures Contract A popular way in which many people choose to make this type of investment is through a futures contract. This is an agreement to buy or sell a quantity of a certain type of commodity at a specific price in the future. These contracts are available on commodities such as gold, natural gas, crude oil, agricultural products, livestock, and so forth. There is normally a set price and quantity amount put forth in the agreement for which the investor agrees to pay at a specific date in the future. Commodity futures contracts can provide me with the most direct way to actively participate in the price movements, but there are other types of investments with less risk involved. I need to take note of the fact that most futures contracts require some type of minimum deposit. It all depends on the value of the account and the broker. If the value of my contract goes down, I may have to put more money into my account to keep everything going. This is referred to as a margin call. Whenever there is leverage involved, even small price movements can mean huge losses or returns, and a futures account can be doubled or completely wiped out in a matter of moments. ‫ق‬ Commodities ETFs With the prices of most commodity indexes cut nearly in half, it might be a good time to look at investing in commodity ETFs for a long term investment in commodities. I will remember the age old investment advice: “Time is your most important asset.” Many people dream of getting rich but most will not pay the price of the investment of their time. If I am not willing to invest my time, then I will leave my investment capital with people who are following the investment plan of my choice. Exchange-traded funds or notes (ETFs and ETNs) are traded like stocks, although they allow for investors to actually participate in commodity price fluctuation without having to use futures contracts. Commodity ETFs commonly track the price of a certain commodity by comprising an index of futures contracts. Invest - 213 - Invest- 55 Assets That Grow Savings and Earn Passive Income ETNs are basically unsecured debt that is created to mimic the price fluctuations of particular commodities or indexes. Investors can invest in a whole host of these with Exchange Traded Commodities (ETCs), including investment precious and base metals such as nickel, lead, gold and platinum, resources like gas, petrol and oil through to soft commodities such as coffee, soya, and livestock. Corn, coca, cotton and sugar are also other examples. ETCs track the performance of a single underlying commodity or a group of associated commodities. Single commodity ETCs obviously follow the spot-price of a single commodity, whilst index-tracking ETCs follow the movement of a group of associated commodities, such as cattle, energy or livestock. ETCs offer the aspiring commodities trader a number of inherent advantages over both shares and futures - without the associated vagaries of trading an individual stock or the dramatic risk inherent in futures trading. Commodities offer direct exposure to the commodities markets - the value of an investment will rise and fall in direct proportion to the price of the underlying commodity, whilst they are also Open-Ended, being created and redeemed on demand. This means that the supply of ETCs is unlimited and that price changes will accurately mirror developments in the price of the underlying commodity. Developing economies continue to boost demand for commodities but supply of energy products is restricted in several areas. Although these factors are expected to have a positive effect on prices, the volatility makes a strong case for a diversified approach. ‫ق‬ Commodity Stocks Some investors choose to use stocks, although significant research is essential for learning which companies are good to invest in. There are many different sectors and stocks to choose from as far as commodities are concernedespecially among oil companies. If I want to know how to invest in commodities with this method, I should do research to find out which commodity is the most profitable in today’s market. ‫ق‬ Commodity Mutual Funds Commodity mutual funds can be useful for diversifying a portfolio. Commodity mutual funds can provide a hedge against inflation, expanding my investment exposure while reducing risk. While I could choose to invest in just one commodity market, I risk losing money if the market experiences negative movement. By investing in a commodity mutual fund, my investments can be spread across many markets, lessening my risk and improving my chances of profiting. Invest - 214 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Commodity Markets Commodity markets are markets where raw or primary products are exchanged. A physical or virtual marketplace for buying, selling and trading raw or primary products. For investors' purposes there are currently about 50 major commodity markets worldwide that facilitate investment trade in nearly 100 primary commodities. ‫ق‬ Type of Product Most commodity markets across the world trade in agricultural products and other raw materials (like wheat, barley, sugar, maize, cotton, cocoa, coffee, milk products, pork bellies, oil, metals, etc.) and contracts based on them. These raw commodities are bought and sold in standardized contracts. The trading of commodities consists of direct physical trading and derivatives trading. These contracts can include spot prices, forwards, futures and options on futures. Other sophisticated products may include interest rates, environmental instruments, swaps, or ocean contracts. Speculators and investors also buy and sell the futures contracts to make a profit and provide liquidity to the system. ‫ق‬ Size of the market The commodities markets have seen an upturn in the volume of trading in recent years. In the five years up to 2007, the value of global physical exports of commodities increased by 17% while the notional value outstanding of commodity OTC (over the counter) derivatives increased more than 500% and commodity derivative trading on exchanges more than 200%. ‫ق‬ Standardization Unlike spot trading, in which delivery either takes place immediately, or with a minimum lag between the trade and delivery due to technical constraints, and where there is visual inspection of the commodity or a sample of the commodity; commodity markets require the existence of agreed standards so that trades can be made without visual inspection. ‫ق‬ Determinants of Commodity Price Movement There are factors that affect the demand, and there are factors affecting supply. It is the change of these factors relative to one another that forms the basis of commodity price movements. Broadly speaking, the following factors affect the prices of commodities at any given time. These factors are not constant and are subject to change. $ Weather (affects mostly agricultural products) Invest - 215 - Invest- 55 Assets That Grow Savings and Earn Passive Income Agricultural products are dependent on weather. It is a known fact that sudden changes in the weather pattern can affect the availability of an agricultural product and hence its supply to meet the demand. A typical example of this is in the corn producing states of the US, where particularly bad hurricane seasons can adversely affect the crop. Shortages will produce a demand shortfall and lead to price increases. $ Seasonal variations Seasonal variations such as the onset of winter will increase the demand for heating oil in affected areas. Heating oil is derived from crude, and if the winters are particularly bitter, we will see increase in demand for heating oil and increase in crude prices. $ Market conditions Market conditions can affect prices of commodities as well. At the tail end of the global economic meltdown in early 2009, the demand for crude dropped, causing the price of crude oil to tumble from $147 to just above $38 a barrel. $ Political and economic conditions Political conditions in countries which are world commodity powers will affect the price of a commodity. The crisis in Cote d’Ivoire, the world’s largest producer of cocoa, caused prices of this commodity to hit record highs. The outbreak of civil war in Libya, which produces 2% of the world’s oil, caused prices of crude to rise from $84 a barrel to about $125 a barrel, an effect that was only mitigated when the International Energy Agency released global oil reserves to increase supply. Market turmoil has also led to an increased demand for gold as traders head to safe haven assets to protect their money. $ Technology & Human Demographics Technology and human demographics all play a role in commodity price shifts. China’s economic boom has placed a huge demand on many commodities such as crude oil. Regulations on the sale of items like diamonds (through the Kimberly process) have affected the price of diamonds by restricting the supply of diamonds in the markets. These factors above indicate the basis of commodity price movements. ¥ Trading in Commodities ‫ق‬ Introduction to Commodity Trading Commodities can be traded on commodity exchanges. An example of a commodity exchange where commodities are traded is the New York Mercantile Exchange (NYMEX), which is the world’s largest futures commodity Invest - 216 - Invest- 55 Assets That Grow Savings and Earn Passive Income exchange. Traders can also trade spot contracts on the trading platforms of their brokers. Just like in forex and stock index trading, I can make money by correctly predicting the price direction of a commodity contract and opening a position accordingly. $ Information Commodity prices fluctuate according to the forces of demand and supply. Trading in commodities requires that a trader has a firm knowledge of the factors that affect the demand and supply of a particular commodity. For example, crude oil is highly susceptible to political and economic situations in the countries of the world’s major oil producers, especially those belonging to the OPEC oil cartel. $ Margin Requirements Margin requirements for trading commodities are not as high as for stock index trading, but are usually higher than for forex trading. ‫ق‬ How to Trade Commodity and Currency Correlations It is not uncommon for there to be correlations between certain currencies and certain commodities. Whether the correlation is positive or negative depends on the country of the currency and whether it is a net exporter or importer of the commodity in question. For example a net exporter of a commodity would have a positive correlation with the local currency, whilst a net importer would have a negative correlation. To effectively trade the correlation between a currency and a commodity the trader must decide whether to trade the currency, the commodity or both. Because Canada is a major exporter of oil and Japan is a major importer of oil there is a strong correlation between the currency pair CAD/JPY. As oil prices are in dollars there is also a strong correlation between oil prices and the USD/CAD rate and the USD/JPY rate. Other currencies which have a strong correlation to commodity prices are the Australian dollar and the New Zealand dollar. These two currencies are correlated to the price of gold and the price of oil. Australia is a major exporter of gold in fact it is the fourth largest exporter in the world. As New Zealand is a big trading partner with Australia, it is very much affected by what the Australian dollar does. Australia is also an exporter of oil and the AUD/USD currency pair correlated positively to the price of oil as it does to the price of gold. If I want to trade these correlations I should make sure that the timing is right because even a highly correlated commodity currency pair will not be 100% correlated 100% of the time. Sometimes a relationship breaks and at these Invest - 217 - Invest- 55 Assets That Grow Savings and Earn Passive Income times a wrong trade can be disaster for a trader whose understanding of what is going on is incorrect. When I know which commodities and currencies have a strong relationship; I need to decide which currency pair to trade or to trade in both the commodity and the currency. One point I need to bear in mind is that quite often a commodity is more volatile than the cross itself. Correlations involving commodities and currencies are not a precise science. Frequently correlations fracture and may well reverse for complete periods. I must stay cautious in observing correlations for opportunities. Relationships will of course change as countries change their prime exports or imports, and correlations will be effected. I must decide what I will trade, a currency, a commodity or both of them. $ Commodity Trading: Tactical Strategy A profitable tactical strategy for commodities trading is a strategy called ‘scaling’ which is often referred to as a ‘can’t lose’ strategy. Maybe this is true in theory but as everyone knows a strategy only comes good when the trader using it is good and has the capital to sustain the strategy. The concept of scale trading is keeping to the simple market principle of buying low and selling high. When trading some traders find it difficult to work out at which point a commodity is trading at a price which is low enough to buy. However, scale trading has some fairly straightforward guidelines to find levels at which the commodity price is a good buy. The first guideline is to take a hard long look at the historical charts of a range of commodities and locate the commodities where the price is historically at its lowest or at least within the lowest 25% of the historical price range. It is best to look back at least 10 years of history. Another guideline to remember is that scale trading has a better success with commodities which are physical such as crude oil and wheat. Scale trading is not a good tactical strategy with financial services commodities. The strategy behind scale trading is to only initiate buy trades and not initiate sell trades. The reason for this is that a physical commodity always holds a positive quantity of value and when the price becomes cheap the commodity producers will ultimately produce less and the prices will stabilize in due course. Once a commodity has been identified that fits the strategies requirements the next thing to do is to set up levels where futures contracts can be bought and sold on that commodity. Take for example a commodity like wheat which is trading at $1.90 a bushel and the price range over the last 20 years has been flowing between $1.70 and $5.40. At these numbers this is an ideal commodity for scale Invest - 218 - Invest- 55 Assets That Grow Savings and Earn Passive Income trading. Now I can set up levels to buy at levels that are 10 cents lower every time. For example buy at levels $1.80, $1.70, $1.60 etc. Once the first order is completed at $1.80 I then place an order to sell the contract at $1.90 which will give me a profit of $500 (10 x 5000) which is the 10 cents multiplied by 5,000 bushels. If the market prices continue to fall I would buy at $1.70 and place an order to sell at $1.80. I would still have the first contract I purchased at $1.80 with an order to sell at $1.90. The general theory behind this tactical strategy is that I level into the market at low prices and sell at prices which have been defined into the strategy, until I have closed all my contracts. This strategy could take some days, or some weeks or sometimes some years but whatever the time frame it will only succeed if I keep to my tactics and strategy. ‫ق‬ Online Commodity Trading Online commodity trading offers an alternative to online stock trading or forex trading online. It is unquestionably an appealing option to stock investing on the internet. As the commodity market gathers momentum and interest in the market is gaining popularity so are the trading volumes being traded daily which in turn lead to greater potential profits. Many online commodity brokers are now offering online courses for absolute beginners to teach their potential clients the basics of the commodity markets. These courses only last a few days and they are a must for a newbie to the world of trading in the financial markets. In addition there are some very informative books on commodity trading for beginners which can easily be purchased through an online bookstore such as Amazon or Barnes and Noble. It is particularly useful to read books that explain fundamental and technical analysis in depth. It is also important to read books that explain the various risk management instruments that are available to reduce my risk when trading commodities. All commodity online brokers offer demo accounts with a balance of cash that I can use to practice trading. These demo accounts function in exactly the same way as the real live trading platforms that are used with risk capital. Opening a demo account and practicing trading is an essential step towards mastering online commodity trading. Trading through a demo account will help me understand the affects that leverage has on my risk capital. It will help me decide what level of leverage is comfortable for me. I will be able to use technical analysis tools to help me decide on exit and entry points in the commodities market without risking my Invest - 219 - Invest- 55 Assets That Grow Savings and Earn Passive Income own risk capital. Finally I will be able to test my discipline and my trading habits before I try the real thing. Once I have mastered the commodity trading software, and have become fairly proficient using some technical analysis tools and have decided on the level of risk capital and leverage I feel comfortable with I am ready to switch from a demo account to a live trading account. I may find that internet commodity trading is quite highly profitable and that eventually it will become a full time job. Trading on the net is flexible in that I can begin slowly and increase my trading level at my convenience. Use the technology which is available on the net to enhance my trading experience. One day I might find that I have a new full time job. ‫ق‬ Procedure of Online Commodity Trading $ $ $ $ $ $ ‫ق‬ Open an online trading account. The first step to buying commodities is opening an online trading account. This is a simple step. Fill out the form online. Download the form, complete the information, and then mail it back to the brokerage firm. Wait for approval from the brokerage firm. Purchase commodities through my online broker. The way I purchase commodities is through futures contracts. Futures contracts are agreements that involve sellers delivering commodities to buyers at a pre-determined date. Advantages of Commodity Trading Online The commodity market trading online is fairly new to many investors and actually is a godsend to many who have learned that it can be profitable in the long run. Online trading has become popular for several reasons including the fact that it is a cost effective way of trading as the commissions are low and I get to trade independently according to my strategies. There are many benefits of commodity trading online. $ Learning about commodity trading Gaining knowledge of commodity trading is one of the basic steps that a commodity trader has to do. Online traders have many sources to turn to as tutorials and webinars to learn all they need to know about trading commodities online. Finally, my online trading broker will also help me with online commodity trading. It is important to know how the markets and the exchanges work before starting to trade in commodities. $ Execution of orders The execution of my trading orders can be placed through the online platform of my broker. This is almost instantly executed and the speed with which trading can be concluded is a definite advantage in any market. $ Low commissions Invest - 220 - Invest- 55 Assets That Grow Savings and Earn Passive Income The commissions that are charged are low for online trading as there are fewer overheads to worry about. Low commissions allow I to be more adventurous in my trading as it gives I more chances of trading with my capital. ‫ق‬ Spot trading Spot trading is any transaction where delivery either takes place immediately, or with a minimum lag between the trade and delivery due to technical constraints. Spot trading normally involves visual inspection of the commodity or a sample of the commodity, and is carried out in markets such as wholesale markets. Commodity markets, on the other hand, require the existence of agreed standards so that trades can be made without visual inspection. ‫ق‬ Forward contracts A forward contract is an agreement between two parties to exchange at some fixed future date a given quantity of a commodity for a price defined today. The fixed price today is known as the forward price. ‫ق‬ Futures contracts A futures contract has the same general features as a forward contract but is transacted through a futures exchange. Commodity and futures contracts are based on what’s termed forward contracts. Early on these forward contracts — agreements to buy now, pay and deliver later — were used as a way of getting products from producer to the consumer. These typically were only for food and agricultural products. Forward contracts have evolved and have been standardized into what we know today as futures contracts. For example, a farmer raising corn can sell a future contract on his corn, which will not be harvested for several months, and guarantee the price he will be paid when he delivers; a breakfast cereal producer buys the contract now and guarantees the price will not go up when it is delivered. This protects the farmer from price drops and the buyer from price rises. In essence, a futures contract is a standardized forward contract in which the buyer and the seller accept the terms in regards to product, grade, quantity and location and are only free to negotiate the price. In 17th century Europe, it became common for dealers to make sales arrangements with the farmers in regard to future shipments of produce. The dealers would agree to pay a certain price and in return the farmers would agree to deliver a given amount of produce on a given date. Once an agreement was reached a contract would be written. If the dealer decided he did not want to purchase the crop then he could sell the contract to another dealer. Likewise, the farmer could choose to sell the contract to another Invest - 221 - Invest- 55 Assets That Grow Savings and Earn Passive Income farmer. Additionally, the value of the contract would rise and fall depending on changing crop related conditions. In modern times, this system is generally used for 1 of 2 distinct purposes; hedging a purchase or speculative investing. Hedging a purchase is simply an attempt by a buyer to offset the risk of changing commodity prices. For example if a bakery needs to purchase a large amount of wheat he may choose to purchase a wheat futures contract. If the price of wheat goes up due to market conditions then the bakery will have to pay more for this commodity. However, at this point it can sell the wheat futures at a profit to cover the additional cost. The purpose of speculative investors is simply to make money. The object is to buy a futures contract and then to sell it when the value increases. A contract states that the buyer is obligated to pay a specified amount of money in exchange for the commodity upon a certain date. However, speculative investors will sell the contracts before the expiration date occurs. Money is made or lost depending on fluctuations in value as market conditions change. The main advantage for speculative trading in commodity futures is that an investor can typically make a greater amount of money in a shorter span of time than other forms of investments. This is possible due to the rapid movement of pricing. However, for the same reasons it is also possible to loose more money in a shorter amount of time. Generally, this is not an investment venue suited for the casual investor. $ Hedging Hedging, a common (and sometimes mandatory) practice of farming cooperatives insures against a poor harvest by purchasing futures contracts in the same commodity. If the cooperative has significantly less of its product to sell due to weather or insects, it makes up for that loss with a profit on the markets, since the overall supply of the crop is short everywhere that suffered the same conditions. Whole developing nations may be especially vulnerable, and even their currency tends to be tied to the price of those particular commodity items until it manages to be a fully developed nation. For example, one could see the nominally fiat money of Cuba as being tied to sugar prices, since a lack of hard currency paying for sugar means less foreign goods per peso in Cuba itself. In effect, Cuba needs a hedge Invest - 222 - Invest- 55 Assets That Grow Savings and Earn Passive Income against a drop in sugar prices, if it wishes to maintain a stable quality of life for its citizens. It is used to protect the client $ Delivery and Condition Guarantees In addition, delivery day, method of settlement and delivery point must all be specified. Typically, trading must end two (or more) business days prior to the delivery day, so that the routing of the shipment can be finalized via ship or rail, and payment can be settled when the contract arrives at any delivery point. ‫ق‬ Regulation of Commodity Markets The principal regulator of commodity and futures markets is the Commodity Futures Trading Commission but it is the National Futures Association that enforces rules and regulations put forth by the CFTC. Invest - 223 - Invest- 55 Assets That Grow Savings and Earn Passive Income COMMODITY INVESTMENT PRODUCTS The commodity investment products are grouped according to the commodity types; and there are three commodity types, namely, hard commodities, medium commodities and soft commodities. HARD COMMODITIES (BASE, RARE EARTH & PRECIOUS METALS) ‫ق‬ Introduction The periodic table represents the earth's known chemical elements, including 94 naturally occurring elements and 24 synthetic elements artificially produced in extreme conditions such as in particle accelerators. The periodic table is divided into nine families of elements with similar properties: alkali metals, alkaline metals, transition metals, other metals, metalloids, non-metals, halogens, noble gases and rare-earth metals. These rare-earth metals, along with a selection of elements known as base and precious metals, provide today’s investors and active traders with a variety of trading opportunities. There are three types of metals for investment: rare earth metals, precious metals and base metals. Precious metals include gold, diamond, silver, platinum, and some other less known materials such as ruthenium, rhodium, palladium, osmium, and iridium. Base and/or industrial metals include copper, nickel, aluminum, zinc, lead, and iron/steel. The reasons for investing in precious metals and base metals can be very different. But their prices are correlated nevertheless because of inflation. Rare earth metals are used for electronics manufacture. ‫ق‬ Tips to Investing $ Leverage Leverage my bets in futures market. This is only recommended for professional traders. $ Geographical Location The most important thing about physical location is the political stability. In general, geographic stability and diversity is very positive for the miners. Buffett avoids purchasing companies that are fundamentally changing direction because their previous plans were unsuccessful. It has been his experience that undergoing major business changes increases the likelihood of committing major business errors. “Severe change and exceptional returns usually don’t mix,” Invest - 224 - Invest- 55 Assets That Grow Savings and Earn Passive Income $ Finished Products Demand Often, investment values are tied to demand for products that use the elements. $ Volatility Risk As with any other investment, including commodities investments, prices can be volatile, and I must take into consideration these risks when deciding my investment time horizon. $ Tax Consequences Investing in commodities ETFs may have different tax consequences than investing in regular stocks. I will research tax breaks prior to investing, so I am not unpleasantly surprised by the tax man. ‫ق‬ The Three Types of Metals The earth’s 118 known elements appear on the periodic table. Among these elements are base metals, precious metals and rare-earth metals, which provide a variety of opportunities for investors and traders. I can invest in the base, precious and rare-earth metals as below. Invest - 225 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Industrial/Base Metals (Copper, Aluminium, Zinc, Lead, & Iron/Steel) ‫ق‬ Introduction In chemistry, metals that oxidize or corrode easily are referred to as ‘base metals.’ These industrial metals include copper (Cu on the periodic table), nickel (Ni), aluminum (Al), zinc (Zn), lead (Pb), tin (Sn) and iron (Fe)/steel (an alloy of iron and carbon). Base metals are generally plentiful, and are used in a variety of commercial and industrial applications, such as copper plumbing, aluminum cans and the steel used in automobile production. Because of their abundance, prices for base metals are far below those of both precious and rare-earth metals, and prices respond to changes in demand for the products for which the metals are used. ‫ق‬ Investing in Base Metals Commodities investing is increasing in popularity as new products make investing in commodities more accessible to the individual investor. Many people invest in commodities like copper because they anticipate a continued bull market as emerging countries continue to industrialize. Also, many people desire a ‘safe haven’ or inflation hedge which is more directly tied to industrial activity than gold or silver. If any of these are true, investing in copper may be for me. Here are easy steps to invest in copper. (Base metals may not glitter like gold, but they can still guide an investor to a conclusion about overall economic health) ‫ق‬ How to Invest in Base Metals Investors and traders can participate in the base metals market in a number of ways. $ Stocks Investments can be made in individual companies specializing in particular base metals production, including steel company or Aluminum Company. Invest in metals/mining stocks. This gives I some leverage compared to holding physical metals, as explained in my previous intro to investing in natural resources. I still should have probably more than 5 stocks, or at least have 3 different stocks for sufficient diversification, assuming that I do not use mutual funds or ETFs. Consider buying stock in companies that engage in copper mining. The thesis behind this approach is that as demand for copper grows, and copper rises in price, copper mining companies will profit. Own shares in companies is also preferable for some people because of the tax consequences. With this approach, however, I must careful. Many other factors besides the price of copper can impact earnings for copper mining companies. To name a few: mining equipment costs, political and regulatory changes in the countries where the mining companies conduct mining. $ Derivative Contracts (Futures and options) Invest - 226 - Invest- 55 Assets That Grow Savings and Earn Passive Income Futures and options contracts of individual metals can be traded, such as copper futures and options. $ Funds/ETFs In addition, a wide variety of base metal exchange-traded funds (ETFs) exist, which is composed of futures contracts on various base metals, including aluminum, zinc and copper; and is made up of companies involved in the metals and mining industries; and which consists of companies involved in the production of basic materials. I can invest in copper using my stock brokerage account by buying a commodity ETF which invests in copper. This ETF invests only in copper. However, there are other ETFs which invest in copper and other industrial metals, if I want more diversification. $ Physical Possession I can buy physical copper bars and ‘copper bullion,’ though the market for physical copper is not highly developed like the markets for gold and silver bullion. Also, buying physical copper is definitely not for the novice copper investor, as there are differences in alloy and material composition that may impact the value of the copper. The better approach for most people is likely to buy a copper ETF or other commodity ETF that invests in futures contracts for industrial metals. Invest - 227 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Rare-Earth Metals (Lanthanum, Cerium, Praseodymium, etc) Rare earth metals are becoming increasingly important to the electronics industry and technological advancements. Elements such a lanthanum (La), Cerium (Ce), praseodymium (Pr) and neodymium (Nd) are used in the manufacturing of electronics like cell phones, computer memory chips, cameras and e-readers. Rare-earths are also a critical component in several military and defense applications, such as night vision goggles, precisionguided weapons and stealth technology. Although none of the rare-earth metals is especially rare, extracting and processing them is challenging due to their widespread geographic distribution, and the environmental concerns with processing (including the release of toxins such as cadmium and radioactive waste). Despite their abundance, rare-earth metals are valuable because they are hard to get, and they are in high demand. Rare earth metals are elements found in ore deposits within the earth's crust. REMs are essential in the production of many goods, such as TVs and cars. China's low extraction costs and high deposits make it a world leader in REM production. ‫ق‬ Rare Earth Metals and Their Uses Rare Earth Metals (REM), also commonly known as Rare Earth Elements (REE), are a group of periodic elements made up of the 15 lanthanides along with yttrium and scandium. Although not lanthanides, yttrium and scandium are still considered rare earths because they are often found in the same ore deposits as the lanthanides and exhibit similar properties. ‘Rare’ is a bit of a misnomer when describing these elements, as the rare earths are actually plentiful in the Earth’s crust. In fact, cerium, one of the Light Rare Earth Elements (LREE), is found in at 68 parts per million (ppm), which is similar to copper. The rare earths have many uses, and keep in mind that these uses find their way into everyday technology, such as flat screen TVs, smart-phones, tablet PCs and hybrid cars. Add to this their use in wind turbines and military equipment and it's plain to see that the rare earths are critical to the global economy. While we read and hear many reports about the wide-ranging uses of oil in our everyday lives, the rare earths are becoming nearly as important. ‫ق‬ China's Rare Earth Stronghold The incredible cost of such rare earth mining projects is the primary reason why China has historically been world's largest producer of rare earth metals. With less than 40% of the world’s proven rare earth reserves, it is China’s massive price undercutting (a luxury made possible by their low cost of labor) that allows them to control the world’s rare earth supplies. That makes many outside of China very nervous. For example, in late 2010, the Chinese government announced plans to limit rare earth exports to ensure that local producers who use rare earth metals in the inputs will have the ability to access the metals. With most other projects and mines abandoned around the world in the early 1990s due to China’s aggressive pricing, China became the only viable player in the rare earth Invest - 228 - Invest- 55 Assets That Grow Savings and Earn Passive Income industry. However, increasing global demand for rare earths has prompted many miners to reopen previously abandoned projects and seek out new deposits across the globe. However, as previously noted, these new projects will not come cheaply or quickly. ‫ق‬ Sourcing and Mining of Rare Earth Metals As mentioned, most REMs are not rare in the Earth`s crust. The problem is finding them and being able to extract and refine them at an economical price point. Rare earth deposits exist all over the world, and most deposits can be categorized as being either a light rare earth element (LREE) deposit or a heavy rare earth element (HREE) deposit, and most deposits will be found with uranium. In fact, in many uranium mines, rare metals are simply left in tailing, as refining the rare earths is not economically viable for the majority of miners. In general, HREE deposits are considered more valuable than LREE deposits, since the heavy rare earths are considered rarer. Additionally, the heavy rare deposits will also typically contain a large amount of LREEs, making such discoveries much more lucrative. There are numerous mines and projects around the world, but notable deposits can be found in parts of Canada, Australia, Russia and China among other locations. While rare earth deposits may be plentiful, the costs associated with mining and refining the minerals is a major barrier to entry. The typical rare earth project can cost anywhere from $500 million to well over $1 billion. This is the reason why investors should be careful when a miner claims to be involved in REM production. Since the cost and time to make such projects viable and economical are quite substantial, many of these junior rare earth miners may simply have the mining rights to a rare earth deposit that they might have no real intention of producing. ‫ق‬ How to Invest in Rare Earth Metals Investors looking for ways to play the industry do not have a multitude of options. The rare earths are not traded like gold, silver or copper, and few ETFs offer prospective investors exposure to the metals. Therefore, the easiest and perhaps most direct way to gain exposure to the rare earth industry is through the miners themselves. While there are a few large-caps out there, there are many more juniors that may or may not have the means or partnerships to actually produce their deposits. So, there is need for due diligence and informed investing. $ Stocks Aside from physical possession of precious metals, investors can trade stocks. Investors can gain exposure to rare-earth metals through exploration and processing companies $ Funds Invest - 229 - Invest- 55 Assets That Grow Savings and Earn Passive Income Investors can also buy into mutual funds and exchange-traded funds based on rare earth metals. Invest - 230 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Precious Metals (Gold, Diamond, Silver, Platinum, & Palladium) While gold has been revered for thousands of years and is likely to remain a popular investment, other elements like palladium and neodymium are attracting attention through a variety of trading vehicles including stocks, futures, options and exchange-traded funds. Precious metals are naturally occurring metallic chemical elements that have a high luster and melting point, are softer and more ductile than other metals, and are less reactive than most elements. Precious metals include silver (Ag), gold (Au), diamond, platinum (Pt) and palladium (Pd). Because of their scarcity, precious metals are valuable – much more so than the base metals. Precious metals are used for jewelry, art, coins, dental work, medical devices, and electronics and for investment/holding purposes. Platinum, together with like precious metals including ruthenium, rhodium, palladium, neodymium, iridium & Osmium, have a much shorter history in the financial sector than either gold or silver, which were known to ancient civilizations. They are also relatively scarce even among the precious metals. As such, it tends to trade at higher per-unit prices. ‫ق‬ How to Invest in Precious Metals Like base metals, a wide range of investment vehicles are available to those interested in the precious metals markets. $ Physical Possession I can invest in physical gold/silver. I will need to deal with authentication of my purchase, physical storage & insurance, and deciding which forms, bars or coins. $ Derivative Contracts Futures and options contracts are available for gold, diamond, silver, platinum and palladium; and other precious metals. $ Stocks Aside from physical possession of precious metals, investors can trade stocks. $ Funds Investors can also buy into mutual funds and exchange-traded funds based on precious metal holdings. Invest - 231 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Rules for Investing In Precious Metals Understanding Macroeconomic Conditions: An investment in precious metals should be based on macroeconomic considerations. If one expects or fears rising inflation, destabilizing deflation, a bear market in stocks or bonds, or financial turmoil, precious metals should do well and exposure is warranted. Understanding market dynamics: Understanding the internal dynamics of the precious metals market can be helpful as to investment timing issues. For example, the weekly position reports of commodity trading funds or sentiment indicators offer useful clues as to entry or exit points for active trading strategies. Reports on physical demand for jewelry, industrial, and other uses compiled by various sources also provide some perspective. However, none of these considerations, non monetary in nature, yield any insight as to the broad market trend. The same can be said for reports of central bank selling and lending activity. Balanced Trading Strategies: Excessive reliance on trading strategies to generate returns can be dangerous and counterproductive. Returns from a ‘buy and hold’ strategy should be more than sufficient to compensate for the inherent volatility. Many who have tried to outsmart this market by hyperactive trading have under performed. Success is dependent in large part on the occurrence of ‘fat tail’ events that lie outside the parameters of trading models. Diversification: A reasonable allocation in a conservative, diversified portfolio is 0 to 3% during a precious metals bear market and 5% to10% during a bull market. Equities of precious metals mining companies offer greater leverage than direct ownership of the metal itself. Precious metals equities tend to appear expensive in comparison to those of conventional companies because they contain an imbedded option component for a possible rise in the precious metals price. Even though precious metals itself is a conservative investment, ‘precious metals fever’ attracts a crowd of speculators, promoters, and charlatans who only want to separate investors from their money. I will avoid offbeat ‘exploration’ companies with little or no current production and gargantuan appetites for new money. Bullion or coins are a more conservative way to invest in precious metals than through the equities. In addition, there is greater liquidity for large pools of capital. Investing in the physical metal requires scrutinizing the custodial arrangements and the creditworthiness of the financial institution. I should not mistake the promise of a financial institution to settle based on the precious metals price, for example, a ‘precious metals certificate’ or a ‘structured note’, (i.e. derivative), for the actual physical possession of the metal. I should insist on possession in a segregated vault, subject to unscheduled audits, and inaccessible to the trading arrangements or financial interest of the financial institution. Invest - 232 - Invest- 55 Assets That Grow Savings and Earn Passive Income Reduced Reliance on Media: Precious metals is a controversial, anti establishment investment. Therefore, I will not rely on conventional financial media and brokerage house commentary. In this area, such commentary is even more misleading and ill informed than usual. ‫ق‬ Factors Influencing the Precious metals Price Speculation: The precious metals market is subject to speculation as other commodities are, especially through the use of futures contracts and derivatives. Supply & Demand: Like most commodities, the price of precious metals is driven by supply and demand. However unlike most other commodities, saving and disposal plays a larger role in affecting its price than its consumption. Sentiment: Most of the precious metals ever mined still exists in accessible form, such as bullion and mass-produced jewelry, with little value over its fine weight — and is thus potentially able to come back onto the precious metals market for the right price. Given the huge quantity of precious metals stored above-ground compared to the annual production, the price of precious metals is mainly affected by changes in sentiment, rather than changes in annual production. Economic Policies: The price of precious metals is also affected by various welldocumented mechanisms of artificial price suppression, arising from fractional-reserve banking and naked short selling in precious metals. Political Instability: Further, the price is also affected by stability, or its absence. In times of war, people fear that their assets may be seized and that the currency may become worthless. They see precious metals as a solid asset which will always buy food or transportation. Thus in times of great uncertainty, particularly when war is feared, the demand for precious metals rises. ‫ق‬ How to Invest in Precious metals In general, investors looking to invest in precious metals directly have three choices: they can purchase the physical asset, they can purchase an ETF that replicates the price of precious metals, or they can trade futures and options in the commodities market. $ Precious metals Bars The most traditional way of investing in precious metals is by buying bullion precious metals bars. These can easily be bought or sold at the major banks. Alternatively, there are bullion dealers that provide the same service. Bars are available in various sizes. Bars generally carry lower price premiums than precious metals bullion coins. However larger bars carry an increased risk of Invest - 233 - Invest- 55 Assets That Grow Savings and Earn Passive Income forgery due to their less stringent parameters for appearance. While bullion coins can be easily weighed and measured against known values, most bars cannot, and precious metals buyers often have bars re-assayed. Larger bars also have a greater volume in which to create a partial forgery using a tungsten-filled cavity, which may not be revealed by an assay. $ Precious metals Coins Precious metals coins are a common way of owning precious metals. Bullion coins are priced according to their fine weight, plus a small premium based on supply and demand (as opposed to numismatic precious metals coins which are priced mainly by supply and demand based on rarity and condition). The Krugerrand is the most widely-held precious metals bullion coin. Other common precious metals bullion coins include the Australian Precious metals Nugget (Kangaroo), Austrian Philharmoniker (Philharmonic), Austrian 100 Corona, Canadian Precious metals Maple Leaf, Chinese Precious metals Panda, Malaysian Kijang Emas, French Coq d’Or (Precious metalsen Rooster), Mexican Precious metals 50 Peso, British Sovereign, and American Precious metals Eagle. Coins may be purchased from a variety of dealers both large and small. Fake precious metals coins are not uncommon, and are usually made of precious metals-plated lead. $ Precious metals Exchange-Traded Products (ETPs) Precious metals exchange-traded products may include ETFs, ETNs, and CEFs which are traded like shares on the major stock exchanges. Precious metals ETPs represent an easy way to gain exposure to the precious metals price, without the inconvenience of storing physical bars. However exchange-traded precious metals instruments, even those which hold physical precious metals for the benefit of the investor, carry risks beyond those inherent in the precious metal itself. Typically a small commission is charged for trading in precious metals ETPs and a small annual storage fee is charged. The annual expenses of the fund such as storage, insurance, and management fees are charged by selling a small amount of precious metals represented by each certificate, so the amount of precious metals in each certificate will gradually decline over time. Exchange-traded funds, or ETFs, are investment companies that are legally classified as open-end companies or Unit Investment Trusts (UITs), but that differ from traditional open-end companies and UITs. The main differences are that ETFs do not sell directly to investors and they issue their shares in what are called ‘Creation Units’ (large blocks such as blocks of 50,000 shares). Also, the Creation Units may not be purchased with cash but a basket of securities that mirrors the ETF's portfolio. Usually, the Creation Units are split up and re-sold on a secondary market. ETF shares can be sold in basically two ways. The investors can sell the individual shares to other investors, or they can sell the Creation Units back to the ETF. In addition, ETFs generally redeem Creation Units by giving Invest - 234 - Invest- 55 Assets That Grow Savings and Earn Passive Income investors the securities that comprise the portfolio instead of cash. Because of the limited redeemability of ETF shares, ETFs are not considered to be and may not call themselves mutual funds. $ Precious metals Certificates Precious metals certificates allow precious metals investors to avoid the risks and costs associated with the transfer and storage of physical bullion (such as theft, large bid-offer spread, and metallurgical assay costs) by taking on a different set of risks and costs associated with the certificate itself (such as commissions, storage fees, and various types of credit risk). Banks may issue precious metals certificates for precious metals which is allocated (nonfungible) or unallocated (fungible or pooled). Unallocated precious metals certificates are a form of fractional reserve banking and do not guarantee an equal exchange for metal in the event of a run on the issuing bank's precious metals on deposit. Allocated precious metals certificates should be correlated with specific numbered bars, although it is difficult to determine whether a bank is improperly allocating a single bar to more than one party. $ Precious metals Accounts Many types of precious metals ‘accounts’ are available. Different accounts impose varying types of intermediation between the client and their precious metals. One of the most important differences between accounts is whether the precious metals is held on an allocated (non-fungible) or unallocated (fungible) basis. Another major difference is the strength of the account holder's claim on the precious metals, in the event that the account administrator faces precious metals-denominated liabilities (due to a short or naked short position in precious metals for example), asset forfeiture, or bankruptcy. Many banks offer precious metals accounts where precious metals can be instantly bought or sold just like any foreign currency on a fractional reserve (non-allocated, fungible) basis. Swiss banks offer similar service on an allocated (non-fungible) basis. Pool accounts facilitate highly liquid but unallocated claims on precious metals owned by the company. Digital precious metals currency systems operate like pool accounts and additionally allow the direct transfer of fungible precious metals between members of the service. $ Derivatives, CFDs and spread betting Derivatives, such as precious metals forwards, futures and options, currently trade on various exchanges around the world and over-the-counter (OTC) directly in the private market. $ Mining Companies/Precious metals Stocks These do not represent precious metals at all, but rather are shares in precious metals mining companies. If the precious metals price rises, the profits of the precious metals mining company could be expected to rise and as a result the Invest - 235 - Invest- 55 Assets That Grow Savings and Earn Passive Income share price may rise. However, there are many factors to take into account and it is not always the case that a share price will rise when the precious metals price increases. Mines are commercial enterprises and subject to problems such as flooding, subsidence and structural failure, as well as mismanagement, theft and corruption. Such factors can lower the share prices of mining companies. The price of precious metals bullion is volatile, but un-hedged precious metals shares and funds are regarded as even higher risk and even more volatile. This additional volatility is due to the inherent leverage in the mining sector. For example, if I own a share in a precious metals mine where the costs of production are $300 per ounce and the price of precious metals is $600, the mine's profit margin will be $300. A 10% increase in the precious metals price to $660 per ounce will push that margin up to $360, which represents a 20% increase in the mine's profitability, and potentially a 20% increase in the share price. Furthermore, at higher prices, more ounces of precious metals become economically viable to mines, enabling companies to add to their reserves. Conversely, share movements also amplify falls in the precious metals price. For example, a 10% fall in the precious metals price to $540 will decrease that margin to $240, which represents a 20% fall in the mine's profitability, and potentially a 20% decrease in the share price. To reduce this volatility, some precious metals mining companies hedge the precious metals price up to 18 months in advance. This provides the mining company and investors with less exposure to short term precious metals price fluctuations, but reduces returns when the precious metals price is rising. Precious metals stocks are much riskier than the metal. Miners have enormous expenses and therefore often hedge production by selling future output at today's prices, foreclosing future gains. Invest - 236 - Invest- 55 Assets That Grow Savings and Earn Passive Income MEDIUM COMMODITIES (ENERGY & WATER) ¥ Electricity ‫ق‬ Investing in Electricity The need of the hour is to invest in all stages of the electricity market to provide steady transmission to networks and ensure a clean and sustainable source of energy, while also gaining steady profits. In the global market scenario, there has been a marked increase of investments in the electricity markets. Here, an investor not only gain significant returns from their investments, but also contributes towards a clean, green and sustainable planet. ‫ق‬ Why invest in electricity The current electricity market offers a lot of attractive opportunities for investors while also promising significant returns. $ Population growth Population growth in the coming years is expected to surge and thus increase the demand for electricity supply. $ Emerging markets The emerging countries in the electricity markets are promising as they are not already hassled with old infrastructure. This makes it relatively easy to build newer and faster systems of infrastructure for supplying electricity. $ Increasing incomes Electricity is not only a source of consumption; it is also a means of establishing prosperity, especially for the developing countries. $ Industrial Development Industries, power plants, various development projects and cities need electricity to survive and flourish. Most of the countries in the emerging electricity market have abundant resources such as biomass, geothermal resources, solar power and water bodies to set up electricity generating plants. ‫ق‬ How to Invest in Electricity $ Stocks: As the fuel and oil prices continue to soar, the demand for electric cars will increase in proportion. Thus, investing in electric car companies is a profitable venture and also a hedge against the current fuel prices. Further, buying shares of companies in the electricity market guarantees good profits and also raises my share price as electric energy is something we cannot do without. $ Derivatives: Electricity futures are traded on most world exchanges. Invest - 237 - Invest- 55 Assets That Grow Savings and Earn Passive Income $ Electricity Generators: I can also invest in electricity by purchasing and installing electricity generators, and selling the generated electric power to private corporations, or to the national grid. Invest - 238 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Coal ‫ق‬ Investing in Coal Coal’s surging price has outpaced crude oil and natural gas. Coal prices are surging ahead even as most other commodities pull back, spurred on by expectations that metallurgical and thermal coal production will again fail to meet rising global demand this year. The result? Record profits for major coal producers like Xstrata, a surge in acquisitions from coal-hungry India, Chinese electricity shortages, and a raging carbon tax debate in Australia amid record investments in that country’s coal-heavy mining sector. China mines more coal than any other country in the world but still imports more to support its power and steel-making needs – the country mines and burns more than three billion tons of the black stuff annually. And India – where the economy is growing at 8% annually – is facing multimillion ton coal shortages even as it works to halve a 14% peak power deficit within two years. It's a Good Time to Invest in Coal ‫ق‬ Why Invest in Coal $ Stability As with any stable commodity, investors want a product that will stand the test of time before including it their investment strategy. Stable investments like gold and coal, are sound ways to maintain some stability in a portfolio. $ Supply pressures Supply pressures alone already increase coal prices. The export market into Asia and Europe is extremely strong. Supply can't keep up with demand. $ Technology There are many different technologies currently being developed to break oil addiction. One such technology is a process of turning solid coal, into synthetic liquid fuels. Coal-to-Liquid (CTL) technology is able to convert the black rocky fuel into valuable, high-quality synthetic fuels. These fuels include clean, sulfur-free synthetic diesel and jet fuel. The most common way to convert coal into liquid fuels is the Fischer-Tropsch process, named after two German scientists who developed the technique back in 1925. Clean coal has been an oxymoron for all these years but this may change soon. There are several endeavors are underway for carbon capture and storage (CCS). $ Higher Exchange Rates Other developments that may boost coal prices include higher exchange rates. Production costs have been rising 14% per year, and further cost inflation is expected, if at a slower rate. $ China factor Invest - 239 - Invest- 55 Assets That Grow Savings and Earn Passive Income China will sharply increase coal imports in the coming months to build its reserves. Coal demand from China, the world's largest coal consumer, will be very strong. $ Risks Yes, there's a drawback to coal. Coal is dirty and toxic. But is will not slow down demand. It's like cigarettes. There's huge demand, and people know it's bad for their health. ‫ق‬ How to Invest This is a good time to invest in coal as its use is only going to increase. $ Stocks One way to get exposure is to invest in the companies dealing with coal. Coal stocks have been performing well. Investments in energy infrastructure are not only needed to support the low-carbon transition of our energy systems, but also to continue providing energy services at current levels. New railways and ports are currently being built in Mongolia and Mozambique as both countries prepare to increase coal exports. Public and private investors are willing to cover the costs associated with infrastructural works because of the expected high returns in terms of the future economic development and revenues from sales $ Funds/ETFs Another way to be exposed is to purchase ETFs. With a real possibility that coal could be the new gold... black gold, there are wonderful pointers on gaining coal stocks. One way for investors to make a play in this sector is through Coal ETFs. Besides the usual benefits that come with investing in an ETF like tax advantages, low costs etc, it also helps to hedge against risk and provides exposure to the coal sector without having to hold several coal stocks as well as an efficient diversification strategy. Besides the usual advantages that come with ETFs like the tax benefits, coal ETFs can be utilized in a portfolio a few different ways. ‫ ق‬Hedge Risk - As I mentioned above, a coal ETF can be used to hedge downside or upside risk. Be it foreign risk, energy risk, or even coal risk. ‫ ق‬Diversification – Any new investment can not only help diversify a portfolio, but decrease systematic risk as well. ‫ ق‬Exposure – A coal ETF can be used to gain exposure to energy, alternative energy, and/or the coal sector. Invest - 240 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Nuclear Energy ‫ق‬ Investing in Nuclear Energy It's been more than 20 years since Three Mile Island and Chernobyl, one year since Japan’s Disaster, and nuclear power's long winter is finally beginning to thaw. Although many crucial issues -- such as how to dispose of toxic byproducts -- must be resolved, nuclear power is clearly assuming a higher profile. Investor interest is rising as well. The business is heavily regulated. However, utility firms that are able to generate lots of cheap, nuclear-powered electricity and sell it on the open market have an even greater advantage. ‫ق‬ Why Invest in Nuclear $ Rising Oil Prices Rising prices for oil and natural gas are making atomic energy seem cheap by comparison, and global-warming concerns are prompting reconsideration of clean-burning nuclear power. $ Demand, Population Worldwide electricity consumption is expected to double by 2030 as more and more residents of developing nations become able to afford TVs, computers and air conditioners. Currently, 28 reactors are under construction in China, India, Russia and elsewhere. The London-based World Energy Council says that meeting new demand for electricity while reducing the current level of emissions will require tripling the world's nuclear-plant capacity by 2050. $ Nuclear's edge Nuclear generating stations' cost a third of the average operational costs in the energy industry. The difference is attributable primarily to fuel costs, which account for 78% to 94% of the tab for producing electricity at fossil-fuel plants but only 26% at nuclear plants. Because of rising gas and coal prices, nuclear have become a big cash machine for utilities. $ Most Used Alternative Energy Source Japan generates 30% of its electricity from nuclear reactors. China can’t seem to build the power plants fast enough. It appears that nuclear power — not wind — is the real alternative energy of the present and future. ‫ق‬ Investment Tips in Nuclear Energy $ Fly With Eagles It is enormously expensive to build nuclear plants. So that's another argument for investing in companies that already own nuclear facilities. It takes years to clear regulatory hurdles for a new nuclear plant, build it and obtain a license for it to operate. The advantage of owning nuclear today is that new competition is probably ten years away, at least. $ China/India Factor Invest - 241 - Invest- 55 Assets That Grow Savings and Earn Passive Income According to a report by the International Atomic Energy Agency, 65% of nuclear plants, currently under construction, are in Asia, with China and India leading the pack. The two countries alone are preparing to build three times as many nuclear power plants in the coming decade as the rest of the world combined. And that means investors should keep their eyes open for ways to invest in this expansion. According to the World Nuclear Association, Mainland China has 14 nuclear power reactors in operation, and more than 25 already under construction. Two rival state-owned nuclear power giants – China National Nuclear Corp. and the China Guangdong Nuclear Power Group – dominate the market, but only provide just 2.7 percent of its electricity. India has 17 nuclear plants. The speed of the construction programs in China and India has attracted companies around the world eager to get in on the nuclear bonanza. France, Russia, Japan, the U.K., Canada and South Korea are actively seeking to play a big part in China and India’s ambitious nuclear plans. But one thing is clear: Asia is the center of the action, and while its leaders recognize that the Fukushima nuclear technology was 30 years old, they realize that they have no real choice if power is to keep pace with economic growth. ‫ق‬ How to Invest There are two direct ways to invest in nuclear power: through utilities with big fleets of reliable, low-cost nuclear plants and through uranium mining& processing companies. Three companies, in the nuclear sector, that I should keep an eye for are: ‫ ق‬Reliance Power of India, which trades on the Bombay Stock Exchange and will have a seat at the table of any big bid. ‫ ق‬General Electric (NYSE: GE), which has developed partnerships with key players in all of the most promising Asian emerging markets. ‫ ق‬Korea Electric Power (NYSE: KEP) – better known as Kepco- is a statecontrolled utility and is known as a ferocious low-price bidder fully backed by the South Korean government. Uranium Stocks: Uranium is a key ingredient in nuclear reactors, and there are many uranium miners which trade publicly. Infrastructure stocks: Investors can invest in companies that run nuclear power plants or offer engineering, construction, and consulting services for nuclear plants. The other easiest, shotgun approach, is with an exchange-traded fund, (ETFs). The funds deal with nuclear mining, storage, infrastructure and utilities. Most of these target the Asian growth market. The ETF are broadly diversified. Invest - 242 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Water ‫ق‬ Investing in Water A ‘watershed moment’ has arrived! Literally! One of the most dynamic and profitable themes for the rest of this decade will be investing in water. Purifying, filtering, transporting, storing and bottling water will become increasingly important global businesses. The growing world population means that companies that process, deliver and/or transport the ‘blue gold’ will always be in high demand. ‫ق‬ Why Invest in Water $ Demand, Supply For most of the world, clean drinking water is a far more precious commodity than oil. 97% of the world’s water is non-potable salt water, which leaves only 3% that could be consumed by humans, and most of that ‘water’ is trapped in glaciers and icecaps. Clean, fresh water is not nearly as plentiful as most. Water is the last thing a consumer will give up as they cannot live without it. It is something always in demand. $ Climate change From India, through China, to Africa and even Europe, wells are drying up. The country is not alone. Shortage of farmland is a minor crisis compared with its shortage of water, especially water where farmers need it. Most of subSaharan Africa seems to be sunk in a perpetual drought that has fed a numbing series of civil wars. Australia's wheat belt emerged from a drought just as Argentina entered one. The crisis is, in fact, global. In part, it's a result of climate change. In part, it's a result of shortsighted depletion of limited water resources through waste and pollution. $ Increasing value Water is also becoming more expensive. Research from wealth advisers show that the average cost of water per acre foot rose from less than $2,000 (£1,289) in 1995 to more than $20,000 by 2009. Water is also as an ongoing participant in the commodity price boom. Invest - 243 - Invest- 55 Assets That Grow Savings and Earn Passive Income $ Emerging markets Although the rising demand for water is most apparent in emerging markets there are also many opportunities in developed markets. Emerging markets tend to need production of water, and solutions to address diminishing resources and climate change. In developed markets there are opportunities in waste water treatment and increasingly stringent regulation. $ Population & pollution Two-thirds of the Earth's surface is covered by water, but only a fraction of that is potable. While desalinization efforts may help satisfy some of the demand, increasing population and pollution has made water a very fragile and important resource. $ Urbanization and industrialization Industrial activities such as manufacturing require water, another growth activity in these regions. ‫ق‬ How to Invest in Water $ Funds There are exchange-trade fund (ETF) based on water stocks. The index seeks to identify a group of companies that focus on the provision of potable water, the treatment of water, and the technology and service that are directly related to water consumption. Unlike oil or other commodities, I cannot invest directly in water by buying it or even investing in futures. Funds investing in water tend to buy into companies involved with water, or in some cases inject private equity into them. $ Stocks I can also invest in companies dealing with water distillation, distribution, infrastructure development, filtration systems design, irrigation systems and construction, etc. To invest in water stocks, I will consider putting money in foreign markets where fresh water is not readily available and water treatment plants are still growing. I will also consider investing in either bottled water companies or water treatment plants with tips from an investment consultant in this free video on investing. $ Risks The risks of investing in water include government intervention, tariffs and taxation. The governments dictate the level at which water utilities can set prices, and as a result of a recent change affect dividends. Of course, companies in emerging markets have inflated risks in this regard. Invest - 244 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Green (Renewable) Energy ‫ق‬ Investing In Renewable Energy Oil, coal and natural gas are non renewable energy sources that will not be available forever and alternative sources of renewable energy will be necessary in the future. I can take part in the world's energy transformation by investing in renewable energy sources including: wind, geothermal energy, biomass, biogas, fuel cells, micro-turbines and solar energy. Investment in renewable energy sources today may bring me big profits tomorrow. ‫ق‬ Why Invest in Renewable Energy? People are drawn to renewable energy for one of several reasons: ¥ ¥ ¥ ¥ ‫ق‬ To fight Global Warming To prepare for Peak Oil. To improve Energy Security and local economies. To cash in on the above trends. Tips for Investing in Renewable Energy $ Funds I will watch out for formation of renewable energy focused mutual funds. While there are not many to choose from currently, such funds will appear in the future. Exchange traded funds (ETF's) which can be bought and sold like stocks. ‫ق‬ How to Invest $ Funds Renewable Energy focused mutual funds have been few and far between, but the recent growth of interest in the sector has lead to a plethora of new offerings. There are also EFTs, which are both sector funds, and broad based, offering a more economical and diversified approach and vehicles, tracking both small and big cap companies. . $ Stocks Here, the rule of thumb is to fly with the eagles. I will identify and invest in established companies that are moving into the renewable energy market. This type of investment is less risky than investing in small start-ups. Given the complex nature of the technologies, and the sparse coverage of many of the companies by industry analysts, there is still considerable room for active management in the sector. An understanding of the business models and technologies in the industry should provide the knowledgeable investor with the tool to differentiate the undervalued quality companies from the cheap trinkets that have been finally recognized for what they are. Invest - 245 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ How To Invest in Oil & Gas: “soil-to-smoke” Investing in natural gas is similar to investing in oil. Investing in oil can be the best investment I have ever done. With all the emerging nations in Asia and South America rising up, the oil demands are soaring and will continue to go up exponentially in the future. The problem is, we do not have enough oil resources in the long run! What does this mean? The oil will get even harder to get, and thus increasing the prices. Investing in oil today could be the smartest thing I can do. Oil is the main source of power that drives economies the world over. It is one of the most precious resources the world has today. Oil also happens to be a diminishing resource which adds to its value as a resource and also as an investment option. Oil has over the years been the source of great wealth for those who were bold enough to invest in it either directly or indirectly. Oil producing countries are to date some of the richest nations as far as revenue is concerned. Those who have surplus funds that are enough to invest in the oil industry may want to consider looking into oil well investment. This form of investment continues today and there are still many individuals who make huge sums of money. ‫ق‬ Characteristics $ Oil Partnerships Oil & Gas partnerships are some of the most lucrative partnerships in the world. Before entering any partnership, one has to know the different types of oil partnerships available and how these partnerships work. One of the most common oil partnerships available is the limited oil partnership. This type of partnership involves more than two members in which one or more partners are considered the general partners while the rest of the partners are limited partners who have limited liability. The general partner has unlimited liability. The investment liability for the limited partner is generally the amount invested. This means that the limited partner risks no more than this should the investment fail. In terms of limited oil partnerships, there are two types of such partnerships: developmental partnerships and the exploratory partnerships. An investor has to understand the two partnerships, how they work and more importantly the risks associated with the two before making a decision on which partnership to join. The development oil partnership refers to a drilling process in which oil wells are only sunk in areas where oil reserves have been determined to exist. On the other hand, exploratory oil partnerships are with Oil & Gas companies that are sinking oil wells in areas in which geological surveys suggest that such oil reserves may exist. In any investment, there is a risk. While the exploratory well is indeed risky, any profit gained from the well by striking oil will be exceedingly large. Most oil companies will choose a combination of both Invest - 246 - Invest- 55 Assets That Grow Savings and Earn Passive Income drilling methods so as to achieve maximum success. However, developmental wells are taking a much larger share due to their success. Oil companies which use developmental wells to locate and expand reservoirs are more likely to attract Oil & Gas investors than companies that rely on exploratory wells. Another class of oil limited partnerships is the Master Limited Partnership, commonly referred to by its abbreviated term MLP. MLPs work through the production and processing of natural resources, in this case oil. Oil & Gas MLPs are made up of both general partners and limited partners. MLPS pay their investors quarterly in terms of Quarterly Required Distributions. MLPS are quite advantageous as oil partnerships mainly due to the high number of tax benefits gained from avoiding corporate tax income as well as limited partners being able to reduce their liability on tax forms. As such, MLPs have relatively cheap funding costs. $ Oil & Gas Investment Fraud Oil & Gas investment scams are alive and well. High oil prices have created a heightened interest in investments in energy-related business ventures. Most Oil & Gas investment opportunities, while involving varying degrees of risks to the investor, are legitimate in their marketing and responsible in their operations. However, as in many other investment opportunities, it is not unusual for unscrupulous promoters to attempt to take advantage of investors by engaging in fraudulent practices. When there is a highly publicized economic circumstance, which creates an opportunity for money to be made legitimately, scamsters follow in the shadows to take advantage of the situation. $ Oil & Gas Royalties Often during the analysis of financial earnings from different Oil & Gas companies, I will find Oil & Gas royalties quoted in these reports. Typically, a royalty is part of the total production which the owner is entitled to. The owner is entitled to this portion of the total production well before the Oil & Gas production ever begins or even before any developmental wells are sunk. The royalty is normally agreed upon as a percentage of the lease and has deductions for the lease owner’s production costs. As such, the Oil & Gas royalties may be seen as a portion of the overall production but is free from all associated costs except for taxes. In the case of government land, Oil & Gas royalties are normally paid to the federal government. While such Oil & Gas royalties are traditionally about 1/8 of the total production, there have been some instances where the agreed Oil & Gas royalties have been lowered. The traditional negotiation practice when determining these royalties was through the override method. In this practice, the override royalty was a portion, about 1/16, that was taken from the Lease owner’s interest. $ Investor Accreditation Invest - 247 - Invest- 55 Assets That Grow Savings and Earn Passive Income When it comes to having the right investors in an Oil & Gas well investment company, the investors are accredited investors. Accredited investors are preferred by Oil & Gas companies primarily because of their financial capabilities. Accredited investor in the Oil & Gas industry is any natural person who has an individual total net worth of $1,000,000 or over, or who has had an individual income of at least $200,000 in each of the last two years. While it may be possible for non-accredited investors to invest in some Oil & Gas exploration companies, many industry regulations prohibit such investments and require that Oil & Gas investors be wholly comprised of accredited investors. The reasoning for such regulations is actually quite sound. Oil & Gas companies require extraordinary amounts of money to fund drilling projects, both exploratory and developmental. Accredited investors, due to their financial background, are able to adequately provide this funding. In some cases, the accredited investors may fund the entire project. Still another reason for the regulations is to keep those who cannot afford to possibly lose large sums of money out of the oil well exploration business. Though the returns can be high, so are the risks. $ Pay outs in the Industry There is a simple formula to use when evaluating an investment. The simple rule of thumb is: One dollar (or less) per percentage point per foot per well Here’s an example (in U.S. dollars) to illustrate how it works: 100.0% First, the landowner is paid a royalty. He gets compensated less directly from the refinery. The royalty percentage varies, 12.5% depending on what Oil & Gas operators have agreed to pay equals him in order to obtain the lease. For this example we will 87.5% use 12.5%. In some cases it can be as high as 30%. The investor group then receives its percentage of the net 80% of revenue interest (the percentage left after the landowner 87.5% receives his royalty). In this example the investor group gets equals 80%. 70.0% The Oil & Gas operator then receives its percentage of the net 20% of revenue interest. In this example the Oil & Gas operator 87.5% gets 20%. equals 17.5% To recap, here is the breakdown: 12.5% • Landowner +70.0% • Investor group +17.5% • Oil & Gas operator 100.0% Next, locate the total dollar amount raised to drill the wells. In $1,720,000 Invest - 248 - Invest- 55 Assets That Grow Savings and Earn Passive Income this example the amount is $1,720,000. Divide this by the investor group’s percentage (70%). divided by 70% equals $24,571 Then divide the amount by the number of wells drilled in the $24,571 program. In this example there are four wells. This leaves divided by us with $6,142 per percentage point per well. 4 equals $6,142 Lastly, find the depth of the wells. Divide the $6,142 by the $6,142 number of feet. In this example, the depth is 6,500 feet. The divided by end result is less than one dollar! 6500 feet equals 94¢ This is a good projection, and I should invest. $ Understanding Monthly Revenue At the end of each production month, the landowner’s portion or royalty (generally about 25% of production) is deducted from the month’s production revenue. Once deducted, my proportionate share of the Oil & Gas is divided up and allocated to my account. The expenses are then divided up and allocated to my account. A good thing to remember is the landowner has royalty so they do not pay the lease expenses. That means I pay 100% of the lease expenses and receive 75% of the production. $ Ongoing Investment Investing in Oil & Gas is a long term investment. Each well can last several weeks to several decades. As the well produces, it is natural for pressure and the resulting production to decline. At some point the production will decline to a point that expenses will catch up with production. At this point the well should be plugged. Until the well is plugged or until the project is sold, the investors have an active investment. Each investor will from time to time vote on the future of the project, such as re-working, plugging, or selling. ‫ق‬ Oil & Gas Investing Tips $ Know the Salesperson If it is a legitimate deal, the salesperson will not be reluctant to answer questions or provide written explanations to questions. I will ask the name of the person offering me the security, where he is calling from and his background, particularly in other oil or gas ventures. I will ask what commission and/or other compensation the salesperson will receive. $ Strategic Plan/Production Plan Invest - 249 - Invest- 55 Assets That Grow Savings and Earn Passive Income When considering a particular company to place one’s investment in Oil & Gas wells, one will have to look at the company’s production plan and how it intends to continue to meet demand supplies. A well drawn out plan ensures that the company is committed to ensuring more oil supply to meet the current demand. This assures the investor that they will continue to receive high returns on their investment each month. Over time, a reservoir will dry up. Thus, the company must have a program that will set up new successful wells. I will take a look at this program so as to better understand where the future revenues of the oil exploration company will come from. This should also cover how funds are sourced and utilized, and the legal issues, including lease terms and tax liabilities. The strategic document will also confirm the legal status of the company and its partners, including salespersons, government partnerships, suppliers, etc. $ Seek Advice of a Neutral Expert It is always advisable to seek the advice of a neutral expert before committing my funds to any investment deal. Professional guidance when getting into oil well investment is not only required for the technical aspects of the project. It is equally important to have a qualified professional look at the paper work for the partnership or other agreements that may be used when getting into the investment. This is because these documents will determine my share of profit or loss as well as other rights and responsibilities I have in the project. The expert will also advise on issues of the geological surveys that indicate which areas have oil reserves and the potential quantities that may lie in those areas. $ Fly With the Eagles When I consider investing in Oil & Gas wells, I should be looking for successful companies, industry partners, and operators, who can pass very strict due diligence requirements. I will avoid groups that are just ‘getting started’ or have more dry holes than producers. That is never a good sign. This could mean they are promoters and not earning their living by producing oil and gas. I will seek to know the group that I am dealing with or know someone else that recommends them. In short, it is best to bet on the rider and not the horse. The best geological prospect can be a disaster with the wrong operator. $ Be Informed (Education Reduces Risk) In the stock market, knowledge is everything. In fact, this principle has been adapted to all forms of business. One can profit a great deal by simply having the basic facts about any topic. Oil & Gas investors know this fact all too well. Investing in the oil industry can be trying at times especially if one has very little background information on the topic. Oil & Gas investing can be exciting and rewarding. The best way to reduce the risk is to learn about the energy industry. Warren Buffet said, Invest - 250 - Invest- 55 Assets That Grow Savings and Earn Passive Income “The market, like the Lord, helps those who help themselves. But unlike the Lord, the market does not forgive those who know not what they do.”” As I am involved in projects, I will learn about geology, drilling, and completion phases of the project. I will make sure I receive and read the drilling and completion reports. I will understand the revenue checks. When asked how he made a lot of money investing, Warren Buffet, the self made billionaire, said, ‘we read countless and countless of reports.’ I will not be afraid to ask questions to the group managing my investment. I will remember Albert Einstein when he advised, ‘always ask questions.’ I need to know the company, and its past performance on wells and drilling. That is their obligation since I am a potential owner in the project or well(s). I can learn through various sources including the internet, subscribing to Oil & Gas investor magazines and I will remember to always ask questions before I invest. I will take time to learn about my investment. I after all, ‘an informed investor, is a protected investor.’ Contrary to the popular belief that Oil & Gas investors are plain lucky, investing in such a business requires precise skills. I need to know their risk control model, and their staff and personnel, basically laid out in the strategic plan. To begin with, an investor must have his research in place and also have a keen sense of intuition to know where exactly to invest. It is true that this form of investment is lucrative and promises break-even points in less than a year; however the risks involved are as high as the promise that this investment holds. $ Diversify Once I make the decision to invest in Oil & Gas ventures, I will set a reasonable amount of money that I want to invest. In gambling casinos; this is called ‘limiting my loss.’ Most importantly I will not try to put all the chips down and hope for the best. No matter how good a deal looks, it has risk. After I have selected the group I would like to work with, I will select numerous projects to invest in. Always I will diversify into numerous wells to spread the risk. This will increase the chances of hitting a successful well. My investment will result in either a non-producer, a well that exceeds my expectations or somewhere in the middle. If I properly diversify, the ‘bell curve’ will hopefully be in the middle. Invest - 251 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Benefits There are advantages and disadvantages to any business investment that people make and it is the same with investing in oil and gas. The advantages are more than just of a financial nature. $ Tax Advantages Investments in Oil & Gas and subsequent profits from these investments enjoy a tax advantage over other forms of investment. Deductible operational expenses also enjoy a pass-through. Choosing exploratory properties are also acceptable as they ensure greater tax benefits. By using these enormous tax incentives I can actually invest money I were going to be required to pay to the government anyway and still have the opportunity for some huge gains. Better still, these gains can be spread over a number of years instead of just one, which would probably put me in a higher tax bracket. $ Slow Progress in Renewable Energy The slow progress in renewable energy sources has upped the value of Oil & Gas as an energy source. Today, a massive fraction of the world’s energy demand is still supplied by oil and gas. Until there is a significant development in research and development fronts for energy sourcing, investing in oil companies will continue to remain a profitable option for many investors. $ Stability By most economic analysis, investing in oil companies produce investments that are less likely to be affected by the fluctuations in the market. More stability means I am less likely to lose money out of an Oil & Gas investment. $ Recovery of Costs Easy and quick recovery of intangible costs such as labor, drilling costs in the first year itself. Straight line depreciations can be opted for as well for over seven years or over the life of the well. $ Demand & Supply Risk of losing out on money owing to losses from these trusts is very minimal as the demand for Oil & Gas will hardly cease in the near future. Cash flow can last investors for more than a decade with the right well. The demand for oil is growing every year. As the third world countries are developing and becoming more prosperous, an increasing number of their citizens are able to afford automobiles, motorcycles, boats and many other items that require Oil & Gas consumption. And then there is Cars, Cars, Cars. With the number of cars leaving the showrooms on a daily basis and with most of these cars still powered by diesel and gasoline, oil companies will continue to command a strong presence in all economic fronts. $ Upward Growth/General Profitability of Oil Investments Invest - 252 - Invest- 55 Assets That Grow Savings and Earn Passive Income The current status of world economies combined with the progress on energy source development ensures that oil will continue to be a viable commodity for the foreseeable future. Oil investment companies are positioned front and center in the developmental strategy of many countries and it can only be expected that any production that can be delivered by small companies will be gladly taken up and used by oil-hungry economies making it a virtual positive investment on all fronts. There is a growing uncertainty in stocks and bonds due to the unpredictability of the economies of many countries but given the prime commodity stature of oil, it’s hard to picture that oil will suddenly lose value in the near future. ‫ق‬ Risks Just like other investments have their risks; Oil & Gas investments have their share of risks as well. $ Possibility of Hitting a Dry Hole The possibility of hitting a dry hole – investing in new wells is a big risk; it is a better idea to invest in a well that is already producing. An unsuccessful development is a looming risk for any investor. The rule of the thumb is that investing in mature operational Oil & Gas fields is a better option to investing in high risk ones. Aggressive trusts usually invest only in producing wells; these carry lesser risks for investors. $ Depletion Curve The oil is bound to run out someday, just the way any performing investment will run out of its flesh some day. This will prove risky. $ Unpredictable ROI Depending on the performance of the well per drill, the return on investment will differ; this brings in unpredictable risks. $ Volatile Prices Rise and fall of energy prices and fluctuation in value of fuel is another risk. $ Wasting Assets As Oil & Gas assets are wasting assets, there is only so much that one can earn them. $ Overheads Income also needs to be spent on maintaining and operating the well head. Further, price rise of overheads such as part replacement, pumping fee, electrical works etc, is always high, and hence, a financial risk. $ Paperwork/Regulatory Invest - 253 - Invest- 55 Assets That Grow Savings and Earn Passive Income A lot of paperwork and legal clauses to deal with. ‫ق‬ How to Invest In Oil & Gas (from soil to smoke) There are a number of ways I can invest in oil. I can literally invest from soil to smoke. This means, I can invest in the land (soil), -through the drilling machines, and machine companies, the refining and processing, the distribution and transport, the pump stations, - to the companies making intelligent, environmentally friendly exhaust pipes, both for vehicle, and industries. Specifically, I can invest as below: $ Funds Oil & Gas investments are similar to all other unit investment trusts. Every trust is fragmented to small individual units that are sold to investors at a predetermined price. Every unit is representative of an undivided equivalent interest in all the properties of Oil & Gas that belong to the trust. Every trust has a maturity date; on the date of maturity the relevant profits or losses resulting form the sale of the oil and natural gas assets are dispersed to individual unit holders. It is important to know that unlike other UITs the investments made by the Oil & Gas trusts are direct. The investments are either in production or in drilling assets. Energy mutual funds are the most accessible options for people with investment capital that they want to stash away in an investment for an extended period. $ Investing in Oil & Gas Wells/ Oil & Gas Partnerships Unlike stocks and futures, when I invest in an oil well I have something I can actually look at. I can reach out and touch it – I can watch it develop. There are many oil rich areas in the world. There are also many small drilling companies and owner operators who need funding to drill new wells or to rework older wells that fell out of use when the price of oil made them no longer economical. Oil drilling investments are usually called oil ventures, and they require me to buy in as a partner. Some may ask why a company would want to drill where wells have already been drilled and taken oil out of the ground. There is a number of reasons for this strategy. $ Thanks to new technology oil can be gotten out of the ground in ways that were not available in years past. New drilling methods can bring out oil that was left behind by older technology. $ Many wells that were producing good quantities of oil in the past were shut down because of low oil prices. With the higher price of oil, wells that were producing but not showing a profit can be turned into profitable ventures. $ At times drilling equipment wears out and needs replacement. This is a very expensive undertaking and the owners may just not have the money to do it Invest - 254 - Invest- 55 Assets That Grow Savings and Earn Passive Income or may feel the price of oil does not justify it. If a developmental company can get a lease on a well of this type at a reasonable price at the same time the price of oil has made an upward movement some very outstanding profits can be made. $ Buying Shares There are many ways to put my money on oil investment companies. The first and easiest is in buying stocks from established companies so all that I have to do is sit back, forget my money for a few years, and expect a little profit at the tail-end of my investment. The more conservative individuals choose to buy stocks in the larger oil companies. There are many Blue Chip companies as they are called who have been around a long time and which are relatively safe investments although they will fluctuate with the price of oil. I can also buy stock options. $ Futures Market There is also the futures market in which I can invest in oil. The more adventurous like to invest in the fast moving but riskier futures market. Invest - 255 - Invest- 55 Assets That Grow Savings and Earn Passive Income SOFT COMMODITIES (PLANT & LIVESTOCK) ¥ Introduction to Soft Commodities Investing Soft commodities are plant and livestock products. ‫ق‬ Global Price Drivers in Soft Commodities Investing Commodities are inherently risky assets, but understanding the price drivers and details of the vehicles that offer exposure to these resources can empower investors to use this asset class efficiently. $ Growing Wealth and Purchasing Power The growing wealth and purchasing power of emerging economies such as China and India are enough on their own to keep the market going at current levels, without demand from other economies. Given the substantial size of the market, a small change in diet or lifestyle will have a significant impact. $ The Law of Supply and Demand The world population breached the six billion barrier in 1999 and, according to the United Nations, every year there are 78m more mouths to feed - providing a strongly expanding market at a time when world food stocks are at historically low levels. Soft commodities will be always in demand. But this demand has also been changed as a result of significant short-term factors. One is the growth in demand for heavily subsidised biofuels, (which is derived from corn) which have especially affected the price of crops competing for the same land. In What's So Great About America, Dinesh D'Souza wryly observed that Indians want to come to America where even the poor people are fat. Today, these same Indians can afford to eat just like Americans. Japanese women are four inches taller than they were 50 years ago. And ‘curvy’ among Japanese women is ‘in.’ Prices of basic staples like fish and vegetables have shot up between 10 and 12% over the past year. Globally, the price of rice has risen by 50%, cattle by 40% and wheat by a third over the past two years. Corn prices seem to be hitting a record high almost every week. Let's turn to supply. Here the bogeyman is climate change. Global inventories of soft commodities haven't been this low. $ The Law of Unintended Consequences The emerging mania surrounding biofuel only exacerbates the problem. With corn-based ethanol the latest (government subsidized) rage, demand for crops as biofuel is set to double by 2030. To meet its green goals, Europe will have to allocate 25% of arable land toward ethanol production. Here the law of unintended consequences kicking in. Land shifted toward corn make soybeans more expensive. The new demand for corn means a bidding war has erupted between livestock producers and the ethanol industry. $ Climate change Invest - 256 - Invest- 55 Assets That Grow Savings and Earn Passive Income It looks as though this bull market will continue as it is also fueled by climate change. Climate change could have a devastating effect such as famine and drought. It is estimated that just a three degree rise in temperature could put another 400 million people on the bread line and at the same time cause cereal crops to fall by 400 million tons. $ Low/Negative Correlation/Smoothing Volatility One primary appeal of commodities lies in the correlation–or lack thereof–to traditional asset classes such as stocks and bonds. Numerous academic studies have shown that commodities exhibit low correlation to equities and fixed income, meaning that when added to traditional stock-and-bond portfolios this asset class has the potential to lower overall risk. It is sensible for investors to diversify away from traditional equities and property, particularly into an asset class such as soft commodities, which historically has a low correlation with other assets. The prices of soft commodities tend not to move in unison with assets such as shares and property, so they are perceived as good for diversification in investors’ portfolios. One of the biggest problems investors face is inflation. But as commodities are linked to inflation, they offer a good hedge against it. The addition of non-correlated assets to a portfolio has the effect of smoothing the overall volatility, since individual components are unlikely to move in the same direction at the same time. ‫ق‬ Commodity Investment Tips $ Coordinate Investments Many commodity ETFs come with a bundle of tax surprises, not to mention complicated taxation rules. As such, coordinating my commodity investments into a tax-deferred account, like a traditional or IRA is one way to lower my tax liabilities. Regardless of the holding period, gains are taxed at the longterm capital gains rate and as short term profits, subject to the investor's ordinary income tax rate. $ Choose Diversified Baskets Owning exchange-traded vehicles tied to a single commodity can be considerably more risky and volatile versus owning a diversified basket of commodities. An alternative solution is to stick with broadly diversified commodity ETFs. $ Natural disasters/Smoothing Volatility Also, natural disasters often have negative effects on equity holdings in my portfolio and positive effects on commodities. That’s the biggest benefit of commodities in a portfolio, because it gives me that hedge against those extreme events. Most of them are priced because of weather effects, or inadequate or excess planting and it’s hard to think of a structural argument for most soft commodities. Bad weather, increasing demand from emerging economies and a growing desire for alternative fuels are the three primary causes of rising crop prices. Invest - 257 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ The Risk of Soft Commodities One of the intrinsic risks of soft commodity trading is that they are not located in one place. They are spread all over the globe and are controlled by the governments and companies of the countries they are located in. However there are some ways to protect my investment from this geopolitical insecurity. One way to minimize the risk is to invest in companies with experience and economies of scale and invest in one with a reputable track record. A company that has the size, width, and know-how in international markets to manage the geopolitical risk they face is a much better risk than a smaller company without this sort of experience. ¥ How to Invest in Food Commodities: ‘field to fork’ For investors looking to establish exposure to commodities, there are a number of different strategies–each of which has potential advantages and drawbacks. ' It takes a broad view, looking to invest ‘from field to fork’. This means the portfolio can include food processing companies and even some infrastructure investment.' There are four primary options for investing in commodities– either physical Exposure, buying shares in commodity companies, through future contracts; or indirectly through a fund or an investment trust. ‫ق‬ Physical Exposure The most basic manner of achieving exposure to natural resources involves simply buying and storing the desired commodity or commodities; this method ensures that investors have exposure to changes in the spot price of the resource. Unfortunately, physical exposure only makes sense for commodities exhibiting certain physical properties and maintaining a sufficient value-to-weight ratio to keep storage costs at a reasonable level. Storing gold coins in a safe is one thing, but attempting to gain physical exposure to crude oil or livestock presents a host of logistical and cost hurdles. Physical Exposure or Investing Physically means actually buying and holding the asset, although this comes with storage problems. In the case of buying a physical asset, gold is typically the most popular, with several bullion firms offering online gold dealing and safe storage of the asset. Buying physical gold coins also offers an easy way to access the metal. The World Gold Council provides details of reputable companies on its website, so always check there first. In other cases, I can buy and feed (hold) livestock, for resell, or buy and plant seedlings, for later resell as trees for construction, furniture, fuel or electricity poles, etc. This can be expensive, with buying and selling costs to consider in addition to the cost of storage and insurance. Investors will also need to ensure they buy the asset at a good price. Invest - 258 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Commodity-Intensive Stocks The other option for commodity exposure involves investing in stocks of companies that are engaged in the production or extraction of commodities. Because the profitability of these firms generally depends on the market price for their goods, their outlook will tend to improve when relevant commodity prices increase and vice versa. As for other natural resources such as oil and gas, one way to access them is to buy shares in companies, such as BP, Royal Dutch Shell and Tullow Oil. The same applies to ‘soft’ commodity companies, although they are less numerous on the UK indices. However, my investment will be subject to movements in the stock market, as well as changes in the price of the commodity. Some companies to buy shares in include fertilisers manufacturing companies; agricultural infrastructure and machinery companies; farming company/plantation company; food-processing companies; biofuel companies; and biotech companies. Stock options, which require a smaller investment than buying stocks directly, are another way to invest in commodities. While risk is limited to the cost of the option, the price movement will not usually directly mirror the underlying stock. ‫ق‬ Investment Funds/Trusts To spread risk, an investment fund is an easy way to access the sector. They also provide a degree of diversification, as they will invest in a variety of commodities. These include natural resources funds, specialist agriculture funds, and passive funds. Further, there are exchange traded commodities (ETCs) are instruments that track the future price of the commodity, or a basket of commodities. They can either be physically-backed by the commodity itself, or use swaps with other financial institutions to provide the exposure. Until recently, the only way for mainstream investors to gain exposure to commodities was through investing in index-tracking Exchange Traded Funds (ETFs). An ETF is an investment product representing an individual or basket of derivatives, which tracks an index. Exchange Traded Notes (ETNs) are traded as debt securities that can be bought, sold and shorted like a stock and can be used to gain exposure to commodities. Investors can trade ETNs on the New York Stock Exchange through a broker, at prices that are set by supply and demand. A third type of product is Exchange Traded Commodities (ETCs). They are openended, asset-backed securities and can be regarded as secured, undated, Invest - 259 - Invest- 55 Assets That Grow Savings and Earn Passive Income zero-coupon notes that trade through an open market maker platform. ETCs track the performance of an underlying commodity index, including total return indices, based on a single commodity. They are similar to ETFs, and are traded and settled like normal shares. They are offered in two types: single commodity and index tracking. While mutual funds cannot invest directly in commodities, they can invest in stocks of companies involved in commodity-related industries, such as energy, agriculture or mining. Like the stocks they invest in, the fund shares may be affected by factors other than commodity prices, including stock market fluctuations and company-specific risks. A small number of commodity index mutual funds invest in futures contracts and commodity-linked derivative investments, thus providing more direct exposure to commodity prices. Investors can also invest via Specialist Agricultural Funds. It is a great way to access the overall theme of soft commodities, and gives investors the opportunity to diversify their portfolio. ‫ق‬ Futures Contracts Developed commodity futures markets allow investors to gain exposure to commodity prices through financial contracts that hold natural resources as the underlying assets. While this method simplifies the investing process, it also introduces additional risk factors; returns to futures-based commodity investing are dependent not only on changes in spot prices, but also on the slope of the futures curve and the prevailing level of interest rates. Investing in a futures contract will require me to open up a new brokerage account, if I do not have a broker that also trades futures, and to fill out a form acknowledging that I understand the risks associated with futures trading. Each commodity contract requires a different minimum deposit, depending on the broker, and the value of my account will increase or decrease with the value of the contract. If the value of the contract goes down, I will be subject to a margin call and will be required to place more money into my account to keep the position open. Due to the huge amounts of leverage, small price movements can mean huge returns or losses, and a futures account can be wiped out or doubled in a matter of minutes. Invest - 260 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Commercial Forestry ‫ق‬ Defining Commercial Forestry Commercial forestry is the plantation of large scale forests for the purposes of harvesting the trees for timber, or electric poles, or other such products such as pulp for paper. ‫ق‬ Why Commercial Forestry Demand: There is a demand to supply ratio of 3:1, and hence, forestry is an all season, all year round, all economic times business. Further, the need is increasing across the globe, yearly. Return on Investment: The return on investment in commercial forestry is between 17%-25% per year, and hence, it is very close to private equity, or trading companies with exceptional performances. The timeline for timber investment is roughly double the timeline for electricity poles investment, that is, 16-18 years, and 8-9 years, respectively. Environmental Bonus: Investing in forestry is a form of ethical and social impact investing since it contributes to reduction of pollution ecosystem regeneration, and beautification of the environment, while also acting as water catchment areas. Financial & Technical Support: There is a lot of help, from governments, donors, and private sector, for investment in the forestry sector as commercial planters. ‫ق‬ Tips on Commercial Forestry Minimum Investment Area: Investing in commercial forestry requires at least 60 acres for viable operations. Choice Between Poles And Timber: The best trees species for timber are pine, whereas Eucalyptus can be used for pulp, poles, as well as timber. I need to determine which option I prefer. Invest - 261 - Invest- 55 Assets That Grow Savings and Earn Passive Income 5. PRIVATE EQUITY INTRODUCTION TO PRIVATE EQUITY “if you fear to start a business, start by investing in someone’s business.” -Ojijo ¥ What Is Private Equity? Private equity is working capital to start-up or operating private companies; and owning equity/shares for a period until returns are collected. It is done by venture capital firms, private equity funds or angel investors through leveraged buy outs, venture capital, growth capital, distressed investments and/or mezzanine capital. PE firms can be Specialist, focusing on particular markets, like emerging markets, or industries, like start ups, or technology. Alternatively, PE firms can be General, investing in a broad range of businesses, with no particular limitation. ¥ What Is Private Equity Investment? Private equity is an asset class consisting of equity securities in operating companies that are not publicly traded on a stock exchange. Investments in private equity most often involve either an investment of capital into an operating company or the acquisition of an operating company. Capital for private equity is raised primarily from institutional investors. ‫ق‬ Characteristics! Investment holding firms: Private equity firms organize limited partnerships to hold investments in which the investment professionals serve as general partner and the investors, who are passive limited partners, put up the capital. A limited partnership is a form of partnership similar to a general partnership, except that in addition to one or more general partners (GPs), there are one or more limited partners (LPs). It is a partnership in which only one partner is required to be a general partner. The GPs are, in all major respects, in the same legal position as partners in a conventional firm, i.e. they have management control, share the right to use partnership property, share the profits of the firm in predefined proportions, and have joint and several liability for the debts of the partnership. As in a general partnership, the GPs have actual authority as agents of the firm to bind all the other partners in contracts with third parties that are in the ordinary course of the partnership's business. However, in Limited partnerships, at least one partner is a general partner, while other partners have limited liability. Like shareholders in a corporation, LPs have limited liability, meaning they are only liable on debts incurred by the firm to the extent of their registered investment and have no management authority. Invest - 262 - Invest- 55 Assets That Grow Savings and Earn Passive Income Ownership: This is a type of financing is essentially an exchange of money for a piece of ownership in a new business. This type of financing can usually be provided by venture capitalists and angel investors. One way to raise extra capital is to sell shares in my company to workers, family, friends, and the public or professional investors. They become partial owners of the company. Their rights will depend on any agreements made between shareholders and the proportion of the capital sold. Managers to have equity stake: Typically the managers of a business should own a substantial equity stake. This means they have a personal interest in its success, which reassures other investors too. Time period: Private investors – or business angels – also invest money in return for equity. Some want the kudos of being involved without taking an active role; others may be more hands-on, investing expertise as well as money. Some angels become employees. All are looking for a return on their investment, usually within three to five years. Venture capitalists are often prepared to make significant investment in return for equity. They are looking for businesses with a solid business plan and a good track record – typically with at least three years’ trading and turnover of at least £1million. ‫ق‬ Investment Criteria PE investors will commit between US$0.5 million to US$4 million of risk capital per investment. They will look at the following before they invest: $ A clear understanding of PEP by business owner $ Ambition, and big future plans by the owner $ Adherence to corporate governance standards and CSR guidelines $ Alignment of exit rights and shareholder protection $ Experienced management team with track record $ Regional growth ambition ¥ Why Invest in Private Equity $ The new business owner can pay back the loaned amount throughout a fixed duration of time. $ In addition, the new business owner can focus on making their product(s) profitable rather than worrying about paying back the investors immediately. $ PE investors provide medium to long term capital to facilitate growth and/ or enabling Management participation through buy outs/ buy ins. $ Improved corporate governance: PE investors help their investee companies transition from informally run businesses to professionally managed organisations with the commensurate benefits of better management control and focus. Invest - 263 - Invest- 55 Assets That Grow Savings and Earn Passive Income NB. It Is Better To Have Small Say In A Big Company; Rather Than Have Big Say, In A Small Company. PRIVATE EQUITY INVESTMENT PRODUCTS There is a wide array of types and styles of private equity and the term private equity has different connotations in different countries. Among the most common investment strategies in private equity include venture capital (start up or growth capital), distressed investments (leveraged buy outs, mezzanine capital, mergers & acquisitions). ¥ Private Equity Funds (Venture Funds & Angel Funds) ‫ق‬ What it is! Private equity is an asset class consisting of equity securities in operating companies that are not publicly traded on a stock exchange. Investments in private equity most often involve either an investment of capital into an operating company or the acquisition of an operating company. ‫ق‬ Characteristics Capital source: Capital for private equity is raised primarily from institutional investors. Most institutional investors do not invest directly in privately held companies, lacking the expertise and resources necessary to structure and monitor the investment. Instead, institutional investors will invest indirectly through a private equity fund. This also allows then diversification. Return on investment: Returns on private equity investments are created through one or a combination of three factors that include: $ debt repayment or cash accumulation through cash flows from operations, $ operational improvements that increase earnings over the life of the investment and $ multiple expansion, selling the business for a higher multiple of earnings than was originally paid. Partnerships: Private equity firms organized limited partnerships to hold investments in which the investment professionals served as general partner and the investors, who are passive limited partners, put up the capital. Compensation structure: The compensation structure, still in use today, also emerged with limited partners paying an annual management fee of 1.5%-3% and a carried interest typically representing up to 20% of the profits of the partnership. ‫ق‬ Types of Private Equity Invest - 264 - Invest- 55 Assets That Grow Savings and Earn Passive Income Private equity investments can be divided into the following two categories: $ venture /growth capital fund, $ angel fund ‫ق‬ Venture Capital Fund $ What is it? Entrepreneurs often develop products and ideas that require substantial capital during the formative stages of their companies' life cycles. Many entrepreneurs do not have sufficient funds to finance projects themselves, and they must therefore seek outside financing. Venture Capital is a broad subcategory of private equity that refers to equity investments made, typically in less mature companies, for the launch, early development, or expansion of a business. Venture investment is most often found in the application of new technology, new marketing concepts and new products that have yet to be proven. Venture Capital Fund: A venture capital fund refers to a pooled investment vehicle (often an LP or LLC) that primarily invests the financial capital of third-party investors in enterprises that are too risky for the standard capital markets or bank loans. Venture capital firms typically comprise small teams with technology backgrounds (scientists, researchers) or those with business training or deep industry experience. $ Operations of Venture Capital Firms Timeline: Most venture capital funds have a fixed life of between 3-7 years, but some go for up to 12 years, with the possibility of a few years of extensions to allow for private companies still seeking liquidity. After this, the focus is managing and making follow-on investments in an existing portfolio. Investments: The investors have a fixed commitment to the fund that is initially unfunded and subsequently ‘called down’ by the venture capital fund over time as the fund makes its investments. There are substantial penalties for a Limited Partner (or investor) that fails to participate in a capital call. VC Portfolios: When approaching a VC firm, I will consider their portfolio: $ $ $ $ $ $ Business Cycle: Do they invest in budding or established businesses? Industry: What is their industry focus? Investment: Is their typical investment sufficient for my needs? Location: Are they regional, national or international? Return: What is their expected return on investment? Involvement: What is their involvement level? Raising Capital: It can take anywhere from a month or so to several years for venture capitalists to raise money from limited partners for their fund. At the Invest - 265 - Invest- 55 Assets That Grow Savings and Earn Passive Income time when all of the money has been raised, the fund is said to be closed. Some funds have partial closes when one half (or some other amount) of the fund has been raised. ‘Vintage year’ generally refers to the year in which the fund was closed and may serve as a means to stratify VC funds for comparison. A vast amount of venture capital money is channeled through venture capital trusts (VCTs). A VCT is a capital fund. Venture capitalists set up these funds to attract money from individual investors and institutions. The cash is then invested in a portfolio of companies, perhaps as many as a dozen in a year. Management and Performance: A core skill within VC is the ability to identify novel technologies that have the potential to generate high commercial returns at an early stage. By definition, VCs also take a role in managing entrepreneurial companies at an early stage, thus adding skills as well as capital (thereby differentiating VC from buy out private equity which typically invest in companies with proven revenue), and thereby potentially realizing much higher rates of returns. Management qualification: There is no evidence that any particular qualification enhances the most desirable characteristic of an investment manager, that is the ability to select investments that result in an above average (risk weighted) long-term performance. The industry has a tradition of seeking out, employing and generously rewarding such people without reference to any formal qualifications. Although the titles are not entirely uniform from firm to firm, other positions at venture capital firms include: $ Venture partners – Venture partners are expected to source potential investment opportunities (‘bring in deals’) and typically are compensated only for those deals with which they are involved. $ Principal – This is a mid-level investment professional position, and often considered a ‘partner-track’ position. Principals will have been promoted from a senior associate position or who have commensurate experience in another field such as investment banking or management consulting. $ Associate – This is typically the most junior apprentice position within a venture capital firm. After a few successful years, an associate may move up to the ‘senior associate’ position and potentially principal and beyond. Associates will often have worked for 1–2 years in another field such as investment banking or management consulting. $ Entrepreneur-in-residence (EIR) – EIRs are experts in a particular domain and perform due diligence on potential deals. EIRs are engaged by venture capital firms temporarily (six to 18 months) and are expected to develop and pitch startup ideas to their host firm (although neither party is bound to work with each other). Some EIR's move on to executive positions within a portfolio company. Invest - 266 - Invest- 55 Assets That Grow Savings and Earn Passive Income Compensation: Venture capitalists are compensated through a combination of management fees and carried interest (often referred to as a ‘two and 20’ arrangement): ¥ ¥ Management fees – an annual payment made by the investors in the fund to the fund's manager to pay for the private equity firm's investment operations. In a typical venture capital fund, the general partners receive an annual management fee equal to up to 2% of the committed capital. Carried interest - a share of the profits of the fund (typically 20%), paid to the private equity fund’s management company as a performance incentive. The remaining 80% of the profits are paid to the fund's investors. $ Which Businesses Qualify? Venture capital is intended for higher risks such as start up situations and development capital for more mature investments. Venture capital is most suitable for businesses with large up-front capital requirements which cannot be financed by cheaper alternatives such as debt. Venture capitalists invest money in businesses, often at an early stage, that have the potential to grow rapidly. More often than not, these companies were exploiting breakthroughs in electronic, medical, or data-processing technology. As a result, venture capital came to be almost synonymous with technology finance. However, even though venture capital is often most closely associated with fastgrowing technology and biotechnology fields, venture funding has been used for other more traditional businesses. VCs will often look for companies that have already established a track record of sales rather than start-ups. This contrasts with angel investors who often do fund start-ups but provide much smaller amounts of money and private equity investors who concentrate on investing larger sums on well established businesses for events such as management buy-outs and re-financings, where one institution buys out another’s stake in order for certain parties to achieve a desired exit. ‫ق‬ Business Valuation Accurate business valuation is one of the most important aspects of M&A as valuations like these will have a major impact on the price that a business will be sold for. Most often this information is expressed in a Letter of Opinion of Value (LOV) when the business is being evaluated for interest's sake. There are other, more detailed ways of expressing the value of a business. While these reports generally get more detailed and expensive as the size of a company increases, this is not always the case as there are many complicated industries which require more attention to detail, regardless of size. The five most common ways to valuate a business are £ asset valuation, Invest - 267 - Invest- 55 Assets That Grow Savings and Earn Passive Income £ £ £ £ historical earnings valuation, future maintainable earnings valuation, relative valuation (comparable company & comparable transactions), discounted cash flow (DCF) valuation Professionals who valuate businesses generally do not use just one of these methods but a combination of some of them, as well as possibly others that are not mentioned above, in order to obtain a more accurate value. The information in the balance sheet or income statement is obtained by one of three accounting measures: a Notice to Reader, a Review Engagement or an Audit. The rule of thumb is to get the factual value of the company, for instance, the assets worth, or the relative valuation, or historical earnings, and multiply by between five (3) and five (5), the industry average in valuation. This gives the expected value of the company. The other rule is to always have controlling stake in my company. The other option is to learn form the banks, who only give money by a measure of EBIDTA (Earnings Before Interested, Depreciation, Taxes And Amortization). in this case then, most investors, as well as banks, will give upto thrice the EBIDTA, that is, a debt:EBIDTA, or private equity: EBIDTA value of 3:1. In addition to this, the person offering to buy the company will also pay for the market value of all assets. This is the most common means of valuation. ‫ق‬ Calculating Goodwill Goodwill is a term used in accountancy and law. It is an intangible asset of a business, and can include trademarks and patents, employees and their skill sets, the brand name and logo recognition, customer lists and relationships. Here is how to calculate it. Add up the Fair Market Value of all the tangible assets, that is, the value that the assets are likely to bring on an open market. Subtract this value from the sale value of the company to determine the value of goodwill. Specifically, the cost of goodwill purchased equals the purchase price minus the value of net assets purchased (COG = PP - NAP). The value on goodwill can be negative; patents may be obsolete, employee skill set may be unsophisticated, customers may leave with seller, etc. The seller will likely inflate goodwill because the business has meant so much to him/her; the buyer is likely to deflate the value of goodwill because it is intangible. Invest - 268 - Invest- 55 Assets That Grow Savings and Earn Passive Income Post - Money Valuation: The valuation of a company immediately after the most recent round of financing. This value is calculated by multiplying the company's total number of shares by the share price of the latest financing. Market Capitalization: The total dollar value of all outstanding shares. Computed as shares multiplied by current price per share. Prior to an IPO, market capitalization is arrived at by estimating a company’s future growth and by comparing a company with similar public or private corporations. (See also: Pre-Money Valuation.) Dilution Protection: Mainly applies to convertible securities. Standard provision whereby the conversion ratio is changed accordingly in the case of a stock dividend or extraordinary distribution to avoid dilution of a convertible bondholder’s potential equity position. Adjustment usually requires a split or stock dividend in excess of 5% or issuance of stock below book value. Share Purchase Agreements also typically contain antidilution provisions to protect investors in the event that a future round of financing occurs at a valuation that is below the valuation of the current round. Weighted Ave rage Antidilution: The investor’s conversion price is reduced, and thus the number of common shares received on conversion increased, in the case of a down round; it takes into account both: (a) the reduced price and, (b) how many shares (or rights) are issued in the dilutive financing. Write - off: The act of changing the value of an asset to an expense or a loss. A write-off is used to reduce or eliminate the value of an asset and reduce profits. Write - up / Write - down : An upward or downward adjustment of the value of an asset for accounting and reporting purposes. These adjustments are estimates and tend to be subjective, although they are usually based on events affecting the investee company or its securities beneficially or detrimentally. Pre - Money Valuation: The valuation of a company prior to a round of investment. This amount is determined by using various calculation models, such as discounted P/E ratios multiplied by periodic earnings or a multiple times a future cash flow discounted to a present cash value and a comparative analysis to comparable public and private companies. $ Venture Capital Financing Stages Venture capitalists typically assist at four stages in the company's development: $ $ $ Idea generation; Start-up; Ramp up; and Invest - 269 - Invest- 55 Assets That Grow Savings and Earn Passive Income $ Exit There are typically six stages of financing offered in Venture Capital, that roughly correspond to these stages of a company's development. $ $ $ $ $ $ Seed Money: Low level financing needed to prove a new idea (Often provided by ‘angel investors‘) Start-up: Early stage firms that need funding for expenses associated with marketing and product development First-Round: Early sales and manufacturing funds Second-Round: Working capital for early stage companies that are selling product, but not yet turning a profit Third-Round: Also called Mezzanine financing, this is expansion money for a newly profitable company Fourth-Round: Also called bridge financing, the 4th round is intended to finance the ‘going public’ process Between the first round and the fourth round, venture backed companies may also seek to take ‘venture debt’. $ Advantages Venture capital is attractive for new companies with limited operating history that are too small to raise capital in the public markets and have not reached the point where they are able to secure a bank loan or complete a debt offering. In exchange for the high risk that venture capitalists assume by investing in smaller and less mature companies, venture capitalists usually get significant control over company decisions, in addition to a significant portion of the company's ownership (and consequently value). $ Disadvantages However, there is a price to be paid in equity. To compensate for their risk, VCs often drive a very hard bargain. Entrepreneurs often find that to secure a VC deal, they have to give up a greater share of the company than they originally expected. In cash terms, that is not necessarily a bad thing. I may end up owning, say, 60% of my company rather than 100% but if the investment fuels significant growth then my new stake will soon be worth considerably more than the old. It is also worth remembering that while VC investors will not micro-manage my company, they will provide help, advice and contacts. Expect to have them appoint to board member. Further, venture capitalists have strict requirements and need high returns. Many entrepreneurs hence seek seed funding from angel investors, who may be more willing to invest in highly speculative opportunities, or may have a prior relationship with the entrepreneur. Invest - 270 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Angels Fund A small but increasing number of angel investors organize themselves into angel groups or angel networks to share research and pool their investment capital. An angel fund is a pool of money by various individuals, or institutions, for their investment in various assets. The difference between angel fund and venture funds is that in angel funds, the investors themselves identify where to invest, and do not give their money to a third party investor to mix it with other ‘outside’ investors funds for investment. ‫ق‬ Who are Angels? Business angels are successful business people who invest in fast growth companies, in exchange for convertible debt or ownership equity. Angel investors have proven themselves to be an integral part of the capital market, particularly for funding start-up companies and providing first-phase financing of businesses. The term “angel” originated in the early 1900s and referred to investors who made risky investments to support Broadway theatrical productions. Today, the term “angel” refers to high-net worth individuals, or “accredited investors,” who typically invest in and support start-up companies in their early stages of growth. The term “angel” originated in the early 1900s and referred to investors who made risky investments to support Broadway theatrical productions. Today, the term “angel” refers to high-net worth individuals, or “accredited investors,” who typically invest in and support start-up companies in their early stages of growth. In the financial world today, angel investors are a critical and essential part of a healthy economy, particularly for the establishment and growth of early-stage companies. Angel groups, which have more resources than individual angels, are playing a more crucial role in funding young companies, as well as in funding second-stage companies, leveraged buyouts, and spin-offs. Angel investors have proven themselves to be an integral part of the capital market, particularly for funding start-up companies and providing first-phase financing of businesses. A venture capitalist: (also known as a VC) is a person or investment firm that makes venture investments, and these venture capitalists are expected to bring managerial and technical expertise as well as capital to their investments. ‫ق‬ Characteristics Networth: One of the primary criteria for membership is net worth or accredited investor status of the group members. Angels are experts: These investors are private individuals, usually with a business background. Most business angels have built and run successful companies themselves and many are serial entrepreneurs. They can also offer the benefits of their own management expertise. A business angel will not – or Invest - 271 - Invest- 55 Assets That Grow Savings and Earn Passive Income shouldn’t – want to micro-manage my company, but in addition to investment finance, they bring to the table a huge amount of experience in the business world. A Harvard report tables evidence that angel-funded startup companies are less likely to fail than companies that rely on other forms of initial financing. Annualized Equity Return/stake: Angel investors generally seek annualized returns of 20-30% and more, as well as extensive involvement in the business. High growth companies: Business Angels are investors, not altruists. They are looking for companies with growth potential and the opportunity for a profitable exit, possibly at the next round of funding. They will certainly expect a clear business plan and a strong management team and I should be prepared for any angel investor or syndicate to conduct due diligence on my company. What I will be able to raise will depend on what I have got. I might attract investment of a few thousand pounds on a strong, innovative idea, but evidence of sales will get me whole lot more. Regional focus: With few exceptions, angels invest on a regional basis, being interested in personal relationships with companies and employees, as well as in giving back to their communities. Angel groups: Historically, the funding gap between investments made by friends and family and the point at which companies could realistically obtain financing from venture capitalists was between $500,000 and $2 million in invested capital. Individual angels could often meet these funding needs. However, with venture capitalists moving further up the funding chain by not investing as early in a company’s development, a second funding gap has emerged between $2 million and $5 million. These groups also have the combined manpower for analysis of multiple or complex investment opportunities, further aiding in making these investments possible. Active participation: Another constant and part of the definition that separates angel groups from other investment vehicles is the active participation of angel group members in the investment of their own capital. In contrast, venture capital funds, brokerdealers and investment bankers typically operate on a passive investor model — the individual is not actively involved in the investment decision-making process. Management: Angel organizations can be everything from an informal group of individuals who conduct cooperative due diligence to a group with paid management and committed investment funds. ‫ق‬ Stages of Financing /Investing The definition of these various stages of business development and corresponding financing can vary between publications and individuals. For Invest - 272 - Invest- 55 Assets That Grow Savings and Earn Passive Income purposes of this book, the following definitions for stages of financing will be utilized from Pratt’s Guidebook to Venture Capital Sources; 2001 Edition, Thomson Financial/Venture Economics: $ Seed financing “is a relatively small amount of capital provided to an inventor or entrepreneur to prove a concept and to qualify for start-up capital. This may involve product development and market research as well as building a management team and developing a business plan, if the initial steps are successful.” (By this definition, pre-seed financing would denote financing to help articulate the concept.) $ Start-up financing “is provided to companies completing product development and initial marketing. Companies may be in the process of organizing, or they may already be in business for one year or less, but have not sold their product commercially. Usually such firms will have made market studies, assembled the key management, developed a business plan and are ready to do business.” $ Early- or first-stage financing “is provided to companies that have expended their initial capital (often in developing and market testing a prototype) and require funds to initiate full-scale manufacturing and sales.” $ Expansion financing is second and subsequent investment rounds typically financing company product and/or market expansion, or keeping the company financially healthy shortly before a liquidity event such as an initial public offering (IPO) or acquisition. ‫ق‬ Tips To Running A Successful Angel’s Investment Fund Starting any type of group can be a daunting task. Establishing a successful angel group can be particularly difficult because angel groups are a recent phenomenon, and angel investors are notoriously private. To make matters more confusing, many different organizational models or structures have been successful. In addition, success is not necessarily measured by return on investment, since angels typically invest at an early stage, and returns may not be seen for several years. Instead, success may be measured by factors such as member retention, investment rate, accomplishment of goals, and member satisfaction. Any successful angel group needs to address several issues: $ A Champion A key factor in the success of an angel organization is an appropriate and active champion. Often, the desire of those forming the angel group will influence the structure of the ultimate organization. They will also likely be the source of other members with similar interests and confidence in my champion or founding group. An organization cannot get off the ground and succeed Invest - 273 - Invest- 55 Assets That Grow Savings and Earn Passive Income without a leader. Ideally, the champion or group of champions should be accredited investors with influence and connections within the community sufficient to attract other accredited investors as potential group members. $ Partnerships The angel group will do better with various partnerships and industry relations which contribute towards leveraging of resources. These partnerships include: Professional advisors: I should be sure to consult qualified counsel regarding rules and regulations that may govern my organization. Attorneys and accountants can be invaluable to any organization, and I should avail myself of their knowledge and background to ensure the legality and economic value of my angel group. The also include independent financial advisors, and technical experts to review technical aspects of investment propositions. Sponsorships: Sponsors can be an effective and significant source of funding, as long as the group e n s u res that member meetings maintain their focus on member needs. It is important to control the number of sponsors and representatives. The Group Operations section contains suggestions for sponsorship parameters and benefits. Remember, however, that service providers will not generally sponsor an angel organization or any other group/event just to be good citizens. Budgets are often tight, and sponsors need to have some return on their investment for sponsorship dollars. Affiliate memberships: we should be affiliated to other investment groups, and especially venture capital funds, which will enable us to get into their database when searching for investments. Industry associations: I should also connect my angel group to an industry association of either investment groups, or angel associations, or even venture capital associations. These are both statewide, national, regional, and international. $ Membership A key determinant of success of an angel group is the quality of membership. One must consider numerous factors when determining the nature and attributes of membership: Angel groups can self-select by numerous criteria, including industry focus, gender, or other variables. But as statistics support, substantially all of the group’s members should be “accredited investors”. Companies typically refuse investors that do not qualify as “accredited investors,” in large part because of regulatory information- disclosure and reporting requirements and the funding limitations imposed upon companies for acceptance of investments from non-accredited investors. The accredited investor status requirement also relates to deal flow for my angel group. If my organization is known for having active investors, high-quality potential investment deals are more likely to seek out my group for investment opportunity. In addition, accredited investors are often previously successful entrepreneurs, which is consistent Invest - 274 - Invest- 55 Assets That Grow Savings and Earn Passive Income with survey results showing that two other important criteria for membership are past investment experiences and member referrals of investable companies. $ Due Diligence Due diligence can be the most complicated and time consuming part of angel investing. Many publications have been devoted to the due diligence process. This discussion is limited to suggestions for structure, rather than the steps and topics for due diligence. In a manager-led organization, the manager will typically lead the investment-evaluation process. The manager will also often negotiate the structure of an investment or participate in the negotiation process with the lead investor. In member-led groups, whether an informal group with individual investment decisions or one in which members invest collectively, the due diligence process must ensure coverage of relevant topics and should be conducted by those with experience and expertise in particular areas. Some groups retain MBA students to support due diligence through an internship program with the local business school. Other groups retain outside experts to evaluate a company or give a briefing on cutting-edge technology related to the potential investment. One angel group with a sidecar fund has the fund complete all due diligence on companies presented to the related angel group. Based on this due diligence, the fund members vote on whether or not to fund at the meeting. If the side fund decides to fund a company, it then shares the results of due diligence with interested members of the angel group to round out the investment offering. General Partner (GP): The partner in a limited partnership responsible for all management decisions of the partnership. The GP has a fiduciary responsibility to act for the benefit of the limited partners (LPs) and is fully liable for its actions. Liquidity Event: An event that allows a VC to realize a gain or loss on an investment. The ending of a private equity provider’s involvement in a business venture with a view to realizing an internal re t u rn on investment. Most common exit routes include Initial Public Offerings [IPOs], buy backs, trade sales, and secondary buyouts. (See also: Exit Strategy.) Management Team: The persons who oversee the activities of a venture capital fund. Key Employees: Professional management attracted by the founder to run the company. Key employees are typically retained with warrants and ownership of the company. Later Stage: A stage of company growth characterized by viable products, a developed market, significant customers, sustained revenue growth, and both profits and positive cash flow from operations. Later-stage Invest - 275 - Invest- 55 Assets That Grow Savings and Earn Passive Income companies would generally be candidates for an IPO. Investments in the C round or after qualify as later stage. Lead Investor: Also known as a bell cow investor. Member of a syndicate of private equity investors holding the largest stake, in charge of arranging the financing and most actively involved in the overall project. Limited Partner (LP): An investor in a limited partnership who has no voice in the management of the partnership. LPs have limited liability and usually have priority over GPs upon liquidation of the partnership. Limited Partnerships: An organization comprised of a general partner, who manages a fund, and limited partners, who invest money but have limited liability and are not involved with the day-to-day management of the fund. In the typical venture capital fund, the general partner receives a management fee and a percentage of the profits (or carried interest). The limited partners receive income, capital gains, and tax benefits. Fund Size: The total amount of capital committed by the investors of a venture capital fund. Corporate Venturing: Venture capital provided by [in-house investment funds of] large corporations to further their own strategic interests. Carried Interest or “Carry”: The portion of any gains realized by the fund to which the fund managers are entitled, generally without having to contribute capital to the fund. Carried interest payments are customary in the venture capital industry, in order to create a significant economic incentive for venture capital fund managers to achieve capital gains. Capital Under Management or Assets Under Management: The amount of capital available to a fund-management team for venture investments. Business Plan: A document that describes the entrepreneur’s idea, the market problem, proposed solution, business and revenue models, marketing strategy, technology, company profile, competitive landscape, as well as financial data for coming years. The business plan opens with a brief executive summary, most probably the most important element of the document due to the time constraints of venture capital funds and angels. Angel Financing: Capital raised for a private company from independently wealthy investors. This capital is generally used as seed financing. Angel Investing: An angel investor is an individual who makes direct investments of personal funds into a venture, typically early-stage businesses. Because the capital is being invested at a risky time in a business venture, the angel must be capable of taking a loss of the entire investment, and, as such, most angel investors are high-net-worth individuals. Venture Capital Financing: An investment in a startup business that is perceived to have excellent growth prospects but does not have access to Invest - 276 - Invest- 55 Assets That Grow Savings and Earn Passive Income capital markets. Type of financing sought by early-stage companies seeking to grow rapidly. Take Down Schedule: A takedown schedule means the timing and size of the capital contributions from the limited partners of a venture fund. Seed Money: The first round of capital for a start-up business. Seed money usually takes the structure of a loan or an investment in preferred stock or convertible bonds, although sometimes it is common stock. Seed money provides startup companies with the capital required for their initial development and growth. Angel investors and early-stage venture capital funds often provide seed money. Recapitalization: The reorganization of a company’s capital structure. A company may seek to save on taxes by replacing preferred stock with bonds in order to gain interest deductibility. Recapitalization can be an alternative exit strategy for venture capitalists and leveraged-buyout sponsors. (See also: Exit Strategy and Leveraged Buyout.) Private Offering/Private Placement: Sale of unregistered, restricted securities by the company. Private Placement: Also known as a Reg. D offering. The sale of a security directly to a limited number of investors in a private transaction. Private Placement Memorandum : Also known as an Offering Memorandum. A document that outlines the terms of securities to be offered in a private placement. Resembles a business plan in content and structure. Private Securities: Private securities are securities that are not registered and do not trade on an exchange. The price per share is set through negotiation between the buyer and the seller or issuer. Seed Stage Financing: An initial state of a company’s growth characterized by a founding management team, business-plan development, prototype development, and beta testing. Mezzanine Financing: Refers to the stage of venture financing for a company immediately prior to its IPO. Investors entering in this round have lower risk of loss than those investors who have invested in an earlier round. Mezzanine-level financing can take the structure of preferred stock, convertible bonds, or subordinated debt. Initial Public Offering (IPO): The sale or distribution of a stock of a portfolio company to (often venture capitalists) to receive significant returns on their original investment. During periods of market downturns or corrections, the opposite is true. Invest - 277 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Distress Investments (Leveraged Buy Out, Mergers & Acquisitions) ‫ق‬ What Are Distressed Investments? These are investments made when one financial entity is facing a possible financial melt down, or for the purposes of increasing the financial muscles of one or several businesses. They can be done through: $ Acquisition (peaceful or hostile) $ Mergers (reversed mergers) $ Leveraged buy out ‫ق‬ Leveraged buy out $ What it is! Leveraged Buy Out, LBO or Buy out refers to a strategy of making equity investments as part of a transaction in which a company, business unit or business assets is acquired from the current shareholders typically with the use of financial leverage. The companies involved in these transactions are typically mature and generate operating cash flows. $ How it works! In a typical leveraged buyout transaction, the private equity firm buys majority control of an existing or mature firm. This is distinct from a venture capital or growth capital investment, in which the private equity firm typically invests in young or emerging companies, and rarely obtain majority control. Leveraged buy outs involve a financial sponsor agreeing to an acquisition without itself committing all the capital required for the acquisition. To do this, the financial sponsor will raise acquisition debt which ultimately looks to the cash flows of the acquisition target to make interest and principal payments. Acquisition debt in an LBO is often non-recourse to the financial sponsor and has no claim on other investment managed by the financial sponsor. Therefore, an LBO transaction's financial structure is particularly attractive to a fund's limited partners, allowing them the benefits of leverage but greatly limiting the degree of recourse of that leverage. This kind of financing structure leverage benefits an LBO's financial sponsor in two ways: (1) the investor itself only needs to provide a fraction of the capital for the acquisition, and (2) the returns to the investor will be enhanced (as long as the return on assets exceeds the cost of the debt). Invest - 278 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Merger and Acquisition $ Definition Mergers and acquisitions (abbreviated M&A) refers to the aspect of corporate strategy, corporate finance and management dealing with the buying, selling, dividing and combining of different companies and similar entities that can aid, finance, or help an enterprise grow rapidly in its sector or location of origin or a new field or new location without creating a subsidiary, other child entity or using a joint venture. $ Acquisition/Takeover An acquisition is the purchase of one business or company by another company or other business entity. Acquisitions are divided into ‘private’ and ‘public’ acquisitions, depending on whether the acquiring or merging company (also termed a target) is or is not listed on public stock markets. An additional dimension or categorization consists of whether an acquisition is friendly or hostile. In the case of a friendly transaction, the companies cooperate in negotiations; in the case of a hostile deal, the board and/or management of the target is unwilling to be bought or the target's board has no prior knowledge of the offer. Hostile acquisitions can, and often do, ultimately become ‘friendly’, as the acquiror secures endorsement of the transaction from the board of the acquire company. This usually requires an improvement in the terms of the offer and/or through negotiation. ‘Acquisition’ usually refers to a purchase of a smaller firm by a larger one. Sometimes, however, a smaller firm will acquire management control of a larger and/or longer-established company and retain the name of the latter for the post-acquisition combined entity. This is known as a reverse takeover. Another type of acquisition is the reverse merger, a form of transaction that enables a private company to be publicly listed in a relatively short time frame. A reverse merger occurs when a privately held company (often one that has strong prospects and is eager to raise financing) buys a publicly listed shell company, usually one with no business and limited assets. There are also a variety of structures used in securing control over the assets of a company, which have different tax and regulatory implications: ¯ The buyer buys the shares, and therefore control, of the target company being purchased. Ownership control of the company in turn conveys effective control over the assets of the company, but since the company is acquired intact as a going concern, this form of transaction carries with it all of the Invest - 279 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¯ liabilities accrued by that business over its past and all of the risks that company faces in its commercial environment. The buyer buys the assets of the target company. The cash the target receives from the sell-off is paid back to its shareholders by dividend or through liquidation. This type of transaction leaves the target company as an empty shell, if the buyer buys out the entire assets. A buyer often structures the transaction as an asset purchase to ‘cherry-pick’ the assets that it wants and leave out the assets and liabilities that it does not. This can be particularly important where foreseeable liabilities may include future, unquantified damage awards such as those that could arise from litigation over defective products, employee benefits or terminations, or environmental damage. A disadvantage of this structure is the tax that many jurisdictions impose on transfers of the individual assets, whereas stock transactions can frequently be structured as like-kind exchanges or other arrangements that are tax-free or tax-neutral, both to the buyer and to the seller's shareholders. The terms ‘demerger’, ‘spin-off’ and ‘spin-out’ are sometimes used to indicate a situation where one company splits into two, generating a second company separately listed on a stock exchange. $ Merger Merger, or consolidation occurs when two companies combine together to form a new enterprise altogether, and neither of the previous companies survives independently. This kind of action is more precisely referred to as a ‘merger of equals’. The firms are often of about the same size. Both companies' stocks are surrendered and new company stock is issued in its place. For example, in the 1999 merger of Glaxo Wellcome and SmithKline Beecham, both firms ceased to exist when they merged, and a new company, [GlaxoSmithKline], was created. ‫ق‬ Financing M&A Mergers are generally differentiated from acquisitions partly by the way in which they are financed and partly by the relative size of the companies. Various methods of financing an M&A deal exist: $ Cash Such transactions are usually termed acquisitions rather than mergers because the shareholders of the target company are removed from the picture and the target comes under the (indirect) control of the bidder's shareholders. $ Stock Payment in the acquiring company's stock, issued to the shareholders of the acquired company at a given ratio proportional to the valuation of the latter. Invest - 280 - Invest- 55 Assets That Grow Savings and Earn Passive Income The form of payment and financing options are tightly linked. If the buyer pays cash, there are three main financing options: £ £ £ Cash on hand: it consumes financial slack (excess cash or unused debt capacity) and may decrease debt rating. There are no major transaction costs. It consumes financial slack, may decrease debt rating and increase cost of debt. Transaction costs include underwriting or closing costs of 1% to 3% of the face value. Issue of stock: it increases financial slack, may improve debt rating and reduce cost of debt. Transaction costs include fees for preparation of a proxy statement, an extraordinary shareholder meeting and registration. If the buyer pays with stock, the financing possibilities are: £ £ Issue of stock (same effects and transaction costs as described above). Shares in treasury: it increases financial slack (if they do not have to be repurchased on the market), may improve debt rating and reduce cost of debt. Transaction costs include brokerage fees if shares are repurchased in the market otherwise there are no major costs. In general, stock will create financial flexibility. Transaction costs must also be considered but tend to have a greater impact on the payment decision for larger transactions. Finally, paying cash or with shares is a way to signal value to the other party, e.g.: buyers tend to offer stock when they believe their shares are overvalued and cash when undervalued. $ Motives behind M&A The dominant rationale used to explain M&A activity is that acquiring firms seek improved financial performance. The following motives are considered to improve financial performance: £ Economy of scale: This refers to the fact that the combined company can often reduce its fixed costs by removing duplicate departments or operations, lowering the costs of the company relative to the same revenue stream, thus increasing profit margins. £ Economy of scope: This refers to the efficiencies primarily associated with demand-side changes, such as increasing or decreasing the scope of marketing and distribution, of different types of products. £ Increased revenue or market share: This assumes that the buyer will be absorbing a major competitor and thus increase its market power (by capturing increased market share) to set prices. £ Cross-selling: For example, a bank buying a stock broker could then sell its banking products to the stock broker's customers, while the broker can Invest - 281 - Invest- 55 Assets That Grow Savings and Earn Passive Income sign up the bank's customers for brokerage accounts. Or, a manufacturer can acquire and sell complementary products. £ Synergy: For example, managerial economies such as the increased opportunity of managerial specialization. Another example is purchasing economies due to increased order size and associated bulk-buying discounts. £ Taxation: A profitable company can buy a loss maker to use the target's loss as their advantage by reducing their tax liability. Tax minimization strategies include purchasing assets of a non-performing company and reducing current tax liability. £ Geographical or other diversification: This is designed to smooth the earnings results of a company, which over the long term smoothens the stock price of a company, giving conservative investors more confidence in investing in the company. However, this does not always deliver value to shareholders (see below). £ Resource transfer: resources are unevenly distributed across firms and the interaction of target and acquiring firm resources can create value through either overcoming information asymmetry or by combining scarce resources. £ Vertical integration: Vertical integration occurs when an upstream and downstream firm merges (or one acquires the other). There are several reasons for this to occur. One reason is to internalize an externality problem. A common example is of such an externality is double marginalization. Double marginalization occurs when both the upstream and downstream firms have monopoly power; each firm reduces output from the competitive level to the monopoly level, creating two deadweight losses. By merging the vertically integrated firm can collect one deadweight loss by setting the downstream firm's output to the competitive level. This increases profits and consumer surplus. A merger that creates a vertically integrated firm can be profitable. £ ‘Acqui-hire’: An ‘acq-hire’ (or acquisition-by-hire) may occur especially when the target is a small private company or is in the startup phase. In this case, the acquiring company simply hires the staff of the target private company, thereby acquiring its talent (if that is its main asset and appeal). The target private company simply dissolves and little legal issues are involved. Acqui-hires have become a very popular type of transaction in recent years. £ Absorption of similar businesses under single management: similar portfolio invested by two different mutual funds namely united money market fund Invest - 282 - Invest- 55 Assets That Grow Savings and Earn Passive Income and united growth and income fund, caused the management to absorb united money market fund into united growth and income fund. $ Brand Considerations Mergers and acquisitions often create brand problems, beginning with what to call the company after the transaction and going down into detail about what to do about overlapping and competing product brands. Decisions about what brand equity to write off are not inconsequential. And, given the ability for the right brand choices to drive preference and earn a price premium, the future success of a merger or acquisition depends on making wise brand choices. Brand decision-makers essentially can choose from four different approaches to dealing with naming issues, each with specific pros and cons: 1. Keep one name and discontinue the other. The strongest legacy brand with the best prospects for the future lives on. In the merger of United Airlines and Continental Airlines, the United brand will continue forward, while Continental is retired. 2. Keep one name and demote the other. The strongest issue becomes the company name and the weaker one is demoted to a divisional brand or product brand. An example is Caterpillar Inc. keeping the Bucyrus International name. 3. Keep both names and use them together. Some companies try to please everyone and keep the value of both brands by using them together. This can create an unwieldy name, as in the case of PricewaterhouseCoopers, which has since changed its brand name to ‘PwC’. 4. Discard both legacy names and adopt a totally new one. The classic example is the merger of Bell Atlantic with GTE, which became Verizon Communications. Not every merger with a new name is successful. By consolidating into YRC Worldwide, the company lost the considerable value of both Yellow Freight and Roadway Corp. ‫ق‬ Reverse Takeover or Reverse Merger $ Definition Reverse Takeover or Reverse Merger (reverse IPO) is the acquisition of a public company by a private company to bypass the lengthy and complex process of going public. The transaction typically requires reorganization of capitalization of the acquiring company. $ Process In a reverse takeover, shareholders of the private company purchase control of the public shell company and then merge it with the private company. The publicly traded corporation is called a ‘shell’ since all that exists of the original company is its organizational structure. The private company shareholders receive a substantial majority of the shares of the public company and control of its board of directors. The transaction can be accomplished within weeks. If the shell is an SEC-registered company, the private company does not go through an expensive and time-consuming Invest - 283 - Invest- 55 Assets That Grow Savings and Earn Passive Income review with state regulators because this process was completed beforehand with the public company. The transaction involves the private and shell company exchanging information on each other, negotiating the merger terms, and signing a share exchange agreement. At the closing, the shell company issues a substantial majority of its shares and board control to the shareholders of the private company. The private company's shareholders pay for the shell company by contributing their shares in the private company to the shell company that they now control. This share exchange and change of control completes the reverse takeover, transforming the formerly privately held company into a publicly held company. $ Benefits The advantages of public trading status include the possibility of commanding a higher price for a later offering of the company's securities. Going public through a reverse takeover allows a privately held company to become publicly held at a lesser cost, and with less stock dilution than through an initial public offering (IPO). While the process of going public and raising capital is combined in an IPO, in a reverse takeover, these two functions are separate. A company can go public without raising additional capital. Separating these two functions greatly simplifies the process. In addition, a reverse takeover is less susceptible to market conditions. Conventional IPOs are risky for companies to undertake because the deal relies on market conditions, over which senior management has little control. If the market is off, the underwriter may pull the offering. The market also does not need to plunge wholesale. If a company in registration participates in an industry that is making unfavorable headlines, investors may shy away from the deal. In a reverse takeover, since the deal rests solely between those controlling the public and private companies, market conditions have little bearing on the situation. The process for a conventional IPO can last for a year or more. Time spent in meetings and drafting sessions related to an IPO can have a disastrous effect on the growth upon which the offering is predicated, and may even nullify it. In addition, during the many months it takes to put an IPO together, market conditions can deteriorate, making the completion of an IPO unfavorable. By contrast, a reverse takeover can be completed in as little as thirty days. The greater number of financing options available to publicly held companies is a primary reason to undergo a reverse takeover. These financing options include: ¥ ¥ The issuance of additional stock in a secondary offering An exercise of warrants, where stockholders have the right to purchase additional shares in a company at predetermined prices. When many Invest - 284 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ shareholders with warrants exercise their option to purchase additional shares, the company receives an infusion of capital. Other investors are more likely to invest in a company via a private offering of stock when a mechanism to sell their stock is in place should the company be successful. In addition, the now-publicly held company obtains the benefits of public trading of its securities: ¥ ¥ ¥ ¥ ¥ Increased liquidity of company stock Higher company valuation due to a higher share price Greater access to capital markets Ability to acquire other companies through stock transactions Ability to use stock incentive plans to attract and retain employees $ Drawbacks Reverse takeovers always come with some history and some shareholders. Sometimes this history can be bad and manifest itself in the form of currently sloppy records, pending lawsuits and other unforeseen liabilities. Additionally, these shells may sometimes come with angry or deceitful shareholders who are anxious to ‘dump’ their stock at the first chance they get. Possibly the biggest caveat is that most CEO's are naive and inexperienced in the world of publicly traded companies unless they have past experience as an officer or director of a public company. Bridge Financing: A limited amount of equity or short-term debt financing typically raised within 6-18 months of an anticipated public offering or private placement meant to “bridge” a company to the next round of financing. Burn Out / Cram Dow n : Extraordinary dilution, by reason of a round of financing, of a non-participating investor’s percentage ownership in the issuer. Burn Rate: The rate at which a company expends net cash over a certain period, usually a month. Business Judgment Rule: The legal principle that assumes the board of directors is acting in the best interests of the shareholders unless it can be clearly established that it is not. If the board was found to violate the business judgment rule, it would be in violation of its fiduciary duties to the shareholders. CAGR: Compound Annual Growth Rate. The year-over-year growth rate applied to an investment or other aspect of a firm using a base amount. Call Option: The right to buy a security at a given price (or range) within a specific time period. Invest - 285 - Invest- 55 Assets That Grow Savings and Earn Passive Income Capital Gains: The difference between an asset’s purchase price and selling price, when the selling price is greater. Long-term capital gains (on assets held for a year or longer) are taxed at a lower rate than ordinary income. Capitalization Table: Also called a “Cap Table,” this is a table showing the total amount of the various securities issued by a firm. This typically includes the amount of investment obtained from each source and the securities distributed — e.g., common and preferred shares, options, warrants, etc. — and respective capitalization ratios. Capitalize: To record an outlay as an asset (as opposed to an expense), which is subject to depreciation or amortization. Invest - 286 - Invest- 55 Assets That Grow Savings and Earn Passive Income 6. COLLECTORS ITEMS INTRODUCTION TO COLLECTIBLES A further way of investing in alternative investments is through collections, or collectors’ items. These include buying art pieces, coins and currencies and wine, etc. ¥ What Is Collectibles? Generally speaking, a collectible is any physical asset that appreciates in value over time because it is rare or it is desired by many. Many people think of collectibles as things like stamps, coins, fine art or sports cards, but there really are no strict rules as to what is or is not a collectible. ‫ق‬ Characteristics of Collectibles $ Time is money! It's generally accepted that the longer I hold the better I will do as more collectors, and emerging economies, enter the collectibles markets. Given the nature of the collectibles, I should do a minimum 5 years holding period, to allow my collection to maximise its growth potential. $ Knowledge Is King I wouldn't invest in the stock market without conducting my due diligence. The collectibles market should be approached with the same caution. $ Nostalgia runs in 20-year cycles. In other words, the things that are popular now will become collectibles in 20 years when people want to reconnect with their past. $ rarity and appeal Items will become collectibles only if they meet two conditions: rarity and appeal. Rarity is becoming a harder thing to find as mass production methods allow companies to (over)fill demand without incurring that much extra cost. It is profitable for a company to sell as many products as it takes to satiate demand, and that mentality destroys a future collector's profits. Appeal is also a difficult thing to nail down. To make money at collecting, I have to predict what will become popular in retrospect - perhaps something that is not in high demand now will become popular in the future, either because they are rare or they were not fully appreciated at the time. $ Hedging against Inflation Invest - 287 - Invest- 55 Assets That Grow Savings and Earn Passive Income If I want to hedge against inflation, collectors’ items is a reliable ways to go about it. Most collectibles increase in value along with inflation. $ Fragility A collectible is an illiquid, taxed investment that produces no income and can lose its value if I drop it. Even a little damage can erase all of a collectible's value. $ Long Term Investing If I am going to buy one, I will make sure it is one I will be happy to own forever, rather than counting on some big money sale in the future. Collectibles can take very long to increase in value, and they offer no assurances as to their value in the future. $ No Fixed Income Unlike other debt investments, collectibles offer no income. This is because a collectible's value is based on emotional factors like nostalgia. These emotional factors can be as erratic as they are powerful. $ Main Uses € € € Capital Appreciation Inflation Protection Self Fulfillment Invest - 288 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Disadvantages (Reasons Not To Buy Collectibles) $ Mark-ups When I buy a collectible from a dealer, that dealer is usually marking up the price to make a profit. Unlike collectors, dealers do not have the luxury of holding an item for years and years while the value may or may not increase they have sales to make and a business to run. $ Maintenance Many collectibles require special care to keep them in top condition. These can range in cost from the $1 plastic cover used to keep hockey cards safe to a special room with moisture, heat and light monitors to lengthen a painting's life. On top of the storage costs, there are the added costs of buying insurance for the more valuable types of collectibles as well as paying to have professionals, appraisers, restorers and dealers look at the collectible before I sell it. A collectible does not produce income while I hold it, and it may actually eat income while I wait for it to increase in value. $ Wear Most categories of collectibles - from Pokemon cards to antique plumbing fixtures - have a manual classifying how much an item is worth in pristine condition and what sorts of damage degrades it by what percentage of value. $ Counterfeiting Most museums display dinosaur fossils models - not the real thing. Can I tell the difference between an Allosauras skull made of plaster and cement and one made of fossilized bone? No matter how experienced the appraiser, forgeries do make it to the dealers and then through to the collectors, which could leave me holding a very expensive piece of criminal art. $ Low Returns Collectibles tend to have lower returns than a stock market index fund, a money market account and most bond funds. If I took an average of the returns on all collectibles – which is practically impossible to do given some have little or no market to measure – it would be dismal compared to the S&P 500. Even if I took only the ones with the best returns, diamonds and stamps, I would still find a sizable gap (a generous estimate is that stamps return is 5-10%). $ Liquidity Not very liquid, they can often be hard to sell at a desirable price. $ Tax Protection They do not provide any tax protection. $ Income Collectibles do not offer any income to the investor. $ Valuation Invest - 289 - Invest- 55 Assets That Grow Savings and Earn Passive Income The true value can often be difficult to determine. ‫ق‬ Advantages (Reasons to Buy Collectibles) $ Inflation Many collectibles offer reasonable protection from inflation. $ Diversification The collectibles markets offer investors a powerful diversification away from mainstream products that have failed in recent years. They offer the opportunity to invest funds in a product that I can feel passionate about, items I can gain pleasure from... and ultimately make me a profit. $ Long Term Value The current low interest environment represents a real opportunity to build a collection of valuable collectibles for long term value. Their value will not disappear overnight. $ Reduced Tax Liability Now is the time to invest with confidence, and create a safe haven for my wealth, in the knowledge that many collectible assets have the added advantage of being termed as ‘wasting assets’, and do not come into Inheritance or Capital Gains Tax calculations. Further, profits are declared as a capital gain rather than income tax, so there is further opportunity to reduce my tax liability. $ Low Correlation Collectible investments are tangible assets that have a low correlation with traditional financial instruments. Unique collectibles have historically been considered a 'safe haven'. They have a low correlation with traditional financial investments. They are tangible, I can hold them, and they will always hold value. Collectibles offer a significant hedge against inflation, and a tangible asset that performs independently of other markets like stock and property. $ Supply & Demand (Expanding Market) The population of the BRIC countries (Brazil, Russia, India, China) is set to double in the next 40 years (With a rise in middle classes by between 1 and 2 Billion), accompanied by a huge increase in disposable income. History shows these people will be looking to buy the collectibles and artefacts that have left their country over the years, with a desire to repatriate them to their homeland. There are now currently around three million autograph collectors worldwide - and growing. The market is continuing to expand as collectors from emerging economies are becoming involved. $ Disposable Income Invest - 290 - Invest- 55 Assets That Grow Savings and Earn Passive Income With an ageing worldwide population, and emerging economies, the size of the collectibles market is expected to double over the next 30 years. Many retirees who are financially stable. This generation is now responsible for 80% of the World's wealth. They are living longer, with a higher disposable income, and with time on their hands to pursue collecting in a serious way. There is also a Middle Class explosion. A survey by Goldman Sachs confirms we are in the middle of a global middle class explosion. Goldman Sachs estimates 70 million people a year are joining the 'middle class' ranks. And the next 20 years will see a huge expansion. $ Accessible To Investors What might once have been alien to investors is now easily accessible with the ability to conduct detailed research before investing. Price levels, supply levels, demand, scarcity and provenance are now totally transparent. Institutional investors are moving in and investment funds have been set up. Wine, stamps, violins, classic cars... they all have investment funds. However the majority require at least a £100,000 minimum investment and charge various management and performance fees. $ A Huge Growth Market History has proven, time and time again, that a carefully selected portfolio of investment grade collectibles can offer exceptional returns over the mid-tolong term. Whatever my passion, there is strong historical evidence that unique collectibles make a profitable investment. Supply shortage and increased demand for unique pieces is leading to a consistent increase in prices at the top-end. Historical returns of up to 20% per annum. Collectible investments have a record of positive historical returns. Rare books have averaged 9% per annum over the last 10 years. The best fine wines have achieved 15% p.a. growth over the last 25 years. The rare stamp market boasts a 9.5% return each year over the last 50 years - and an asset that has not dipped in value in any five year period over the last 50 years. High-end collectibles continue to compound in price by 10% per annum. $ Emotional Satisfaction I have the opportunity to become a custodian of an important piece of history, which is a great appeal to many investors. I am guaranteed gain the most pleasure from any investment I have ever made. Little can match the sheer joy at holding a 500 year old Henry VIII document, or building a valuable wine investment portfolio. Malcolm Forbes founder of Forbes magazine believed autographs to be a great and under-appreciated investment. ‘None of my other investments give me the joy that autographs do because they make me feel that I am holding a piece of history in my hands.’ $ Safe Haven Invest - 291 - Invest- 55 Assets That Grow Savings and Earn Passive Income This can safeguard my overall wealth, helps to diversify my assets, and is a safe haven investment showing excellent profit contribution on a regular and consistent basis. $ Low Initial Cost A significant portfolio of investment grade autographs can be assembled at relatively low cost. Many of the 100 most actively traded autographs sell for prices that range from a few hundred to a few thousand pounds. The truly unique items costs a little more but have historically performed better. Autographs are a uniquely personal form of investment - they give me the opportunity to profit from something I feel passionate about $ Pension Planning with Collectibles Given the long term historical performance of investment grade collectibles an increasing number of investors are now investing in collectibles as part of their overall pension plan. As many people have found out; pensions contributions do not always guarantee a comfortable retirement. Most of us are at the mercy of our Pension Fund managers and have little direct involvement with their investment decisions. Recent financial events have highlighted the need to take ownership of these decisions. And what's interesting is that there are Pension Funds that invest in the collectibles markets. So why not consider taking control of my own pension and investing funds directly, myself. Invest - 292 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ How to Invest In Collectibles Recent financial turmoil has highlighted the need to have control of my own investment portfolio. It has also highlighted the fragility of mainstream investment products. The loss of confidence in those at the head of the financial markets has led to more and more astute investors to look at Alternative Investments. The world of unique collectibles is high on the list. Collectibles can be bought just about anywhere. More popular places are flea markets, antique stores, collectible retailers, auctions, garage sales, and more recently, online exchanges such as eBay. The value of the collectible can vary widely, but is dependent for the most part on supply and demand for the asset. The maturity for a collectible can also widely vary. For fads such as Beanie Babies or Pokémon cards, the price of the collectible can reach its peak very quickly. Other items such as antiques can take several decades before appreciating in value. ‫ق‬ How to Invest $ Funds The index lists autograph values and details the 2000-2011 price performance of the most sought-after collectibles, both celebrity and historical. The collectibles values within the index are for genuine, fully authenticated items, of museum grade quality. The collectibles investment indices include: £ £ £ £ £ Autograph index Coin index Classic car index Rare stamp indices Wine index $ Build a Collection Building a collection option offers the lowest entry level to investors wishing to diversify into the rewarding world of unique collectibles. It is the perfect way to build a valuable collection, in a non-correlated asset class, that offers long term investment potential plus the enjoyment and pleasure of becoming the custodian of a unique piece of history. Building a collection gives me the ability to make monthly or quarterly contributions to an account which will be used to finance an investment in unique collectibles. This option also gives me the opportunity to create an investment tailored to my personal requirements over the forthcoming years. $ Investment Funds There are already many investment funds operating in the collectibles markets. Coins, rare stamps, violins, art - they all have dedicated funds charging management fees. Fund managers have seen the benefits of the collectibles markets. Invest - 293 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Investment Tips $ Compare & Call If I have my eye on a collectible, I should take the time to call other dealers and price out similar items. Yes, there will always be, ‘two interested buyers’ coming back the next day, but I should not make snap decisions under pressure from the dealer. The best method is to browse the store and call the dealer when I get home. I will think more clearly and have fewer regrets in the end. If possible, I will purchase from other collectors (better yet, trade). They will be less likely to mark-up items because they will assume I have the same pricing guide they do. $ Ask for a Written Guarantee If a collectible is really an ‘unbelievable buy’ with ‘several interested buyers’, I will ask the seller to write a buy-back guarantee for an agreed period of time. After all, the dealer can buy it back at the same price and then sell it again to all those interested buyers banging on the windows. $ Research I should use the resources available and do my own research. I will pick up ’Kovels' Guide To Selling, Buying And Fixing My Antiques And Collectibles’ (1995) (or any of the other guides written by Ralph and Terry Kovel) or another collectibles publication and read up on the items I want. The literature will tell me the pricing guides as well as how to care for my collectibles and what kind of markets to buy and sell them in. Invest - 294 - Invest- 55 Assets That Grow Savings and Earn Passive Income COLLECTIBLES INVESTMENT PRODUCTS ¥ Art and Photography ‘Fine art is a fine - if not the finest - investment in more ways than one.’ J. Paul Getty (1892-1976), oil magnate and museum founder. The fine art market has grown substantially in the past 30 years. An estimated one million people worldwide now consider themselves to be serious art collectors, compared to just 10,000 people in 1980. I can read more about the demographics behind the collectibles markets at our market information & demographics page. Currently, the highest valued artwork is No. 5, 1948 by Jackson Pollock. It was sold, privately, in 2006 by U.S. record company mogul David Geffen for $140 million. Even during the recession, fine art has achieved huge prices at auction. The Andy Warhol piece 200 One Dollar Bills sold for $43.8 million in November 2009. The seller had originally purchased the piece for $385,000 in 1986. That's a return of almost 23% per annum, compounded over the last 23 years. May 2010 saw the record breaking $106,482,500 sale of Picasso's Nude Green Leaves, and Bust - the most expensive painting to ever sell at auction. But art investing is not just for the super wealthy. I do not need to be a millionaire to benefit from an art investment. With prices as low as £2,000 for a unique artwork I have every possibility to profit from enjoying the artwork at home during the investment term. The search for alternatives to the classic forms of investment will ensure that art as an asset class will enjoy an unimagined upswing. ‘Buying art should feel the same as falling in love.’ Roberta Maneker, New York Magazine Invest - 295 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Books & Manuscripts ‘It is a man's duty to have books. A library is not a luxury, but one of the necessaries of life.’ Henry Ward Beecher Few things can be more personal and cherished than a rare book or important manuscript. They represent some of mankind's greatest achievements and most defining historical moments. And rare book collecting can take this passion to a new level. Books have many appealing factors, from the fame and history surrounding them to the classic artwork that often adorns their covers. ‘That is a good book which is opened with expectation, and closed with delight and profit.’ Amos Bronson Alcott (1799-1888) - American Author In the rare book investment market: ‘Once is a fluke, twice is a pattern, more is a trend’ Few other investments can evoke as much passion as a library of classic books. The rare book market, especially first editions, is booming. Invest - 296 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Classic Cars ‘These cars — with their exquisite lines and innovative designs — are works of art, and their designers are artists.’ Malcolm Rogers, Director of the Museum of Fine Arts Sleek fender lines, chrome grills, plush vintage interiors; no wonder the international designer Ralph Lauren once described classic cars as, ‘moving works of art.’ Classic cars fascinate collectors for all kinds of reasons. Their engineering, their aesthetic beauty...Many collectors have feelings of nostalgia. Designers back then could indulge their imaginations. Cars capture people's imaginations like nothing else. The world record price for a classic car in 2008 was $10,894,400 for a 1961 Ferrari 250 GT SWB Cal Spyder. In May 2009 a 1957 Ferrari 250 Testa Rossa broke the record selling for $12,402,500. The most expensive car in the world - Bugatti 57SC at $30,000,000. In three years the world record price has almost trebled, and amidst a global financial recession. It proves the benefits of diversification with collectible investments. Classic car investment is a market that is open to all. As with all areas of collectibles investments; the demographics behind the market should ensure that an investment in classic cars will reap rewards in the mid to long term. There is also the added pleasure and enjoyment of owning a tangible asset that I can enjoy on a daily basis. Classic cars have a global appeal. The BBC's most popular programme is Top Gear, with an estimated 350 million viewers worldwide. Unsurprisingly, there is a massive market for classic cars. An ageing worldwide demographic is expected to have a further positive impact on the market. The world record price for a classic car has trebled in the past 2 years. Now is the time to get involved whilst prices are still achievable. Invest - 297 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Memorabilia (Coins, Stamps, Militaria, etc) ‘Like the museums that protect and preserve artefacts for future generations, collectors share a similar responsibility - we are insuring that the smaller pieces and parts are not forgotten.’ Memorabilia - from the Latin, meaning 'memorable' - can be anything of value associated to a person or event in history. We could be talking about the Beatle's multi-coloured soldier uniforms, or Jimi Hendrix's Fender Stratocaster guitar, even a young Henry VIII's chainmail and suit of armour. The unique Bruce Lee hand-drawn Kung Fu manual was sold at £100,000. Investing in memorabilia is one of the most unlimited and varied collectibles categories - with endless opportunities for me as an investor. The internet has created a much more transparent market, with easy research, open pricing and a clearer picture of rarity. Further, a celebrity driven culture ensures huge demand. The current low interest rate environment makes it the perfect opportunity to invest for maximum growth potential. There is also the added pleasure and enjoyment of investing in an item of history that I can enjoy on a daily basis. An interest in science could lead to ownership of Albert Einstein letters discussing the theory of relativity. A passion for history could result in ownership of Henry VIII's personal divorce plea. The opportunities are endless, and on a personal level are much more rewarding than owning a share certificate. ‫ق‬ Medals and Militaria ‘Nothing gives medals more meaning than the story of achievement behind them.’ Mark Piersall, collector. Of all the Collectibles Investment possibilities, none captures history more poignantly than war medals and militaria. These artefacts are symbols of heroic action, loyal service and accomplishment. All medals tell a story and, for investors, the events surrounding them are essential to their appeal and value. In 2010 Bonhams auction house confirmed the huge increase in this market by declaring: 'The Arms & Armour market has never been stronger...' Buoyant market as more collectors begin to appreciate history and achievements. Every opportunity to mix historic interest with a valuable investment In terms of appreciation, the value of medals & militaria has increased about fivefold in the last two decades. As with all areas of collectibles investments; the growing demographics behind the market should ensure that an investment in historic items will reap rewards in the mid to long term. Even to an investor, the pleasure and enjoyment of being the custodian of an important piece of history should not be underestimated. This is an opportunity for me to research and immerse myself in the heroism of previous generations. The number of collectors behind the market is growing rapidly which offers investors an excellent incentive to enter the market now, before prices escalate further. More than any other investment, I can be sure Invest - 298 - Invest- 55 Assets That Grow Savings and Earn Passive Income that I am helping to ensure that the brave remain unforgotten - and that their legacy is protected and preserved for future generations. ‫ق‬ Coins ‘The opportunity to buy a rare coin is often rarer than the coin itself.’ Lester Merkin, noted dealer. Rare coins are one of the best categories for illustrating how collectibles can offer enjoyment and rewarding investment opportunities. Rare coins are among the oldest and most prized forms of collectible. Famous collectors include the former British Prime Minister Tony Blair and actress Nicole Kidman. Many collectors use the power of coin investments to fund college tuition, estate building and retirement. Intrinsic value of gold & silver coins linked to rising mineral prices. As with stamps, rare misprints can also bring in large sums. An investment in rare coins can open me to a world of history and fascination. Rare coins are one of the most liquid of all collectible markets, and an enviable amount of historical price data is available for investors to make informed decisions. The sheer demand for rare coins ensures that they remain one of the most traditional, portable and rewarding collectible investments. ‫ق‬ Space & Aviation Memorabilia ‘It's got magic attached to it, don’t you think?’ A seller commenting on a piece of moon rock, priced at $50,000. 2009 saw the 40th Anniversary of the Apollo 11 moon landings and space memorabilia has been making headlines ever since. These artefacts signify mankind's bravery and scientific ingenuity unlike anything else. The heroism and significance of the Apollo explorations will remain unique for all time. This is one of the most popular areas of collecting. An estimated 500 million people sat glued to their televisions at the time. Many are now fondly buying into the market with prices rising accordingly. Collectors are often amazed that unique items are available for sale, and not sitting in museums. Incredibly limited supply does not go close to meeting demand. As with all areas of collectible investments; the demographics behind the market should ensure that an investment in the finest pieces will reap rewards in the mid to long term. The beauty of space memorabilia is that it caters for all budgets. ‫ق‬ Unique Collectibles ‘To renew the old world; that is the collector's greatest desire’ - Walter Benjamin Unique items range from the surprising to the unusual. Elvis Presley's hair - a TRex skeleton - Winston Churchill's settee - a stuffed giraffe's head - Mahatma Gandhi's glasses - Charles Dickens dog's collar - a Mummy head - the stairs Invest - 299 - Invest- 55 Assets That Grow Savings and Earn Passive Income from the Eiffel Tower These are all unique collectibles that have far exceeded auction estimates in the last 12 months. T-Rex skeleton: sold for $5m. There is no better way to build a collection than to focus on items that are utterly unique, connected to a legendary event, iconic person, or my own personal passion. I will not be alone. This is one of the fastest growing areas of collecting. The appeal of owning a totally unique piece of history that I feel passionate about is a very compelling investment proposition. Apple founder Steve Jobs collected Beatles memorabilia; Hollywood star Tom Hanks collects vintage typewriters; and director Quentin Tarantino collects TV-related vintage board games. Charles Dickens' dog collar fetched $11.5k: Forget about the A Christmas Carol and Oliver Twist author - his dog was the star at this auction... Truly unique pieces are aspirational; the market is very liquid as there will always be a buyer. This knowledge is invaluable when making important investment decisions. Unique items offer the greatest personal pleasure and a sound long-term investment. The pleasure alone should not be underestimated. Investing in unique items is limitless; whatever my passions there are unique items available that will excite me and offer me a profitable investment for the future. What's more there is something available for all budgets. ‫ق‬ Rare Postage Stamps ‘Four times profit, it's better than the stock market.’ Bill Gross, billionaire 'Bond King' investor, on investing in postage stamps. The global market for investing in rare postage stamps includes two of the world's most astute business moguls. Warren Buffet, the second richest man in the world, is one of them. His passion for investing in postage stamps goes back to childhood. Bill Gross, head of the PIMCO fund - the world's largest investment fund with assets of $1 trillion under management - is another. Portuguese footballer Louis Figo, the Rolling Stones guitarist Ronnie Wood, pop singer Sophie Ellis-Bextor and tennis superstar Maria Sharapova are all avid stamp collectors. The Royal Philatelic Collection of Her Majesty Queen Elizabeth II is believed to be one of the most complete collections in the world - and, as a stamp investment, is considered to be the Queen's largest single asset. Rare stamps offer one of the most popular and attractive forms of investment diversification. Historical returns are impressive and the rare stamp market is underpinned by 48 million collectors and investors around the world. Over 48 million collectors worldwide protect price, liquidity and demand. Historical returns of 9.5% per annum over the last 50 years. Strong emerging markets, especially China where there are estimated to be 50,000 philatelic societies and 18m collectors. Very detailed information exists on individual rare stamps, including print quantities, and numbers of copies still known to exist. This knowledge is invaluable when making informed postage stamp investment decisions. Invest - 300 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‘More people collect rare stamps than anything else on Earth.’ Paul Fraser ‫ق‬ Watches & Jewellery 'A thing of beauty is a joy forever.' John Keats The rare watch market sprang-up out of nowhere about 15 years ago, when wristwatches took over from pocket watches as a favoured collectible item. Investing in rare watches, or fine pieces of jewellery, is an attractive proposition as they can be worn on a daily basis, I can constantly enjoy them. Jewellery investment is governed by the same principles as rare watch investment: rarity and condition should be the top priority. In this investment area value is realised over time, when their scarcity and true value is fully appreciated and recognised. The Chinese are proving to be avid collectors of rare watches and fine jewellery, as have been the Russians before them. This area of collectible investment is seen as a status symbol in many emerging economies. ‘The quality remains long after the price has been forgotten.’ F.H. Royce, of RollsRoyce fame The performance of the jewellery market in has seen one auction house declare jewellery to be ‘the world's strongest investment.’ As with all areas of collectible investments; the demographics behind the market, especially the interest from China, should ensure that an investment in vintage watches & jewellery will continue to reap rewards in the mid to long term. More so than any other area of investment this market also offers the opportunity to enjoy my investment on a daily basis. Invest - 301 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Wine, Whisky & Cigars ‘My rule of life prescribed, as an absolutely sacred rite, smoking cigars and also the drinking of alcohol before, after and - if need be - during all meals, and in the intervals between them.’ Winston Churchill If I am looking to diversify my portfolio - or merely looking for something a bit different - then collecting wine, whisky or cigars could be for me. Demand for fine wine has risen in recent years with growing wealth in Russia and the Far East helping to push up prices. A new generation of buyers in China is buying and they are not just storing vintage wines, they are drinking them. This is leading to higher auction prices for the best vintages. The whisky market has been very strong recently with limited edition single malts setting world records at auction. Whisky is recognised as a premium product in the Far East. The global market for cigars has been growing with approximately 18 billion consumed around the world each year. The main growth has been in the sale of premium cigars which have shown a 10% increase each year. The finest quality wine, whisky & cigars are in finite supply, only so much is produced each year. There is huge interest from emerging economies where wine, whisky & cigars are seen as status symbols and a mark of prestige. ‘If I cannot smoke cigars in Heaven, I shall not go.’ Mark Twain Winston Churchill's cigar sold for £4.5k: The WW2 leader's half-smoked Cuban brought over ten times its estimate. Now is a perfect time to start investing in fine wine, whisky & cigars. Invest - 302 - Invest- 55 Assets That Grow Savings and Earn Passive Income 7. COLLECTIVE INVESTMENT SCHEMES (FUNDS & CLUBS) INTRODUCTION TO COLLECTIVE INVESTMENT SCHEMES (CISS) ¥ What is Collective Investment Scheme ‫ق‬ Definition A Collective Investment Scheme (CIS) is a way of investing money with others to participate in a wider range of investments than feasible for most individual investors, and to share the costs and benefits of doing so. Around the world large markets have developed around collective investment and these account for a substantial portion of all trading on major stock exchanges. Collective investment schemes may be formed under company law, by legal trust or by statute. The nature of the scheme and its limitations are often linked to its constitutional nature and the associated tax rules for the type of structure within a given jurisdiction. ‫ق‬ Characteristics Collective investments are promoted with a wide range of investment aims either targeting specific geographic regions (e.g. Emerging, Europe) or specified industry sectors (e.g. Technology). Depending on the country there is normally a bias towards the domestic market to reflect national self-interest as perceived by policymakers, familiarity, and the lack of currency risk. Funds are often selected on the basis of the specified investment aims, their past investment performance and other factors such as fees. ‫ق‬ Management ¥ ¥ ¥ ¥ ¥ A fund or investment manager who manages the investment decisions. A fund administrator who manages the trading, reconciliations, valuation and unit pricing. A board of directors or trustees who safeguards the assets and ensures compliance with laws, regulations, and rules. The shareholders or unitholders who own (or have rights to) the assets and associated income. A ‘marketing’ or ‘distribution’ company to promote and sell shares/units of the fund. Net Asset Value (NAV): The value of a scheme's assets less the value of its liabilities. Gearing and leverage: Some collective investment schemes have the power to borrow money to make further investments; a process known as gearing or leverage. If markets are growing rapidly this can allow the scheme to take advantage of the growth to a greater extent than if only the subscribed contributions were invested. However this premise only works if the cost of Invest - 303 - Invest- 55 Assets That Grow Savings and Earn Passive Income the borrowing is less than the increased growth achieved. If the borrowing costs are more than the growth achieved a net loss is achieved. This can greatly increase the investment risk of the fund by increased volatility and exposure to increased capital risk. Availability and access: Collective investment schemes vary in availability depending on their intended investor base: ¥ ¥ ¥ Public-availability Schemes - are available to most investors within the jurisdiction they are offered. Some restrictions on age and size of investment may be imposed. Limited-availability schemes - are limited by laws, regulations, and/or rules to experienced and/or sophisticated investors and often have high minimum investment requirements. Hedge funds are often restricted this way. Private-availability schemes - may be limited to family members or whoever set up the fund. They are not publicly quoted and often are arranged for tax- or estate-planning purposes. Private equity funds are typically structured this way. Duration: Some schemes are designed to have a limited term with enforced redemption of shares or units on a specified date. Unit or share class: Many collective investment schemes split the fund into multiple classes of shares or units. The underlying assets of each class are effectively pooled for the purposes of investment management, but classes typically differ in the fees and expenses paid out of the fund's assets. These differences are supposed to reflect different costs involved in servicing investors in various classes; for example: ¥ ¥ ¥ One class may be sold through a broker or financial adviser with an initial commission (front-end load) and might be called retail shares. Another class may be sold with no commission (load) direct to the public called direct shares. Still a third class might have a high minimum investment limit and only be open to financial institutions, and called institutional shares. Investment aims and benchmarking: Each fund has a defined investment goal to describe the remit of the investment manager and to help investors decide if the fund is right for them. The investment aims will typically fall into the broad categories of Income (value) investment or Growth investment. Income or value based investment tends to select stocks with strong income streams, often more established businesses. Growth investment selects stocks that tend to reinvest their income to generate growth. Some prefer a blend approach using aspects of each. Invest - 304 - Invest- 55 Assets That Grow Savings and Earn Passive Income Active or passive management: The aim of most funds is to make money by investing in assets to obtain a real return (i.e. better than inflation). The methods used to make investment vary and two opposing views exist. ¥ Active management - Active managers believe that by selectively buying within a Financial Market that it is possible to outperform the market as a whole. Therefore they employ dynamic portfolio strategies buying and selling investments with changing market conditions. ¥ Passive management - Passive managers believe that it is impossible to predict which individual holdings or section of the market will perform better than another therefore their portfolio strategy is determined at outset of the fund and not varied thereafter. Many passive funds are index funds where the fund tries to mirror the market as a whole. Another example of passive management is the ‘buy and hold’ method used by many traditional Unit Investment Trusts where the portfolio is fixed from outset. Fee types: There may be an initial charge levied on the purchase of units or shares which covers dealing costs, and commissions paid to intermediaries or salespeople. Typically this fee is a percentage of the investment. Some schemes waive the initial charge and apply an exit charge instead. This may be graduated disappearing after a number of years. The scheme will charge an annual management charge or AMC to cover the cost of administering the scheme and remunerating the investment manager. This may be a flat rate based on the value of the assets or a performance related fee based on a predefined target being achieved. Different unit/share classes may have different combinations of fees/charges. Cash Position: The amount of cash available to a company at a given point in time. Chapter 11: The part of the Bankruptcy Code that provides for reorganization of a bankrupt company’s assets. Chapter 7: The part of the Bankruptcy Code that provides for liquidation of a company’s assets. Claim Dilution: A reduction in the likelihood that one or more of the firm’s claimants will be fully repaid, Clawback : A clawback obligation represents the general partner’s promise that, over the life of the fund, the managers will not receive a greater share of the fund’s distributions than they bargained for. Generally, this means that the general partner may not keep distributions re p resenting more than a specified percentage (e.g., 20%) of the fund’s cumulative profits, if any. When triggered, the clawback will require that the general partner return to the fund’s limited partners an amount equal to what is determined to be “excess” distributions. Invest - 305 - Invest- 55 Assets That Grow Savings and Earn Passive Income Closing: An investment event occurring after the required legal documents are implemented between the investor and a company and after the capital is transferred in exchange for company ownership or debt obligation. Co - investment: The syndication of a private equity financing round or an investment by an individual (usually general partners) alongside a private equity fund in a financing round. Collar Agreement: Agreed-upon adjustments in the number of shares offered in a stock-for-stock exchange to account for price fluctuations before the completion of the deal. Corporate Charter: The document prepared when a corporation is formed. The Charter sets forth the objectives and goals of the corporation, as well as a complete statement of what the corporation can and cannot do while pursuing these goals. Corporate Resolution: A document stating that the corporation’s board of directors has authorized a particular individual to act on behalf of the corporation. Corporation: A legal, taxable entity chartered by a state or the federal government. Ownership of a corporation is held by the stockholders. Covenant: A protective clause in an agreement. Deficiency Letter: A letter sent by the SEC to the issuer of a new issue regarding omissions of material fact in the registration statement. Demand Registration: Resale registration that gives the investor the right to require the Company to file a Registration Statement registering the resale of the securities issued to the investor in a private offering. Demand Rights: Contemplate that the company must initiate and pursue the registration of a public offering including, although not necessarily limited to, the shares proffered by the requesting shareholder(s). Depreciation : An expense recorded to reduce the value of a long-term tangible asset. Since it is a non-cash expense, it increases free cash flow while decreasing the amount of a company’s reported earnings. Dilution: A reduction in the percentage ownership of a given shareholder in a company caused by the issuance of new shares. Director: Person elected by shareholders to serve on the board of directors. The directors appoint the president, vice president and all other operating officers, and decide when dividends should be paid (among other matters). Invest - 306 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ ‫ق‬ Why Collective Investment Scheme Diversity and risk One of the main advantages of collective investment is the reduction in investment risk (capital risk) by diversification. An investment in a single equity may do well, but it may collapse for investment or other reasons (e.g., Marconi, Enron). By investing in a range of equities (or other securities) the capital risk is reduced. The more diversified my capital, the lower the capital risk. This investment principle is often referred to as spreading risk. Collective investments by their nature tend to invest in a range of individual securities. However, if the securities are all in a similar type of asset class or market sector then there is a systematic risk that all the shares could be affected by adverse market changes. To avoid this systematic risk investment managers may diversify into different non-perfectly-correlated asset classes. For example, investors might hold their assets in equal parts in equities and fixed income securities. Also, collective schemes reduce costs. If one investor were to buy a large number of direct investments, the amount they would be able to invest in each holding is likely to be small. ‫ق‬ Disadvantages $ Costs The fund manager managing the investment decisions on behalf of the investors will of course expect remuneration. This is often taken directly from the fund assets as a fixed percentage each year or sometimes a variable (performance based) fee. If I managed my own investments, this cost would be avoided. Often the cost of advice given by a stock broker or financial adviser is built into the scheme. Often referred to as commission or load this charge may be applied at the start of the plan or as an ongoing percentage of the fund value each year. While this cost will diminish my returns it could be argued that it reflects a separate payment for an advice service rather than a detrimental feature of collective investment schemes. Indeed it is often possible to purchase units or shares directly from the providers without bearing this cost. $ Lack of choice Although the investor can choose the type of fund to invest in, they have no control over the choice of individual holdings that make up the fund. $ Loss of owner's rights If the investor holds shares directly, they may be entitled to shareholders' perks (for example, discounts on the company's products) and the right to attend the company's annual general meeting and vote on important matters. Investors in a collective investment scheme often have none of the rights connected with individual investments within the fund. Invest - 307 - Invest- 55 Assets That Grow Savings and Earn Passive Income TYPES OF COLLECTIVE INVESTMENT SCHEMES Collective investment schemes are grouped into two types, namely, self-directed collective investment schemes, and third-party or professionally managed investment schemes. ¥ Self-Directed Collective Cooperatives) ‫ق‬ Introduction Investment Schemes (Investment Clubs & The self directed collective investment schemes are existent in two main forms: 1. Investment Clubs; And 2. Cooperatives. The main feature is that the members are in control of determining the investment strategies, investment objectives and the assets to invest in. A practical guide on Investment Clubs is Making Money Together: Ojijo’s Investment Clubs Manual. This is an essential reference for all investment clubs - both new and established - to ensure that they are run correctly and efficiently. Ojijo’s Investment Clubs Manual tells me everything I need to know about joining or starting and running a successful investments club. A practical reference on cooperatives is Ojijo’s, Successful Saccos - Managers' Guide to Acquire, Retain and Grow Membership, Savings and Assets, which analyses the strategies of running an efficient and effective cooperative, from both a members’ and managers’ perspective. The main difference between cooperatives and investment clubs is that cooperatives have a leaning towards saving and credit, or rather, lending money to members at interest rates lower than the base commercial rates, whereas investment clubs are purely for investing, and shy away from lending money to members, and focus more on group investment of the pooled funds. Disclosure Document: A booklet outlining the risk factors associated with an investment. Diversification: The process of spreading investments among various types of securities and various companies in different fields. Drag-Along Rights: A majority shareholders’ right, obligating shareholders whose shares are bound into the shareholders’ agreement to sell their shares into an offer the majority wishes to execute. Due Diligence: A process undertaken by potential investors — individuals or institutions — to analyze and assess the desirability, value, and potential of an investment opportunity. Invest - 308 - Invest- 55 Assets That Grow Savings and Earn Passive Income Early Stage: A state of a company that typically has completed its seed stage and has a founding or core senior management team, has proven its concept or completed its beta test, has minimal revenues, and no positive earnings or cash flows. EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization. A measure of cash flow calculated as: = Revenue - Expenses (excluding tax, interest, depreciation, and amortization). EBITDA looks at the cash flow of a company. By not including interest, taxes, depreciation, and amortization, we can clearly see the amount of money a company brings in. This is especially useful when one company is considering a takeover of another because the EBITDA would cover any loan payments needed to finance the takeover. Economies of Scale: Economic principle that, as the volume of production increases, the cost of producing each unit decreases. Elevator Pitch: An extremely concise presentation of an entrepreneur’s idea, business model, company solution, marketing strategy, and competition delivered to potential investors. Should not last more than a few minutes, or the duration of an elevator ride. Employee Stock Option Plan (ESOP): A plan established by a company whereby a certain number of shares is reserved for purchase and issuance to key employees. Such shares usually vest over a certain period of time to serve as an incentive for employees to build long-term value for the company. Employee Stock Ownership Plan: A trust fund established by a company to purchase stock on behalf of employees. Equity: Ownership in the capital of a Company. In corporations, it is called “stock”; in limited partnerships or LLCs, it is called “interests” or “units.” Equity Kicker: Option for private equity investors to purchase shares at a discount. Typically associated with mezzanine financings where a small number of shares or warrants are added to what is primarily a debt financing. Invest - 309 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Professionally Managed Investment Schemes/Investment Companies The professionally managed investment schemes are also called investment companies. An investment company is a company whose main business is holding securities of other companies purely for investment purposes. The investment company invests money on behalf of its shareholders who in turn share in the profits and losses. There are three types of (professionally managed) investment companies: $ Open-End Management Investment Companies (mutual funds) $ Closed-End Management Investment Companies (closed-end funds) $ Unit Investment Trusts (UITs) The main purpose of investing through an investment company is to consistently achieve returns higher than the share indices of securities exchanges or capital markets. Invest - 310 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Closed-End Investment Funds ‫ق‬ Definition A closed-end fund issues a limited number of shares (or units) in an initial public offering (or IPO) or through private placement. It is called a closed-end fund (CEF) because new shares are rarely issued once the fund has launched, and because shares are not normally redeemable for cash or securities until the fund liquidates. If shares are issued through an IPO, they are then traded on an exchange or directly through the fund manager to create a secondary market subject to market forces. If demand for the shares is high, they may trade at a premium to net asset value. If demand is low they may trade at a discount to net asset value. Further share (or unit) offerings may be made by the scheme if demand is high although this may affect the share price. ‫ق‬ Characteristics The market price of the shares is determined by supply and demand and not by net asset value. Closed-end funds are usually specialized in their investment focus. For example, one might concentrate its focus on a particular geographic region. ¥ NET ASSET VALUE (NAV) is a fund's assets minus liabilities. NAV per share is the value of one share in the mutual fund and it is the number that is quoted in newspapers. I can basically just think of NAV per share as the price of a mutual fund. It fluctuates everyday as fund holdings and shares outstanding change. When I buy shares, I pay the current NAV per share plus any sales front-end load. When I sell my shares, the fund will pay me NAV less any back-end load. Objectives can vary from fund to fund, so it is important to read the prospectus before investing. Some closed-end funds have capital appreciation as their primary concern, while others are more interested in income. There are also ‘dual purpose’ closed-end funds, which simply means that they have two classes of shareholders: preferred shareholders who receive mainly dividends as income, and common shareholders who profit from the capital appreciation of the fund's share price. Registered investment companies that are not UITs or open-end investment companies are closed-end funds. Closed-end funds are usually sponsored by a funds management company which will control how the money is invested. They begin by soliciting money from investors in an initial offering, which may be public or limited. The investors are given shares corresponding to their initial investment. What exactly the fund manager can invest depends on the fund's charter. Distinguishing features: Some characteristics that distinguish a closed-end fund from an ordinary open-end mutual fund are that: ¥ It is closed to new capital after it begins operating, and Invest - 311 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Its shares (typically) trade on stock exchanges rather than being redeemed directly by the fund. ¥ Its shares can therefore be traded during the market day at any time. An open-end fund can usually be traded only at the closing price at the end of the market day. ¥ A CEF usually has a premium or discount. An open-end fund sells at its NAV (except for sales charges). ¥ A closed-end company can own unlisted securities. ¥ Another distinguishing feature of a closed-end fund is the common use of leverage or gearing to enhance returns. CEFs can raise additional investment capital by issuing auction rate securities, preferred stock, long-term debt, and/or reverse-repurchase agreements. In doing so, the fund hopes to earn a higher return with this excess invested capital. When a fund leverages through the issuance of preferred stock, two types of shareholders are created: preferred stock shareholders and common stock shareholders. Since closed-end funds are traded like stock, a customer trading them will pay a brokerage commission similar to one paid when trading stock (as opposed to commissions on open-ended mutual funds where the commission will vary based on the share class chosen and the method of purchasing the fund). Closed-end funds trade on exchanges and in that respect they are like exchangetraded funds (ETFs), but there are important differences between these two kinds of security. Discounts and Premiums: As a secondary effect of being exchange-traded, the price of CEFs can vary from the NAV. In particular, fund shares often trade at what look to be irrational prices because secondary market prices are often very much out of line with underlying portfolio values. A CEF can also have a premium at some times, and a discount at other times.’ Benjamin Graham claimed that an investor can hardly go wrong by buying such a fund with a 15% discount. ‫ق‬ Advantages £ These funds are easy to buy and sell on financial markets. Furthermore, they are regulated by the Securities and Exchange Commission. £ The funds usually invest in hundreds of companies, so they offer good diversification in certain areas. £ If bought in a tax-deferred account, closed-end funds are a great investment for long-term capital appreciation. ‫ق‬ Disadvantages £ Fixed interest payments are taxed at the same rate as income. Invest - 312 - Invest- 55 Assets That Grow Savings and Earn Passive Income £ ‫ق‬ The price of the closed-end fund is not exclusively linked to the performance of the securities held by the fund. The fund's share price depends on supply and demand in the open market. How to Invest I can buy shares on a secondary market from a broker, market maker, or other investor as opposed to an open-end fund where all transactions eventually involve the fund company creating new shares on the fly (in exchange for either cash or securities) or redeeming shares (for cash or securities). I am typically charged the usual brokerage commission as well as an annual management fee, usually under 1%. ERISA Significant Participation Test: A test that is satisfied if the General Partner determines in its reasonable discretion that Persons that are “benefit plan investors” within the meaning of Section (f)(2) of the Final Regulation constitute or are expected to constitute at least 25 percent of the interests of the Limited Partners. Note that the test is 25% of the interests of all the limited partners, which means 20% (+/-) in the partnership as a whole, taking into account the general partner’s interest. Exercise price: The price at which an option or warrant can be exercised. Exit Strategy: A fund’s intended method for liquidating its holdings while achieving the maximum possible return. These strategies depend on the exit climates, including market conditions and industry trends. Exit strategies can include selling or distributing the portfolio company’s shares after an initial public offering (IPO), a sale of the portfolio company, or a recapitalization. Finder: A person who helps to arrange a transaction. Flipping: The act of buying shares in an IPO and selling them immediately for a profit. Brokerage firms underwriting new stock issues tend to discourage flipping and will often try to allocate shares to investors who intend to hold on to the shares for some time. However, the temptation to flip a new issue once it has risen in price sharply is too irresistible for many investors who have been allocated shares in a hot issue. Free cash flow : The cash flow of a company available to service the capital structure of the firm. Typically measured as operating cash flow less capital expenditures and tax obligations. Full Ratchet Antidilution: The sale of a single share at a price less than the favored investors paid reduces the conversion price of the favored investors’ convertible preferred stock “to the penny.” For example, from $1.00 to 50 cents, regardless of the number of lower-priced shares sold. Fully Diluted Earnings Per Share : Earnings per share expressed as if all outstanding convertible securities and warrants have been exercised. Invest - 313 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ ‫ق‬ Open-End Funds (Mutual Funds) Definition An open-end fund is equitably divided into shares which vary in price in direct proportion to the variation in value of the fund's net asset value. Each time money is invested, new shares or units are created to match the prevailing share price; each time shares are redeemed, the assets sold match the prevailing share price. In this way there is no supply or demand created for shares and they remain a direct reflection of the underlying assets. ‫ق‬ Characteristics Being open-ended means, at the end of every day, the fund continually issues new shares to investors buying into the fund and must stand ready to buy back shares from investors redeeming their shares at the then current net asset value per share. An investor will generally purchase shares in the fund directly from the fund itself rather than from the existing shareholders. It contrasts with a closed-end fund, which typically issues all the shares it will issue at the outset, with such shares usually being tradeable only between investors thereafter. The mutual fund is the common name for what is classified as an open-end investment company by the SEC. A mutual fund is an investment vehicle that comprises a pool of funds collected from a large number of investors who invest in securities such as stocks, bonds, and short term money market instruments. Mutual funds must be structured as corporations or trusts, such as business trusts, and any corporation or trust will be classified by the SEC as an investment company if it issues securities and primarily invests in nongovernment securities. An investment company will be classified by the SEC as an open-end investment company if they do not issue undivided interests in specified securities (the defining characteristic of unit investment trusts or UITs) and if they issue redeemable securities. The price at which shares in an open-ended fund are issued or can be redeemed will vary in proportion to the net asset value of the fund, and therefore directly reflects the fund's performance. The price of a mutual fund is known as the Net Asset Value (NAV). Charges: There may be a percentage charge levied on the purchase of shares or units. Some of these fees are called an initial charge (UK) or 'front-end load' (US). Some fees are charged by a fund on the sale of these units, called a 'close-end load,' that may be waved after several years of owning the fund. Some of the fees cover the cost or distributing the fund by paying commission to the adviser or broker that arranged the purchase. These fees are commonly referred to as commission (UK) or 12b-1 (U.S.). Not all funds have initial Invest - 314 - Invest- 55 Assets That Grow Savings and Earn Passive Income charges; if there are no such charges levied; the fund is ‘no-load’ (US). These charges may represent profit for the fund manager or go back into the fund. LOAD: The load is investment terminology for the fee I pay the manager. Here is how certain loads work: £ Front-End Loads: I pay the fee when I purchase the fund. If I invest $1,000 in a mutual fund with a 5% front-end load, $50 will pay for the sales charge, and $950 will be invested in the fund. £ Back-End Loads: (also known as deferred sales charges) - These are a bit more complicated. In such a fund I pay the back-end load if I sell a fund within a certain time frame. A typical example is a 6% back-end load that decreases to 0% in the seventh year. The load is 6% if I sell in the first year, 5% in the second year, etc. If I do not sell the mutual fund until the seventh year, I do not have to pay the back-end load at all. £ A No-Load Fund sells its shares without a commission or sales charge. My returns will be higher because the professional advice put me into a better fund. £ Level-load fund, in which no sales charge is paid when buying the fund, but a back-end load may be charged if the shares purchased are sold within a year. Just about every study ever done has shown no correlation between high expense ratios and high returns. This is a fact. If I want more evidence, I will consider this quote from the U.S. Securities and Exchange Commission's website that: ‘Higher expense funds do not, on average, perform better than lower expense funds.’ Loads are just fees that a fund uses to compensate brokers or other salespeople for selling me the mutual fund. All I really need to know about loads is this: not to buy funds with loads. In fact, when I take the fees into account, the average load fund performs worse than a no-load fund. The value of the investment is reduced by the amount of the load. Some funds have a deferred sales charge or back-end load. In this type of fund an investor pays no sales charge when purchasing shares, but will pay a commission out of the proceeds when shares are redeemed depending on how long they are held. Prospectus: A prospectus tells me about the fees, objectives and people associated with the mutual fund, and also the companies invested in, the management and the returns expected. Regulations: Trading in mutual funds is carried out under strict government regulations. Specific features of mutual funds include liquidity, transfer of Invest - 315 - Invest- 55 Assets That Grow Savings and Earn Passive Income money, purchase of units and high competition. Investment in mutual funds is highly liquid as funds are required to redeem shares daily. It permits transfer of money from one type of fund to another, but the exchange takes place within the same fund family. Investors should buy mutual funds as a long-term investment. The nice thing about mutual funds is that the objectives change from fund to fund. Each mutual fund has a different strategy - it is my job to decide what my objectives are and which fund best suits those objectives. Mutual fund strategies include growth/aggressive, low risk, balanced, momentum, and many others. ‫ق‬ Mutual fund fees and expenses Mutual fund fees and expenses are charges that may be incurred by investors who hold mutual funds. Running a mutual fund involves costs, including shareholder transaction costs, investment advisory fees, and marketing and distribution expenses. Funds pass along these costs to investors in a number of ways. Some funds impose ‘shareholder fees’ directly on investors whenever they buy or sell shares. In addition, every fund has regular, recurring, fund-wide ‘operating expenses.’ Funds typically pay their operating expenses out of fund assets — which means that investors indirectly pay these costs. Seemingly negligible, fees and expenses can substantially reduce an investor's earnings. There are one-off fees, and periodic fees, as below: $ One-off fees Purchase fee: A type of fee that some funds charge their shareholders when they buy shares. Unlike a front-end sales load, a purchase fee is paid to the fund (not to a Stockbroker) and is typically imposed to defray some of the fund's costs associated with the purchase. Redemption fee: Another type of fee that some funds charge their shareholders when they sell or redeem shares. Unlike a deferred sales load, a redemption fee is paid to the fund (not to a Stockbroker) and is typically used to defray fund costs associated with a shareholder's redemption. Exchange fee: A fee that some funds impose on shareholders if they exchange (transfer) to another fund within the same fund group or ‘family of funds.’ $ Periodic fees Management fee: Management fees are fees that are paid out of fund assets to the fund's investment adviser for investment portfolio management, any other Invest - 316 - Invest- 55 Assets That Grow Savings and Earn Passive Income management fees payable to the fund's investment adviser or its affiliates, and administrative fees payable to the investment adviser that are not included in the ‘Other Expenses’ category (discussed below). They are also called maintenance fees. Account fee: Account fees are fees that some funds separately impose on investors in connection with the maintenance of their accounts. For example, some funds impose an account maintenance fee on accounts whose value is less than a certain dollar amount. $ Waivers, reimbursements & recoupments Some funds will execute ‘waiver or reimbursement agreements’ with the fund's adviser or other service providers, especially when a fund is new and expenses tend to be higher (due to a small asset base). These agreements generally reduce expenses to some pre-determined level or by some pre-determined amount. Sometimes these waiver/reimbursement amounts must be repaid by the fund during a period that generally cannot exceed 3 years from the year in which the original expense was incurred. If a recoupment plan is in effect, the effect may be to require future shareholders to absorb expenses of the fund incurred during prior years. $ Changes in expense ratio (fixed & variable expenses) Generally, unlike past performance, expenses are very predictive. Funds with high expenses ratios tend to continue to have high expenses ratios. An investor can examine a fund's ‘Financial Highlights’ which is contained in both the periodic financial reports and the fund's prospectus, and determine a fund's expense ratio over the last five years (if the fund has five years of history). It is very hard for a fund to significantly lower its expense ratio once it has had a few years of operational history. This is because funds have both fixed and variable expenses, but most expenses are variable. Variable costs are fixed on a percentage basis. For example, assuming there are no breakpoints, a .75% management fee will always consume .75% of fund assets, regardless of any increase in assets under management. The total management fee will vary based on the assets under management, but it will always be .75% of assets. Fixed costs (such as rent or an audit fee) vary on a percentage basis because the lump sum rent/audit amount as a percentage will vary depending on the amount of assets a fund has acquired. Thus, most of a fund's expenses behave as a variable expense and thus, are a constant fixed percentage of fund assets. It is therefore, very hard for a fund to significantly reduce its expense ratio after it has some history. Thus, if an investor buys a fund with a high expense ratio that has some history, he/she should not expect any significant reduction. $ Other expenses Invest - 317 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‘Other expenses’ are expenses not included under ‘Management Fees’ or ‘Distribution or Service (12b-1) Fees,’ such as any shareholder service expenses that are not already included in the 12b-1 fees, custodial expenses, legal and accounting expenses, transfer agent expenses, and other administrative expenses. ‫ق‬ Advantages € Professional Management - Investors purchase funds because they do not have the time or the expertise to manage their own portfolios. A mutual fund is a relatively inexpensive way for a small investor to get a full-time manager to make and monitor investments. € Diversification - By owning shares in a mutual fund instead of owning individual stocks or bonds, my risk is spread out. The idea behind diversification is to invest in a large number of assets so that a loss in any particular investment is minimized by gains in others. In other words, the more stocks and bonds I own, the less any one of them can hurt me. Large mutual funds typically own hundreds of different stocks in many different industries. It would not be possible for an investor to build this kind of a portfolio with a small amount of money. € Economies of Scale - Because a mutual fund buys and sells large amounts of securities at a time, its transaction costs are comparatively lower than what an individual would pay for securities transactions. € Liquidity - Just like an individual stock, a mutual fund allows I to request that my shares be converted into cash at any time. € Simplicity - Buying a mutual fund is easy! Pretty well any bank has its own line of mutual funds, and the minimum investment is small. Most companies also have Automatic Purchase Plans whereby as little as $100 can be invested on a monthly basis. ‫ق‬ Disadvantages € Costs - Creating, distributing, and running a mutual fund is an expensive proposition. Everything from the manager’s salary to the investors’ statements cost money. Those expenses are passed on to the investors. Since fees vary widely from fund to fund, failing to pay attention to the fees can have negative long-term consequences. Every dollar spend on fees is a dollar that has no opportunity to grow over time. € Dilution - It is possible to have too much diversification. Because funds have small holdings in so many different companies, high returns from a few investments often do not make much difference on the overall return. Dilution is also the result of a successful fund getting too big. When money pours into funds that have had strong success, the manager often has trouble finding a good investment for all the new money. € Taxes - When a fund manager sells a security, a capital-gains tax is triggered. Investors who are concerned about the impact of taxes need Invest - 318 - Invest- 55 Assets That Grow Savings and Earn Passive Income € € ‫ق‬ to keep those concerns in mind when investing in mutual funds. Taxes can be mitigated by investing in tax-sensitive funds or by holding nontax sensitive mutual fund in a tax-deferred account. Price fluctuation: Mutual funds are like many other investments without a guaranteed return: there is always the possibility that the value of my mutual fund will depreciate. Unlike fixed-income products, such as bonds and Treasury bills, mutual funds experience price fluctuations along with the stocks that make up the fund. When deciding on a particular fund to buy, I need to research the risks involved – just because a professional manager is looking after the fund that does not mean the performance will be stellar. No government insurance: Mutual funds are not guaranteed by the government, so in the case of dissolution, I will not get anything back. How to Invest There are several different mutual fund companies in almost all countries. Most of them can be purchased directly at the mutual fund company, a bank, a brokerage or a financial planner/investment advisor. The commissions on mutual funds can vary widely depending on the company and the style of the fund. A load mutual fund charges me for the shares bought, plus a sales fee. A no-load fund sells its shares without a commission or sales charge, but management fees can be higher. I can buy some mutual funds (no-load) by contacting fund companies directly. Other funds are sold through brokers, banks, financial planners, or insurance agents. If I buy through a third party, I may pay a sales charge (load). Further, funds can be purchased through no-transaction fee programs that offer funds from many companies. Sometimes referred to as ‘fund supermarkets,’ these programs let me buy funds from many different companies. They also provide consolidated recording that includes all purchases made through the supermarket, even if they are from different fund families. ‫ق‬ Types of Mutual Funds Mutual funds are classified on the basis of maturity period or investment objective. On the basis of maturity period, mutual funds include Open-Ended funds and close ended funds. Based on investment objectives, when I invest in the stock market, it is called equity funds; when I invest in a basket of government securities and stocks, this is balanced fund; and when I invest in funds dedicated to government bonds and other bonds, this is bond fund. These funds are usually handled by private companies. The SEC or CMA monitors these privately managed funds. € GROWTH AND INCOME FUND: A mutual fund that seeks long-term growth of capital and current dividend income from stocks. Invest - 319 - Invest- 55 Assets That Grow Savings and Earn Passive Income € € € € INCOME FUND: A mutual fund that seeks current income rather than growth of capital. Income funds typically invest in bonds and/or highyielding stocks. GROWTH FUND: A mutual fund that emphasises stocks of companies believed to offer above-average prospects for capital growth due to their strong earnings and revenue potential. Growth stocks tend to offer relatively low dividend yields, because these companies prefer to reinvest earnings in the company. INDEX FUND: A passively managed mutual fund that seeks to parallel the performance of a particular market index. INDEXING: A low-cost investment strategy that seeks to match, rather than outperform the return and risk characteristics of an index, by holding all securities that make up the index or a statistically representative sample of the index. Also known as passive management. There are wide ranges of mutual funds from the high-risk foreign security funds all the way down to the Government bond fund, which is almost as safe as the bonds themselves. Many mutual funds offer more than one class of shares. For example, I may have seen a fund that offers ‘Class A‘ and ‘Class B‘ shares. Each class will invest in the same pool (or investment portfolio) of securities and will have the same investment objectives and policies. But each class will have different shareholder services and/or distribution arrangements with different fees and expenses. These differences are supposed to reflect different costs involved in servicing investors in various classes. € EXPENSE RATIO: The percentage of a portfolio's average net assets used to pay its annual expenses. $ Equity Funds (Stocks) Equity funds, which consist mainly of stock investments, are the most common type of mutual fund, holding 50% of all amounts invested in mutual funds. Generally, the investment objective of this class of funds is long-term capital growth with some income. There are, however, many different types of equity funds because there are many different types of equities. The idea is to classify funds based on both the size of the companies invested in and the investment style of the manager. The term value refers to a style of investing that looks for high quality companies that are out of favor with the market. These companies are characterized by low P/E and price-to-book ratios and high dividend yields. The opposite of value is growth, which refers to companies that have had (and are expected to continue to have) strong growth in earnings, sales and cash flow. ‫ق‬ Index Fund $ Definition Index Fund or Index Tracker is a collective investment scheme (usually a mutual fund or exchange-traded fund) that aims to replicate the movements of a market index of a specific financial market, or a set of rules of ownership that Invest - 320 - Invest- 55 Assets That Grow Savings and Earn Passive Income are held constant, regardless of market conditions. The index fund was founded by the legendary John Bogle, founder of the Vanguard Group and creator of the index mutual fund. $ Overview of Market Indices € Stock Market Index Stock market index is a method of measuring a section of the stock market. Many indices are cited by news or financial services firms and are used as benchmarks, to measure the performance of portfolios such as mutual funds. € Types of Indices Stock market indices may be classed in many ways. ¥ Global: A 'world' or 'global' stock market index includes (typically large) companies without regard for where they are domiciled or traded. Two examples are MSCI World and S&P Global 100. ¥ National: A 'national' index represents the performance of the stock market of a given nation—and by proxy, reflects investor sentiment on the state of its economy. The most regularly quoted market indices are national indices composed of the stocks of large companies listed on a nation's largest stock exchanges, such as the American S&P 500, the Japanese Nikkei 225, and the British FTSE 100. ¥ Specialized: More specialised indices exist tracking the performance of specific sectors of the market. Other indices may track companies of a certain size, a certain type of management, or even more specialized criteria. A notable specialised index type is Ethical stock market indices, for ethical investing indices that include only those companies satisfying ecological or social criteria, e.g. those of The Calvert Group, KLD, FTSE4Good Index, Dow Jones Sustainability Index and Wilderhill Clean Energy Index. € Index Versions Some indices have multiple versions. These versions can differ based on how the index components are weighted and on how dividends are accounted for. For example: price return, which only considers the price of the components; total return, which accounts for dividend reinvestment; and net total return, which accounts for dividend reinvestment after the deduction of a withholding tax. Other versions are: full capitalization total return, full capitalization price, float-adjusted total return, float-adjusted price, and equal weight. The difference between the full capitalization, float-adjusted, and equal weight versions is in how index components are weighted. Weighting: An index may also be classified according to the method used to determine its price. In a price-weighted index, the price of each component stock is the only consideration when determining the value of the index. Thus, price movement of even a single security will heavily influence the value of the index even Invest - 321 - Invest- 55 Assets That Grow Savings and Earn Passive Income though the dollar shift is less significant in a relatively highly valued issue, and moreover ignoring the relative size of the company as a whole. In contrast, a market-value weighted or capitalization-weighted index factors in the size of the company. Thus, a relatively small shift in the price of a large company will heavily influence the value of the index. In a market-share weighted index, price is weighted relative to the number of shares, rather than their total value. Traditionally, capitalization- or shareweighted indices all had a full weighting, i.e. all outstanding shares were included. Recently, many of them have changed to a float-adjusted weighting which helps indexing. A modified capitalization-weighted index is a hybrid between capitalization weighting and equal weighting. It is similar to a capitalization weighting with one main difference: the largest stocks are capped to a percent of the weight of the total stock index and the excess weight will be redistributed equally amongst the stocks under that cap. That is, a stock's weight in the index is decided by the score it gets relative to the value attributes that define the criteria of a specific index, the same measure used to select the stocks in the first place. For these two stocks, a score is calculated for every stock, be it their growth score or the value score (a stock can't be both) and accordingly they are weighted for the index. Index funds routinely beat a large majority of actively managed mutual funds. Indices are also a common basis for a related type of investment, the exchange-traded fund or ETF. Unlike an index fund, which is priced daily, an ETF is priced continuously, is optionable, and can be sold short. $ Characteristics It has a portfolio constructed to match or track the components of a market index. An index mutual fund is said to provide broad market exposure, low operating expenses and low portfolio turnover. ‘Indexing’ is a passive form of fund management that has been successful in outperforming most actively managed mutual funds. Investing in an index fund is a form of passive investing. The primary advantage to such a strategy is the lower management expense ratio on an index fund. Also, a majority of mutual funds fail to beat broad indexes. An index fund is passive investing. It provides instant diversification (because the fund owns many different kinds of stocks) without having to invest huge sums of money. Most importantly, the fees are far less than the cost of the average mutual fund. These lower fees are another advantage of passive investing. Because the fund does not have to pay some hotshot (and expensive) MBA fund manager to pick stocks, an index fund is often cheaper than any other mutual fund. ‘..the best way to own common stocks is through an index fund...’ Invest - 322 - Invest- 55 Assets That Grow Savings and Earn Passive Income said Warren Buffett of Berkshire Hathaway, Inc. Here's the logic behind index funds, which aim simply to match the return of a market index: The average fund in any market will always earn that market's return (because in aggregate investors are the market) minus expenses. Since index funds match the market but have much smaller expenses than other funds, they will always beat the average fund in the long run. It is hard to argue with the math). Besides, if the Greatest Investor of Our Time believes that index funds are superior for most investors, shouldn't I? Many institutional funds are one hundred percent indexed. Even Charles Schwab and Company recommends that investors put 80% of their large cap assets into index funds. Mr. Schwab himself has 75% of his mutual funds in index funds. The difference between the index performance and the fund performance is known as the ‘tracking error’ or informally ‘jitter’. $ Advantages ¥ Low costs: Because the composition of a target index is a known quantity, it costs less to run an index fund. No highly paid stock pickers or analysts are needed. ¥ Simplicity: The investment objectives of index funds are easy to understand. Once an investor knows the target index of an index fund, what securities the index fund will hold can be determined directly. Managing my index fund holdings may be as easy as rebalancing every six months or every year. ¥ Lower turnovers: Turnover refers to the selling and buying of securities by the fund manager. Selling securities in some jurisdictions may result in capital gains tax charges, which are sometimes passed on to fund investors. Even in the absence of taxes, turnover has both explicit and implicit costs, which directly reduce returns on a dollar-for-dollar basis. Because index funds are passive investments, the turnovers are lower than actively managed funds. ¥ No style drift: Style drift occurs when actively managed mutual funds go outside of their described style (i.e. mid-cap value, large cap income, etc.) to increase returns. Such drift hurts portfolios that are built with diversification as a high priority. Drifting into other styles could reduce the overall portfolio's diversity and subsequently increase risk. With an index fund, this drift is not possible and accurate diversification of a portfolio is increased. $ Disadvantages ¥ Possible Tracking Error: Since index funds aim to match market returns, both under- and over-performance compared to the market is considered a Invest - 323 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‘tracking error’. For example, an inefficient index fund may generate a positive tracking error in a falling market by holding too much cash, which holds its value compared to the market. ¥ Cannot Outperform The Target Index: By design, an index fund seeks to match rather than outperform the target index. Therefore, a good index fund with low tracking error will not generally outperform the index, but rather produces a rate of return similar to the index minus fund costs. ¥ Index Composition Changes Reduce Return: Whenever an index changes, the fund is faced with the prospect of selling all the stock that has been removed from the index, and purchasing the stock that was added to the index. In effect, the index, and consequently all funds tracking the index, are announcing ahead of time the trades that they are planning to make. As a result, the price of the stock that has been removed from the index tends to be driven down, and the price of stock that has been added to the index tends to be driven up, in part due to arbitrageurs, in a practice known as ‘index front running’. The index fund, however, has suffered market impact costs because they had to sell stock whose price was depressed, and buy stock whose price was inflated. Fully Diluted Outstanding Shares : The number of shares representing total company ownership, including common shares and current conversion or exercised value of the preferred shares, options, warrants, and other convertible securities. GAAP: Generally Accepted Accounting Principles. The common set of accounting principles, standards, and procedures. GAAP is a combination of authoritative standards set by standard-setting bodies as well as accepted ways of doing accounting. Golden Handcuffs: This occurs when an employee is required to relinquish unvested stock when terminating his employment contract early. Golden Parachute : Employment contract of upper management that provides a large payout upon the occurrence of certain control transactions, such as a certain percentage share purchase by an outside entity or when there is a tender offer for a certain percentage of a company’s shares. This is discussed in more detail at the Executive Employment Agreement . Invest - 324 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Income Funds (Bonds) Income Fund is a mutual fund whose goal is to provide an income from investments. Income funds are often assumed to be synonymous with bond funds, however income funds may hold stocks instead (typically those with a good history of paying dividends), more accurately called equity income funds, or even some combination. The point in any case is that the investor is more interested in income than capital gains; perhaps with the intention the fund will never be sold. When referring to mutual funds, the terms ‘fixed-income,’ ‘bond,’ and ‘income’ are synonymous. These terms denote funds that invest primarily in government and corporate debt. While fund holdings may appreciate in value, the primary objective of these funds is to provide a steady cash flow to investors. As such, the audience for these funds consists of conservative investors and retirees. Bond funds are likely to pay higher returns than certificates of deposit and money market investments, but bond funds are not without risk. Because there are many different types of bonds, bond funds can vary dramatically depending on where they invest. For example, a fund specializing in high-yield junk bonds is much more risky than a fund that invests in government securities. Furthermore, nearly all bond funds are subject to interest rate risk, which means that if rates go up the value of the fund goes down. $ Types of bond funds £ Term funds, which have a fixed set of time (short-, medium-, or long-term) before they mature. £ Municipal bond funds generally have lower returns, but have tax advantages and lower risk. £ High-yield bond funds invest in corporate bonds, including high-yield or junk bonds. With the potential for high yield, these bonds also come with greater risk. Invest - 325 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Money Market Funds Money market funds are an investment fund that carries the purpose of earning interest for shareholders. I will not get great returns, but I will not have to worry about losing my principal. Higher returns: A typical return is twice the amount I would earn in a regular checking/savings account and a little less than the average certificate of deposit (CD). Low risk: Money market funds generally entail the least risk, as well as lower rates of return. Unlike certificates of deposit (CDs), open-end money fund shares are generally liquid and redeemable at ‘any time’ (that is, normal business hours during which redemption requests are taken - generally not after 4 PM ET). Safety & security: This is a safe place to park my money. Money market funds invest in short-term money market legal documents like commercial paper, government securities, CDs (certificates of deposit) etc. Some of the money market funds purchase specifically the government securities like treasury bills, while the other general purpose funds normally invest on short-term paper. It is observed that a major amount of funds invest only in governmentbacked securities. For this reason, shareholders can think themselves as safe. Investors prefer these money market funds for their high yielding capacity, and security. Flexibility: Money market funds allow me as an investor to attain the flexibility of switching my money from one fund to the other. The other advantage is that it exerts no charge. No insurance: Money funds are required to advise investors that a money fund is not a bank deposit, not insured and may lose value. Interest & fees: Money market funds sell shares to the investors and they get interest payments on a regular basis. There are several factors which are responsible to acquire the interest amount. These are management fee, level of interest rates, commissions etc. Some of the major factors responsible behind money market funds are maturity, quality and diversity. Restriction: One restriction regarding money market funds investment is that money funds can invest up to 5% in any one issuer. Money market securities need to maintain a stable value and higher liquidity. Investors should cautiously observe the important information stated in the prospectus, which comprise risks, investment policies, expenses and charges before they decide to deal with money market funds. $ How to invest! Invest - 326 - Invest- 55 Assets That Grow Savings and Earn Passive Income Suppliers of money market funds are brokerage firms, mutual funds, banks, etc. Most of the money market funds are not nationally insured, they are normally covered by private insurance. Investment companies, who are registered with the Securities and Exchange Commission, normally handle the money market funds. Invest - 327 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Balanced Funds The objective of these funds is to provide a balanced mixture of safety, income and capital appreciation. The strategy of balanced funds is to invest in a combination of fixed income and equities. A typical balanced fund might have a weighting of 60% equity and 40% fixed income. The weighting might also be restricted to a specified maximum or minimum for each asset class. A similar type of fund is known as an asset allocation fund. Objectives are similar to those of a balanced fund, but these kinds of funds typically do not have to hold a specified percentage of any asset class. The portfolio manager is therefore given freedom to switch the ratio of asset classes as the economy moves through the business cycle. Holding Company: A corporation that owns the securities of another, in most cases with voting control. Holding Period: The amount of time an investor has held an investment. The period begins on the date of purchase and ends on the date of sale, and determines whether a gain or loss is considered short term or long term, for capital-gains-tax purposes. Hot Issue: A newly issued stock that is in great public demand. Technically, it is when the secondary market price on the effective date is above the new issue offering price. Hot issues usually experience a dramatic rise in price at their initial public offering because the market demand outweighs the supply. Hurdle Rate: The internal rate of return that a fund must achieve before its general partners or managers may receive an increased interest in the proceeds of the fund. Often, if the expected rate of return on an investment is below the hurdle rate, the project is not undertaken. Institutional Investors: Organizations that professionally invest, including insurance companies, depository institutions, pension funds, investment companies, mutual funds, and endowment funds. Investment Letter: A letter signed by an investor purchasing unregistered long securities under Regulation D, in which the investor attests to the long-term investment nature of the purchase. These securities must be held for a minimum of one year before they can be sold. IRA Rollover: The reinvestment of assets received as a lump-sum distribution from a qualified tax-deferred retirement plan. Reinvestment may be the entire lump sum or a portion thereof. If reinvestment is done within 60 days, there are no tax consequences. IRR: Internal Rate of Return. A typical measure of how VC Funds measure performance. IRR is technically a discount rate: the rate at which the Invest - 328 - Invest- 55 Assets That Grow Savings and Earn Passive Income present value of a series of investments is equal to the present value of the returns on those investments. Invest - 329 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Funds of Funds (FoF) ‘Fund of Funds’ (FOF) is an investment strategy of holding a portfolio of other investment funds rather than investing directly in shares, bonds or other securities. This type of investing is often referred to as multi-manager investment. Lower Fees: A fund of funds will typically charge a much lower management fee than that of a fund investing in direct securities because it is considered a fee charged for asset allocation services which is presumably less demanding than active direct securities research and management. Classification: FoFs have been classified into those that are actively managed (in which the investment advisor reallocates frequently among the underlying funds in order to adjust to changing market conditions) and those that are passively managed (the investment advisor allocates assets on the basis of on an allocation model which is rebalanced on a regular basis). Diversity: Investing in a fund of funds achieves greater diversification. Expertise: As in the case of schemes of mutual funds, FOF schemes also work under the due diligence of a fund manager. This gives the scheme an additional expertise. Tracking: Since a fund of funds buys many different funds which themselves invest in many different securities, it is possible for the fund of funds to own the same stock through several different funds and it can be difficult to keep track of the overall holdings. There are different types of 'fund of funds', each investing in a different type of collective investment scheme (typically one type per FoF), eg. 'mutual fund' FoF, hedge fund FoF, private equity FoF or investment trust FoF. Invest - 330 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Exchange-Traded Funds (ETF) € Definition An exchange-traded fund (ETF) is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds and trades at approximately the same price as the net asset value of its underlying assets over the course of the trading day. Most ETFs track an index, such as the S&P 500 or MSCI EAFE. € Characteristics Like mutual funds: The Exchange-Traded Fund or ETF is often structured as an Open-End Investment Company (OEIC). ETFs combine characteristics of both mutual funds and closed-end funds. Like stocks: ETFs are traded throughout the day on a stock exchange, just like closed-end funds, but at prices generally approximating the ETF's net asset value. Their prices are determined by supply and demand just like stocks. Put & call options: ETFs also allow investor to write put and call options, which is not possible with mutual funds. Like index funds: Most ETFs are index funds and track stock market indexes. Availability to foreign investors: Exchange-traded funds are also valuable for foreign investors who are often able to buy and sell securities traded on a stock market, but who, for regulatory reasons, are limited in their ability to participate in traditional mutual funds. Fees: When I buy, I pay both broker fee, and a management fee, unlike mutual fund. No prospectus: Further, companies are not required to give ETF prospectus, unlike mutual funds which regulations require to have prospectus to investors. Efficiency: ETFs are attractive as investments because of their low costs, tax efficiency, and stock-like features. High investments: Only so-called authorized participants (typically, large institutional investors) actually Invest shares of an ETF directly from or to the fund manager, and then only in creation units, large blocks of tens of thousands of ETF shares, which are usually exchanged in-kind with baskets of the underlying securities. Other investors, such as individuals using a retail broker, trade ETF shares on this secondary market. Invest - 331 - Invest- 55 Assets That Grow Savings and Earn Passive Income Commodity focus: Some ETFs invest primarily in commodities or commoditybased instruments, such as crude oil and precious metals. Although these commodity ETFs are similar in practice to ETFs that invest in securities, they are not ‘investment companies’. Investment Uses: ETFs generally provide the easy diversification, low expense ratios, and tax efficiency of index funds, while still maintaining all the features of ordinary stock, such as limit orders, short selling, and options. Because ETFs can be economically acquired, held, and disposed of, some investors invest in ETF shares as a long-term investment for asset allocation purposes, while other investors trade ETF shares frequently to implement market timing investment strategies. € Advantages of ETFs ¥ ¥ ¥ ¥ ¥ Lower costs - ETFs generally have lower costs than other investment products because most ETFs are not actively managed and because ETFs are insulated from the costs of having to buy and sell securities to accommodate shareholder purchases and redemptions. ETFs typically have lower marketing, distribution and accounting expenses, and most ETFs do not have 12b-1 fees. Buying and selling flexibility - ETFs can be bought and sold at current market prices at any time during the trading day, unlike mutual funds and unit investment trusts, which can only be traded at the end of the trading day. As publicly traded securities, their shares can be purchased on margin and sold short, enabling the use of hedging strategies, and traded using stop orders and limit orders, which allow investors to specify the price points at which they are willing to trade. Tax efficiency - ETFs generally generate relatively low capital gains, because they typically have low turnover of their portfolio securities. While this is an advantage they share with other index funds, their tax efficiency is further enhanced because they do not have to sell securities to meet investor redemptions. Market exposure and diversification - ETFs provide an economical way to rebalance portfolio allocations and to ‘equitize’ cash by investing it quickly. An index ETF inherently provides diversification across an entire index. ETFs offer exposure to a diverse variety of markets, including broad-based indexes, broad-based international and countryspecific indexes, industry sector-specific indexes, bond indexes, and commodities. Transparency - ETFs, whether index funds or actively managed, have transparent portfolios and are priced at frequent intervals throughout the trading day. Some of these advantages derive from the status of most ETFs as index funds. Invest - 332 - Invest- 55 Assets That Grow Savings and Earn Passive Income € Types of ETFs Most ETFs are index funds, or Index ETFs, that that hold securities and attempt to replicate the performance of a stock market index. Commodity ETFs, or Exchange traded Commodities, ETCs, invest in commodities, such as precious metals and futures. Among the first commodity ETFs were gold exchange-traded funds, which have been offered in a number of countries. Exchange-traded commodities (ETCs) are investment vehicles (asset backed bonds, fully collateralised) that track the performance of an underlying commodity index including total return indices based on a single commodity. The third category is Bond ETFs, which invest in bonds. They thrive during economic recessions because investors pull their money out of the stock market and into bonds (for example, government treasury bonds or those issues by companies regarded as financially stable). Because of this cause and effect relationship, the performance of bond ETFs may be indicative of broader economic conditions. Then there are Currency ETF, also called ETCs, which are funds tracking major currencies. The funds are total return products where the investor gets access to the FX spot change, local institutional interest rates and a collateral yield. Issued Shares: The amount of common shares that a corporation has sold (issued). Issuer: Refers to the organization issuing or proposing to issue a security. Lock-up Period: The period of time that certain stockholders have agreed to waive their right to sell their shares of a public company. Investment banks that underwrite initial public offerings generally insist upon lockups for a set period of time, typically 180 days from large shareholders (such as 1% ownership or more) in order to allow an orderly market to develop in the shares. The shareholders that are subject to lockup usually include the management and directors of the company, strategic partners, and such large investors. These shareholders have typically invested prior to the IPO at a significantly lower price to that offered to the public and therefore stand to gain considerable profits. If a shareholder attempts to sell shares that are subject to lockup during the lockup period, the transfer agent will not permit the sale to be completed. NASDAQ: An automated information network which provides brokers and dealers with price quotations on securities traded over the counter. Net Asset Value (NAV): NAV is calculated by adding the value of all of the investments in the fund and dividing by the number of shares of the fund that are outstanding. NAV calculations are required for all mutual funds (or open-end funds) and closed-end funds. The price per share of a closed-end fund will trade at either a premium or a discount to the NAV of Invest - 333 - Invest- 55 Assets That Grow Savings and Earn Passive Income that fund, based on market demand. Closed-end funds generally trade at a discount to NAV. Invest - 334 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Sovereign Wealth Fund (SWF) Nature and purpose: SWFs are typically created when governments have budgetary surpluses and have little or no international debt. This excess liquidity is not always possible or desirable to hold as money or to channel into immediate consumption. Many central banks in recent years possess reserves massively in excess of needs for liquidity or foreign exchange management. State owned: A sovereign wealth fund (SWF) is a state-owned investment fund composed of financial assets such as stocks, bonds, property, precious metals or other financial instruments. Global reach: Sovereign wealth funds invest globally. Held by central bank or state agencies: Some sovereign wealth funds may be held by a central bank, which accumulates the funds in the course of its management of a nation's banking system; this type of fund is usually of major economic and fiscal importance. Other sovereign wealth funds are simply the state savings which are invested by various entities for the purposes of investment return, and which may not have a significant role in fiscal management. Long Term Returns: Sovereign wealth funds can be characterized as maximizing long term return, with foreign exchange reserves serving short term currency stabilization and liquidity management. There are two types of funds: saving funds and stabilization funds. ¥ Stabilization SWFs are created to reduce the volatility of government revenues, to counter the boom-bust cycles' adverse effect on government spending and the national economy. ¥ Savings SWFs build up savings for future generations. It is believed that SWFs in resource rich countries can help avoid resource curse. Net Financing Cost: Also called the cost of carry or, simply, carry, the difference between the cost of financing the purchase of an asset and the asset’s cash yield. Positive carry means that the yield earned is greater than the financing cost; negative carry means that the financing cost exceeds the yield earned. Net Income: The net earnings of a corporation after deducting all costs of selling, depreciation, interest expense, and taxes. Net Present Value: An approach used in capital budgeting where the present value of cash inflow is subtracted from the present value of cash outflows. NPV compares the value of a dollar today versus the value of that same dollar in the future after taking inflation and return into account. Invest - 335 - Invest- 55 Assets That Grow Savings and Earn Passive Income New Issue: A stock or bond offered to the public for the first time. New issues may be initial public offerings by previously private companies or additional stock or bond issues by companies already public. New public offerings are registered with the Securities and Exchange Commission. Newco: The typical label for any newly organized company, particularly in the context of a leveraged buyout. No Shop, No Solicitation Clauses: A no shop, no solicitation, or exclusivity, clause requires the company to negotiate exclusively with the investor, and not solicit an investment proposal from anyone else for a set period of time after the term sheet is signed. The key provision is the length of time set for the exclusivity period. Non accredited investor: An investor not considered accredited for a Regulation D offering. Offering Documents: Documents evidencing a private-placement transaction. Include some combination of a purchase agreement and/or subscription agreement, notes or stock certificates, warrants, registration-rights agreement, stockholder or investment agreement, investor questionnaire, and other documents required by the particular deal. Open-end Fund: An open-end fund, or a mutual fund, generally sells as many shares as investor demand requires. As money flows in, the fund grows. If money flows out of the fund, the number of the fund’s outstanding shares drops. Open-end funds are sometimes closed to new investors, but existing investors can still continue to invest money in the fund. In order to sell shares, an investor generally sells the shares back to the fund. If an investor wishes to buy additional shares in a mutual fund, the investor generally buys newly issued shares directly from the fund. Option Pool: The number of shares set aside for future issuance to employees of a private company. OTC: Over-the-Counter. A market for securities made up of dealers who may or may not be members of a formal securities exchange. The over-the-counter market is conducted over the telephone and is a negotiated market rather than an auction market such as the NYSE. Participating Preferred : A preferred stock in which the holder is entitled to the stated dividend and also to additional dividends on a specified basis upon payment of dividends to the common stockholders. Participating Preferred Stock: Preferred stock that has the right to share on a pro-rata basis with any distributions to the common stock upon liquidation, after already receiving the preferred-liquidation preference. Partnership: A nontaxable entity in which each partner shares in the profits, losses, and liabilities of the partnership. Each partner is responsible for the taxes on its share of profits and losses. Invest - 336 - Invest- 55 Assets That Grow Savings and Earn Passive Income Partnership Agreement: The contract that specifies the compensation and conditions governing the relationship between investors (LPs) and the venture capitalists (GPs) for the duration of a private equity fund’s life. Penny Stocks: Low-priced issues, often highly speculative, selling at less than $5/share. Piggyback Registration: A situation when a securities underwriter allows existing holdings of shares in a corporation to be sold in combination with an offering of new public shares. PIK Debt Securities: (Payment in Kind) PIK Debt are bonds that may pay bondholders compensation in a form other than cash. PIPE: [“Private Investment for Public Equity”] Private offering followed by a resale registration. PIV: Pooled Investment Vehicle. A legal entity that pools various investors’ capital and deploys it according to a specific investment strategy. Placement Agent : The investment bank, broker, or other person that locates investors to purchase securities from the Company in a private offering, in exchange for a commission. Poison Pill: A right issued by a corporation as a preventative to a takeover measure. It allows right holders to purchase shares in either their company or in the combined target and bidder entity at a substantial discount, usually 50%. This discount may make the takeover prohibitively expensive. Port folio Companies: Companies in which a given fund has invested. Promissory Note: [“Note”] Debt instrument in which the maker promises to pay the holder according to its terms. Prospectus: A formal written offer to sell securities that provides an investor with the necessary information to make an informed decision. A prospectus explains a proposed or existing business enterprise and must disclose any material risks and information according to the securities laws. A prospectus must be filed with the SEC and be given to all potential investors. Companies offering securities, mutual funds, and offerings of other investment companies including Business Development Companies are required to issue prospectuses describing their history, investment philosophy or objectives, risk factors, and financial statements. Investors should carefully read them prior to investing. Public Company: A company that has securities that have been sold in a registered offering and that are traded on a stock exchange. Must be a Reporting Company under SEC rules. Often used incorrectly to describe companies that are only Reporting Companies and that have not conducted a registered offering under Securities Act. Put option: The right to sell a security at a given price (or range) within a given time period. Invest - 337 - Invest- 55 Assets That Grow Savings and Earn Passive Income QPAM : Qualified professional asset manager. Reconfirmation: The act a broker/dealer makes with an investor to confirm a transaction. Red Herring: The common name for a preliminary prospectus, due to the red SEC required legend on the cover. (See also: Prospectus.) Redeemable Preferred Stock: Redeemable preferred stock, also known as exploding preferred, at the holder’s option after (typically) five years, which in turn gives the holders (potentially converting to creditors) leverage to induce the company to arrange a liquidity event. The threat of creditor status can move the founders off the dime if a liquidity event is not occurring with sufficient rapidity. ‫ق‬ Hedge Funds Hedge funds are pooled investment funds with loose, if any, regulation, unlike mutual funds. Availability: Hedge funds are typically open only to a limited range of professional or wealthy investors. This provides them with an exemption in many jurisdictions from regulations governing short selling, derivative contracts, leverage, fee structures and the liquidity of interests in the fund. Value: The net asset value of a hedge fund can run into many billions of dollars, and this will usually be multiplied by leverage. Hedge funds dominate certain specialty markets such as trading within derivatives with high-yield ratings and distressed debt. Management: Hedge funds are run and managed by hedge fund managers. They use a combination if investment strategies for trading purposes. Fees: A hedge fund manager will typically receive both a management fee and a performance fee (also known as an incentive fee) from the fund. A typical manager may charge fees of ‘2 and 20’, which refers to a management fee of 2% of the fund's net asset value each year and a performance fee of 20% of the fund's profit. Withdrawal/Redemption Fees: Some funds charge investors a redemption fee (or ‘withdrawal fee’ or ‘surrender charge’) if they withdraw money from the fund. A redemption fee is often charged only during a specified period of time (typically a year) following the date of investment, or only to withdrawals representing a specified portion of an investment. The purpose of the fee is to discourage short-term investment in the fund, thereby reducing turnover and allowing the use of more complex, illiquid or long-term strategies. The fee may also dissuade investors from withdrawing funds after periods of poor performance. Unlike management and performance fees, redemption fees are Invest - 338 - Invest- 55 Assets That Grow Savings and Earn Passive Income usually retained by the fund and therefore benefit the remaining investors rather than the manager. Strategies: Hedge funds employ many different trading strategies, which are classified in many different ways. Each strategy can be said to be built from a number of different elements: ¥ ¥ ¥ ¥ ¥ ¥ ¥ Style: global macro, directional, event-driven, relative value (arbitrage), managed futures (CTA) Market: equity, fixed income, commodity, currency Instrument: long/short, futures, options, swaps Exposure: directional, market neutral Sector: emerging market, technology, healthcare etc. Method: discretionary/qualitative (where the individual investments are selected by managers), systematic/quantitative (or ‘quant’ - where the investments are selected according to numerical methods using a computerized system) Diversification: multi-manager, multi-strategy, multi-fund, multi-market The most common label for a hedge fund is ‘long/short equity’, meaning that the fund takes both long and short positions in shares traded on public stock exchanges. Hedge Fund Structure: A hedge fund is a vehicle for holding and investing the money of its investors. The most common service providers are: ¥ Prime broker – prime brokerage services include lending money, acting as counterparty to derivative contracts, lending securities for the purpose of short selling, trade execution, clearing and settlement. Many prime brokers also provide custody services. Prime brokers are typically parts of large investment banks. ¥ Administrator – the administrator typically deals with the issue and redemption of interests and shares, calculates the net asset value of the fund, and performs related back office functions. ¥ Distributor - the distributor is responsible for marketing the fund to potential investors. Frequently, this role is taken by the investment manager. $ Benefits Low Correlation - Hedge funds are typically lowly correlated or non-correlated with stocks and bonds. Adding a non-correlated asset class to a portfolio could improve its risk-adjusted performance. This aid to diversification is the most recognized feature of hedge funds. Expertise - Hedge fund managers may have disproportional advantages to market research and or data. His/her management in the fund may yield unusually high returns compared to other asset classes. Invest - 339 - Invest- 55 Assets That Grow Savings and Earn Passive Income Absolute Returns - Many hedge funds offer products that yield absolute returns, guaranteeing a certain return per year. This may be essential enhancements to many complex portfolios. ‫ق‬ ‫ق‬ ‫ق‬ ‫ق‬ ‫ق‬ Leverage amplifies profits as well as losses; Short selling opens up new investment opportunities; Riskier investments typically provide higher returns; Secrecy helps to prevent imitation by competitors; and Being unregulated reduces costs and allows the investment manager more freedom to make decisions on a purely commercial basis. $ Risks Leverage - in addition to money invested into the fund by investors, a hedge fund will typically borrow money, with certain funds borrowing sums many times greater than the initial investment. If a hedge fund has borrowed $9 for every $1 received from investors, a loss of only 10% of the value of the investments of the hedge fund will wipe out 100% of the value of the investor's stake in the fund, once the creditors have called in their loans. Short selling - due to the nature of short selling, the losses that can be incurred on a losing bet are theoretically limitless, unless the short position directly hedges a corresponding long position. Therefore, where a hedge fund uses short selling as an investment strategy rather than as a hedging strategy it can suffer very high losses if the market turns against it. Appetite for risk - hedge funds are culturally more likely than other types of funds to take on underlying investments that carry high degrees of risk, such as high yield bonds, distressed securities and collateralized debt obligations based on sub-prime mortgages. Lack of transparency - hedge funds are secretive entities with few public disclosure requirements. It can therefore be difficult for an investor to assess trading strategies, diversification of the portfolio and other factors relevant to an investment decision. Short volatility - certain hedge fund strategies involve writing out of the money call or put options. If these expire in the money the fund may take large losses. Conflict of Interest - Inherent within the concept of paying a performance fee is the notion that an investment advisor may construct a portfolio of higher risk than would otherwise be taken, in hopes of increasing return and therefore performance fees. Invest - 340 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Unit Investment Trust Funds (UITF) $ Definition A Unit Investment Trust (UIT) is an investment company that offers a fixed, unmanaged portfolio, generally of stocks and bonds, as redeemable ‘units’ to investors for a specific period of time. It is designed to provide capital appreciation and/or dividend income. $ Characteristics Trusts: Unit trust is constituted under a trust deed. UITs are assembled by a sponsor and sold through brokers to investors. Open-Ended: Unit trusts are open-ended investments; therefore the underlying value of the assets is always directly represented by the total number of units issued multiplied by the unit price less the transaction or management fee charged and any other associated costs. Specific period: Unlike a mutual fund, a UIT is created for a specific length of time and is a fixed portfolio, meaning that the UIT is securities will not be sold or new ones bought, except in certain limited situations (for instance, when a company is filing for bankruptcy or the sale is required due to a merger). Constitution: A UIT may be constituted as either a regulated investment company (RIC) or a grantor trust. A RIC is a trust, corporation or partnership in which investors have common investment and voting rights but do not have direct interest in investments of the Investment Company or fund. A grantor trust, in contrast, grants investors proportional ownership in the underlying securities. Tax: From a tax perspective, UIT is offer a shelter from the unrealized capital gains taxes typical inside of a mutual fund. Cost: Because individual UIT is are assembled and purchased for specific periods of time, the cost basis consists of the initial purchase price of the securities held in the trust. A mutual fund on the other hand, taxes the individual based on the entire previous tax year regardless of the date purchased. A UIT avoids this potential tax consequence by assembling an entirely new ‘fund’ for each individual investor. $ Structure ¥ ¥ ¥ ¥ ¥ The fund manager runs the trust for profit. The trustees ensure the fund manager keeps to the fund's investment objective and safeguards the trust assets. The unitholders have the rights to the trust assets. The distributors allow the unitholders to transact in the fund manager's unit trusts The registrars are usually engaged by the fund manager and generally acts as a middleman between the fund manager and various other stakeholders. Invest - 341 - Invest- 55 Assets That Grow Savings and Earn Passive Income Bid–Offer Spread: The trust manager makes a profit in the difference between the purchase price of the unit or offer price and the sale value of units or the bid price. This difference is known as the bid–offer spread. The bid–offer spread will vary depending on the type of assets held and can be anything from a few basis points on very liquid assets like government bonds, to 5% or more on assets that are harder to buy and sell such as property. Management charge: To cover the cost of running the investment portfolio the manager will collect an Annual Management Charge or AMC. Typically this is 1-2% of the market value of the fund. In addition to the annual management charge, costs incurred in managing and dealing the underlying assets will often be born by the trust. Regulation: A UIT may be either a regulated investment corporation (RIC) or a grantor trust. The former is a corporation in which the investors are joint owners; the latter grants investors’ proportional ownership in the UIT is underlying securities. $ Advantages £ UITs are very well diversified. £ Steady and predictable income stream makes bond UITs very popular with retirees looking for supplements to their income. £ UITs are fairly low-risk investments, but stock UITs depend heavily on the performance of the stock market, and in a stock trust there is no certainty of return like there is in a bond trust. $ Disadvantages £ Because the interest payments on a UIT are fixed, holding a UIT for a long time could undermine performance. £ UIT can sometimes be difficult to sell quickly. £ Because the interest on the UIT is fixed for the life of the security, it is more susceptible to inflation. $ Types of UITs A UIT portfolio may contain one of several different types of securities. The two main types are stock (equity) trusts and bond (fixed income) trusts. Stock Trusts: Stock trusts are generally designed to provide capital appreciation and/or dividend income. They usually issue as many units (shares) as necessary for a set period of time before their primary offering period closes. Equity trusts have a set termination date, on which the trust liquidates and distributes its net asset value as proceeds to the unitholders. (The unitholders may then have special options for the reinvestment of this principal.) Invest - 342 - Invest- 55 Assets That Grow Savings and Earn Passive Income Bond Trusts: Bond trusts issue a set number of units, and when they are all sold to investors, the trust's primary offering period is closed. Bond trusts pay monthly income, often in relatively consistent amounts, until the first bond in the trust is called or matures. When this occurs, the funds from the redemption are distributed to the clients via a pro rata return of principal. The trust then continues paying the new monthly income amount until the next bond is redeemed. This continues until all the bonds have been liquidated out of the trust. Bond trusts are generally appropriate for clients seeking current income and stability of principal. Split Capital Investment Trusts: ‘Traditional’ investment trusts normally issue only one type of share (ordinary shares) and have a limited life. Split Capital Investment Trusts (Splits) have a more complicated structure. Splits issue different classes of share to give the investor a choice of shares to match their needs. Most Splits have a limited life determined at launch known as the wind-up date. Typically the life of a Split Capital Trust is five to ten years. Every Split Capital Trust will have at least two classes of share. The type of share invested in is ranked in a predetermined order of priority, which becomes important when the trust reaches its wind-up date. If the Split has acquired any debt, debentures or loan stock, then this is paid out first, before any shareholders. Next in line to be repaid are Zero Dividend Preference shares, followed by any Income shares and then Capital. Although this order of priority is the most common way shares are paid out at the windup date, it may alter slightly from trust to trust. ‫ق‬ How to Invest I will usually pay a sales fee when purchasing the UIT - therefore, UITs do not make good short-term investments. Units can be bought direct from the fund manager, held through a nominee account or through a PEP (Personal Equity Plan) or ISA (Individual Savings Account). UITs can be resold in the secondary market. Most UITs usually cannot be purchased through traditional brokers. Instead, they can be bought through some insurance companies or financial advisors/planners and brokers in the secondary market. UITs are assembled by a sponsor and sold through brokers to investors. A UIT portfolio may contain one of several different types of securities. Invest - 343 - Invest- 55 Assets That Grow Savings and Earn Passive Income ‫ق‬ Real Estate Investment Trusts (REITs) $ Definition If I want to invest in the real estate sector, but I either already have a house or do not have enough money to buy one right now, the answer is Real Estate Investment Trusts (REITs) around that pools money from common investors together and buy properties. $ Characteristics Assets: Real Estate Investment Trusts (REITs) invest in real estate: incomeproducing properties and/or mortgage-backed securities. The REIT structure was designed to provide a similar structure for investment in real estate as mutual funds provide for investment in stocks. Distribution: REITs are required to distribute 90% of their income, which may be taxable, into the hands of the investors. This avoids the double taxation which would otherwise arise when shareholders sell their shares in the investment trust and are taxed on their gains. Restrictions: Further, REITs must not hold more than 15% of its investments in any single company (except another investment trust); must not be empowered to distribute capital gains as dividends to shareholders, and must not be a close company. Statistics: The key statistics to look at in a REIT are its NAV (Net asset value), AFFO (Adjusted Funds From Operations) and CAD (Cash Available for Distribution). REITs face challenges from both a slowing economy and the global financial crisis, depressing share values by 40- 70% percent in some cases. High yields/high liquidity: REITs typically offer investors high yields as well as a highly liquid method of investing in real estate. Even better, as REITs acquire more property and increase the value of the properties they own, the value of the equity increases as well, providing a nice total return. Public or private: Like other corporations, REITs can be publicly or privately held. Public REITs may be listed on public stock exchanges like shares of common stock in other firms. Performance based on value of assets: The performance of a REIT is determined by the value of its real estate assets. This is one major advantage to a REIT - its performance is not correlated to other financial assets such as stocks and bonds. As a result, REITs are usually less volatile and provide some degree of inflation protection. $ Types of REITs There is a wide variety of REITs, but I can break it down into three main categories: Invest - 344 - Invest- 55 Assets That Grow Savings and Earn Passive Income £ £ £ Equity REITs - Equity REITs invest in and own properties (thus responsible for the equity or value of their real estate assets). Their revenues come principally from their properties' rents. Mortgage REITs - Mortgage REITs deal in investment and ownership of property mortgages. These REITs loan money for mortgages to owners of real estate, or invest in (purchase) existing mortgages or mortgagebacked securities. Their revenues are generated primarily by the interest they earn on the mortgage loans. Mortgage REITs tend to do poorly as interest rates rise. Hybrid REITs - Hybrid REITs combine the investment strategies of equity REITs and mortgage REITs by investing in both properties and mortgages. $ Advantages £ £ Dividends are higher than those of common stocks. The performance of an REIT follows the real estate market more closely than it follows the stock market. $ £ Disadvantages Dividends are taxed at the same rate as income, so the higher dividends mean I will likely pay more taxes. $ How to Invest REITs sell like stocks on the major exchanges. Therefore, they can usually be bought through a brokerage, either full service or discount. Commissions to buy REITs are usually the same as common stock fees. There is no minimum investment for most REITs, although I may need to buy the shares in even blocks of 10 or 100. Also, many brokerages require clients to have at least $500 to open an account and trade stocks or REITs. ‫ق‬ Income Trust $ Definition An income trust is an investment that may hold equities, debt instruments, royalty interests or real properties. The trust can receive interest, royalty or lease payments from an operating entity carrying on a business, as well as dividends and a return of capital. The main attraction of income trusts (in addition to certain tax preferences for some investors) is their stated goal of paying out consistent cash flows for investors, which is especially attractive when cash yields on bonds are low. $ Characteristics Pre-determined business: Many investors are attracted by the fact that income trusts are not allowed to make forays into unrelated businesses: if a trust is in the oil and gas business it cannot buy casinos or motion picture studios. Invest - 345 - Invest- 55 Assets That Grow Savings and Earn Passive Income Valuation: A Trust Unit with high Return of Capital distributions will often attract a higher market value because the Return of Capital portion of the distribution is tax deferred until the unit is sold. Lack of income guarantees: Similar to a dividend paying stock, income trusts do not guarantee minimum distributions or even return of capital. If the business starts to lose money, the trust can reduce or even eliminate distributions; this is usually accompanied by sharp losses in units' market value. Exposure to interest rate risk: Since the yield is one of the main attractions of income trusts, there is the risk that trust units will decline in value if interest rates in the rest of the cash/treasury market increase. This risk is common to other dividend/income based investments such as bonds. Tax characteristics: In a typical income trust structure, the income paid to an income trust by the operating entity may take the form of interest, royalty or lease payments, which are normally deductible in computing the operating entity’s income for tax purposes. These deductions can reduce the operating entity’s tax to nil. The trust in turn, ‘flows’ all of its income received from the operating entity out to unitholders. The distributions paid or payable to unitholders reduces a trust's taxable income, so the net result is that a trust would also pay little to no income tax. The net effect is that the interest, royalty or lease payments are taxed at the unitholder level. ¥ As a flow-through entity (FTE) whose income is redirected to unitholders, the trust structure avoids any possible double taxation that comes from combining corporate income tax with shareholders' dividend tax. ¥ Where there is no double taxation, there can be the advantage of deferring the payment of tax. When the distributions are received by a non-taxed entity (like a pension fund), all the tax due on corporate earnings is deferred until the eventual receipt of pension income by participants of the pension fund. ¥ Where the distributions are received by foreigners, the tax applied to the distributions may be at a lower rate determined by treaty that had not considered the forfeiture of tax at the corporate level. ¥ The effective tax an income trust owner could pay on earnings could actually be increased because trusts typically distribute all of their cashflow as distributions, rather than employing leverage and other tax management techniques to reduce effective corporate tax rates. Certain investors, particularly those in the highest tax brackets, could be significantly worse off investing in income trusts compared to traditionally structured corporations. While the benefits of trusts for taxdeferred and tax exempt entities are clear, trusts are clearly less attractive for other investors facing high marginal rates. Invest - 346 - Invest- 55 Assets That Grow Savings and Earn Passive Income $ Types of Income Trusts There are four primary types of income trusts: Investment Trusts: Investment trusts (aka ‘mutual funds‘) are trusts established for communal investment in securities, encapsulated under the umbrella of a flow-through entity and typically managed by a 'fund sponsor', usually an investment firm, asset management firm, or investment bank. These trusts invest in a variety of investments including stocks, bonds, futures, etc., and are often marketed to the public directly when authorization has been received from provincial securities regulators to do so. Some investment trusts have been specially structured with leverage in order to amplify cash yields paid to investors, while others deplete their assets to pay distributions to investors on a regular basis. Royalty/Energy Trusts: A royalty trust, ‘resource trust’ or ‘energy trust’, is a type of corporation, usually involved in oil and gas production or mining. An outside company must perform the actual operation of the oil or gas field, or mine, and the trust itself, may have no employees. Shares of the trust generally trade on the public stock markets, but the trust itself is typically overseen by a trust officer in a bank. However, unlike most corporations, its profits are not taxed at the corporate level provided a certain high percentage (e.g. 90%) of profits are distributed to shareholders as dividends. The dividends are then taxed as personal income. This system, similar to real estate investment trusts, effectively avoids the double taxation of corporate income. The amount of distributions paid will vary from time to time based on production levels, commodity prices, royalty rates, costs and expenses, and deductions. They are a powerful investment tool for people who wish to invest directly in extraction of petroleum or mining of other materials, but who do not have the resources or risk-tolerance to buy their own well or mine. Also, since commodities are considered a hedge against inflation, the popularity of royalty trusts as investments rises as interest rates fall, and their shares often rise as a result. In addition, royalty trusts allow investors to speculate directly on commodities such as gas, oil, or iron ore without having to buy futures contracts, or use the other investment vehicles traditionally associated with commodities – since the trusts trade like stocks. Business Trusts: Business income trusts are individual companies that have converted some or all of their stock equity into an income trust capital structure for tax reasons. Business income trusts are used in many sectors, such as manufacturing, food distribution, and power generation and distribution. They are not investment trusts in the classic sense, since they represent a single company's assets and not a pool of investments. Invest - 347 - Invest- 55 Assets That Grow Savings and Earn Passive Income Registered Offering: [“Public Offering”] A transaction in which a Company sells specified securities to the public under a Registration Statement which has been declared effective by the SEC. Registration : The SEC’s review process of all securities intended to be sold to the public. The SEC requires that a registration statement be filed in conjunction with any public securities offering. This document includes operational and financial information about the company, the management, and the purpose of the offering. The registration statement and the prospectus are often referred to interchangeably. Technically, the SEC does not “approve” the disclosures in prospectuses. Registration Obligation: The obligation of Company to register the shares issued to an investor in a private offering for resale to the public through a Registration Statement which the SEC has declared effective. Registration Rights: The right to require that a company register restricted shares. Demand Registered Rights enable the shareholder to request registration at any time, while Piggy Back Registration Rights enable the shareholder to request that the company register his or her shares when the company files a registration statement (for a public offering with the SEC). Registration Rights Agreement: Separate agreement in which the investor’s registration rights are evidenced. Registration Statement: The document filed by a Company with the SEC under the Securities Act in order to obtain approval to sell the securities described in the Registration Statement to the public. Reporting Company : A company that is registered with the SEC under the Exchange Act. Resale Registration : Registration by a Company of the investor’s sale of the shares purchased by the investor in a private offering. Restricted Securities: Public securities that are not freely tradable due to SEC regulations. (See also: Securities and Exchange Commission.) Restricted Shares: Shares acquired in a private placement are considered restricted shares and may not be sold in a public offering absent registration or after an appropriate holding period has expired. Nonaffiliates must wait one year after purchasing the shares, after which time they may sell less than 1% of their outstanding shares each quarter. For affiliates, there is a two-year holding period. Invest - 348 - Invest- 55 Assets That Grow Savings and Earn Passive Income Appendix ¥ Investment Curriculum INTRODUCTION TO INVESTING ¥ What Is Investing? ¥ Why Bother Investing? ¥ The Two Types of Investors ¥ The Ojijo 3 Investment Vehicles ¥ The Ojijo 9 (The Nine Fundamental Principles of Investing) CLASS 1 VEHICLES: PERSONAL DEVELOPMENT THE SCOPE OF PERSONAL DEVELOPMENT CLASS 2 INVESTMENT VEHICLES: FINANCIAL INSTRUMENTS INTRODUCTION TO FINANCIAL INSTRUMENTS & INVESTMENTS ¥ What Is A Financial Instrument? ¥ What is Financial Investment? ¥ Professional Players (Individuals & Firms) FINANCIAL INVESTMENT PRODUCTS CASH ¥ Bank Deposit Accounts ¥ Money Market Account STOCKS ¥ Preferred Stock ¥ Common Stock BONDS ¥ Municipal Bonds ¥ Corporate Bond ¥ Foreign Currency Bonds ¥ Government Bonds/Treasuries ¥ Assets Backed Securities & Mortgage-Backed Securities ABS/MBS ¥ Money Market/Cash Market Instruments DERIVATIVES ¥ Futures/Forwards ¥ Options ¥ Swaps CLASS 3 VEHICLES: ALTERNATIVE INVESTMENT VEHICLES ¥ Disadvantages ¥ Advantages Invest - 349 - Invest- 55 Assets That Grow Savings and Earn Passive Income 1.PROPERTY & REAL ESTATE INVESTMENT INTRODUCTION TO REAL ESTATE ¥ Property vis-a-vis Real Estate ¥ Non-Real Estate Investment ¥ Real Estate Investment (Income-Producing and Non-Income-Producing Investments) ¥ Real Estate Markets REAL ESTATE INVESTMENT PRODUCTS ¥ Real Estate Investment Groups ¥ Rental ¥ Real Estate Trading ¥ Real Estate Investment Trusts (REITs) 2.INSURANCE INVESTMENT INTRODUCTION TO INSURANCE ¥ What is Insurance? ¥ What is Insurance Investment? ¥ Insurance Markets ¥ How to Invest in Insurance INSURANCE INVESTMENT PRODUCTS ¥ Insurance Bond/Investment Bond ¥ Endowment Plans ¥ Unit Linked Insurance Plan (ULIP) ¥ Child Education Plan ¥ Value Added Term (VAT) Assurance ¥ Personal Pension Plan ¥ Annuity ¥ Value Added Mortgage (VAM) Protection Assurance ¥ Investment-Linked Insurance Plan /Life Insurance Investing 3.FOREX INVESTMENT INTRODUCTION TO FOREX ¥ What is Forex? ¥ What is Forex Investment? ¥ Why Forex Investing ¥ Forex Markets ¥ Forex Trading: How Forex Works! FOREX INVESTMENT PRODUCTS ¥ Physical Delivery ¥ Stocks ¥ Currency Funds, ETFs & ETCs ¥ Currency Futures 4.COMMODITY INVESTMENT INTRODUCTION TO COMMODITY ¥ What Is A Commodity? ¥ What Is Commodity Investment? ¥ Why Invest In Commodities? ¥ How to Invest In Commodities! (From Farm to Fork) ¥ Commodity Markets Invest - 350 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Trading in Commodities COMMODITY INVESTMENT PRODUCTS HARD COMMODITIES (INDUSTRIAL/BASE, RARE EARTH & PRECIOUS METALS) ¥ Industrial/Base Metals (Copper, Nickel, Aluminum, Zinc, Lead, & Iron/Steel) ¥ Rare-Earth Metals (Lanthanum, Cerium, Praseodymium, etc) ¥ Precious Metals (gold, diamond, silver, platinum, & palladium) ¥ Gold ¥ Silver ¥ Platinum (, ruthenium, rhodium, palladium, neodymium, iridium & osmium) ¥ Diamonds MEDIUM COMMODITIES (ENERGY & WATER) ¥ Electricity ¥ Coal ¥ Nuclear Energy ¥ Water ¥ Green (Renewable) Energy ¥ Oil & Gas SOFT COMMODITIES (PLANT & LIVESTOCK) ¥ Introduction to Soft Commodities Investing ¥ Physical Exposure ¥ Commodity-Intensive Stocks ¥ Investment Funds/Trusts ¥ Futures Contracts 5.PRIVATE EQUITY INTRODUCTION TO PRIVATE EQUITY ¥ What is private equity? ¥ What Is Private Equity Investment? ¥ How They Work! ¥ Why Invest in Private Equity PRIVATE EQUITY INVESTMENT PRODUCTS ¥ Private Equity Fund ¥ Business Angels ¥ Venture Capital ¥ Leveraged Buy Out ¥ Reverse Takeover or Reverse Merger 6.COLLECTORS ITEMS INTRODUCTION TO COLLECTIBLES ¥ What Is Collectibles? ¥ How to Invest In Collectibles COLLECTIBLES INVESTMENT PRODUCTS ¥ Art and Photography ¥ Books and Manuscripts 7.COLLECTIVE INVESTMENT SCHEMES (TRUSTS, FUNDS & CLUBS) Invest - 351 - Invest- 55 Assets That Grow Savings and Earn Passive Income INTRODUCTION TO COLLECTIVE INVESTMENT SCHEMES (CISS) ¥ What is Collective Investment Scheme ¥ Why Collective Investment Scheme TYPES OF COLLECTIVE INVESTMENT SCHEMES ¥ Self-Directed Collective Investment Schemes ( Investment Clubs) ¥ Professionally Managed Investment Schemes/Investment Companies ¥ Closed-End Investment Funds ¥ Open-End Funds (Mutual Funds) EAST AFRICAN FINANCIAL MARKETS: AN OVERVIEW THE EAST AFRICAN COMMUNITY (EAC) EA FINANCIAL MARKET ¥ Regulators ¥ Markets ¥ Licensed Firms ¥ Listed Companies ¥ Trading ¥ Stock Market Indices in East Africa ELEMENTARY ECONOMICS THEORIES & INSTITUTIONS ¥ Introduction to Economics ¥ Economic Development ¥ Monetary/Financial Institutions ¥ International Trade ¥ Economic Theories ¥ Competition & Market Structures ¥ Economic Systems Invest - 352 - Invest- 55 Assets That Grow Savings and Earn Passive Income ¥ Index of Investment Terms 401(K) Plan, - 96 A M T, - 96 Accelerated Cost Recovery System, 96 Accredited Investor, - 96 Accrued (Final or Terminal) Bonuses, 182 ACCRUED INTEREST, - 115 Acquisition, - 276 ACRS, - 96 Add On CDs, - 118 Administrator, - 334 Advisory Board, - 96 ALL OR NONE (AON), - 45 Allocation, - 96 Alternative Assets, - 26 Alternative Minimum Tax., - 96 amortising swap, - 139 Amortization, - 96 Angel Financing, - 273 Angel groups, - 269 Angel Investing, - 273 Angels Fund, - 268 Annual (Reversionary) Bonuses, - 182 Annual Percentage Rate (APR), - 116 Annual Percentage Yield (APY), - 116 Annuity, - 191 Anticipated Endowment Assurance, 182 Appraisers, - 165 APPRECIATION, - 62 ASKED PRICE, - 45 Asset-Backed Securities (ABS), - 108 Assets Backed Securities, - 107 Assets Under Management, - 273 back up to the initial margin level of $1,000., - 126 Back-End Loads, - 312 Balance Sheet, - 96 Balanced Funds, - 325 Bank Deposit Accounts, - 58 Bankers Acceptance, - 120 - Bankruptcy:, - 96 Bear Hug, - 96 BEAR MARKET, - 64 Best Efforts, - 96 BID PRICE, - 45 BLUE CHIP:, - 63 Blue Sky Laws, - 96 BOND, - 40 Bond Markets, - 40 bond yields:, - 78 Bonds, - 76 Book Value, - 97 Borrowers, - 36 Bridge Financing, - 282 Broker Dealers, - 55 Brokerage commission, - 42 Brokered CDs, - 117 Brokers (Licensed Dealing Members (LDMs)), - 55 Budget, - 12 Budget Plan, - 11 BULL MARKET, - 64 Bump Up CDs, - 117 Burn Out, - 282 Burn Rate, - 283 Business Judgment Rule, - 283 Business Plan, - 273 Business Valuation, - 264 CAGR, - 283 Call Option, - 283 Callable CDs, - 117 CANCEL:, - 45 CAPITAL GAIN:, - 46 Capital Gains, - 283 Capital Markets, - 37 Capital Under Management, - 273 Capitalization Table, - 283 Capitalize, - 283 Carried Interest, - 273 Carry, - 273 Cash Flow and Liability Management, - 54 Cash instruments, - 29 Cash Market, - 50 Invest - 353 - Invest- 55 Assets That Grow Savings and Earn Passive Income Cash Market Instruments, - 110 Cash Position, - 302 CDS fees:, - 43 Certificate of Deposit (CD), - 115 Chapter 11, - 302 Chapter 7, - 302 Child Education Plan, - 183 Claim Dilution, - 302 Clawback, - 302 CLEARING AND SETTLEMENT, - 38 Closed-End Investment Funds, - 308 Closing, - 303 Co - investment, - 303 Collar Agreement, - 303 Collectibles, - 27 -, - 284 Collectibles Investment Products, 292 Collective Investment Scheme, - 300 Collective Investment Scheme (CIS), 26 Collective Investment Schemes, - 305 Commercial Mortgage-Backed Security (CMBS), - 157 Commercial Paper, - 119 Commercial Property, - 154 Committed Capital, - 61 Commodities, - 27 Commodities ETFs, - 210 Commodity, - 203 Commodity Derivatives, - 47 Commodity Investment, - 205 Commodity Investment Products, 221 Commodity Markets, - 212 Commodity Mutual Funds, - 211 Commodity Stocks, - 211 Commodity Trading, - 215 Common Stock, - 61 -, - 72 Compound Annual Growth Rate., 283 Compounding, - 23 Conversion Ratio, - 61 Convertible Bonds, - 87 Convertible Debenture:, - 60 Convertible Note, - 60 - Convertible preferreds, - 69 Convertible Security, - 61 Corporate Bond, - 84 Corporate bond rating:, - 84 Corporate Charter, - 303 Corporate Resolution, - 303 Corporate Venturing, - 273 Corporation, - 303 COST BASIS:, - 46 COUNTERPARTY DEFAULT, - 131 Coupon rate, - 77 Covenant, - 303 Cram Dow, - 282 Credit default swaps, - 138 Credit Derivatives, - 47 CREDIT QUALITY:, - 87 CREDIT RISK, - 79 Cumulative preferred stock, - 70 Cumulative Preferred Stock, - 60 Cumulative Voting Rights, - 60 Currency Funds, ETFs & ETCs, - 201 Currency Futures, - 201 Currency Stocks, - 201 Current Account, - 58 DAY ORDER, - 45 dealer options’, - 135 Dealers, - 55 Debenture, - 60 Debt, - 60 Debt Instrument, - 60 Deferred Annuity, - 192 Deficiency Letter, - 303 Demand Registration:, - 303 Demand Rights, - 303 Depreciation, - 303 DERIVATIVE, - 47 Derivative instruments, - 29 Derivatives, - 121 Derivatives Market, - 46 Derivatives, CFDs and spread betting, - 232 Dilution, - 303 Dilution Protection, - 266 Direct deposit CDs, - 117 Director, - 303 Disclosure Document:, - 305 Invest - 354 - Invest- 55 Assets That Grow Savings and Earn Passive Income Distressed Investments?, - 275 Distributor, - 334 Diversification, - 305 Dividend, - 60 Dividend Reinvestment, - 24 DO NOT REDUCE (DNR), - 45 Dollar Cost Averaging, - 17 Drag-Along Rights, - 305 Due Diligence, - 306 Early Stage, - 306 Earnings Before Interest, Taxes, Depreciation, and Amortization, 306 EBITDA, - 306 Economies of Scale:, - 306 Education Planning, - 54 eighted Ave rage Antidilution, 266 Electronic Bookkeeping, - 105 Elevator Pitch, - 306 Employee Stock Option Plan, - 306 Employee Stock Ownership Plan, 306 Endowment Plans, - 181 Equity, - 306 Equity Derivatives, - 47 Equity Funds (Stocks), - 317 Equity Kicker, - 306 Equity Swap, - 138 ERISA, - 310 ESOP, - 306 EUROBOND, - 49 Eurobond Market, - 49 Eurobonds, - 91 Eurodollars, - 112 Exchange Levy, - 42 Exchangeable preferred stock, - 70 Exchange-Traded Derivatives Markets, - 48 Exchange-Traded Funds (ETF), - 327 Execution of orders, - 218 Exercise price, - 310 Exit Strategy, - 310 expense ratio, - 314 EXPIRATION DATE:, - 121 - Extendible Bonds, - 89 Fidelity fees, - 43 FILL OR KILL (FOK), - 45 Financial Instrument, - 29 Financial Instruments, - 26 Financial investment, - 31 Financial Markets, - 33 -, - 34 Financial Planner, - 53 Finder, - 310 Fixed Annuity, - 192 Fixed Assets, - 26 Fixed Property, - 144 Fixed-Income’ Securities, - 76 Flipping, - 310 Foreign Currency Bonds, - 93 Foreign Exchange Derivatives, - 47 Forex Investment, - 195 Forex Investments, - 27 Forex Markets, - 198 Forex Trading, - 199 Forex Trading Plan, - 199 Forex?, - 195 Forward contracts, - 218 Founders’ Share, - 60 Free cash flow, - 310 Front-End Loads, - 312 Full Ratchet Antidilution, - 310 Fully Diluted Earnings Per Share, - 310 Fully Diluted Outstanding Shares, - 321 fund managers, - 56 Fund Size, - 273 FUNDAMENTAL ANALYSIS, - 31 Fundamental Analysis (forex), - 196 Funds of Funds (FoF), - 326 Futures contracts, - 218 Futures/Forwards, - 123 GAAP, - 321 Gambling, - 2 General obligation bonds:, - 83 General Partner (GP), - 272 Generally Accepted Accounting Principles, - 321 Goal Setting, - 54 Going Long, - 128 Going Short, - 128 Invest - 355 - Invest- 55 Assets That Grow Savings and Earn Passive Income Gold Accounts, - 232 Gold Bars, - 230 Gold Certificates, - 232 Gold Coins, - 231 Gold Exchange-Traded Products (ETPs), - 231 Golden Handcuffs, - 321 Golden Parachute, - 321 GOOD DELIVERY, - 45 GOOD 'TIL CANCELED (GTC), - 45 Government Bonds, - 98 Guaranteed Investment Contracts, 113 Hard Commodities (Base, Rare Earth & Precious Metals), - 221 Hedge Funds, - 333 Hedgers, - 124 Holding Company, - 325 Holding Period, - 325 HOLDOUT PROBLEM, - 100 Hot Issue, - 325 How to Buy Securities, - 43 How to Sell Securities, - 44 Hurdle Rate, - 325 Hybrid Annuity, - 193 \i, - 23 Income Annuity, - 193 Income Funds (Bonds), - 322 Income Trust, - 340 Income-Producing Properties, - 145 Index Fund, - 318 INDEX OPTIONS, - 135 Individual Savings Accounts (ISAs), 59 Industrial Property, - 155 Industrial/Base Metals (Copper, Aluminium, Zinc, Lead, & Iron/Steel), - 223 Inflation-Linked Bonds, - 91 Initial Public Offer (IPO, - 41 Initial Public Offering (IPO):, - 274 Institutional Investors, - 325 Insurance, - 168 Insurance Assets, - 27 Insurance Bond, - 172 Insurance Investment, - 168 Insurance Market Regulators, - 168 - Insurance Markets, - 168 intangible assets, - 144 Intellectual Property, - 144 Interest Rate Derivatives, - 47 INTEREST RATE RISK, - 79 Interest rate swaps, - 138 Intermediaries, - 36 Internal Rate of Return, - 325 Investing, - 1 Investment Accounts, - 60 Investment Advisors, - 53 Investment banks, - 55 Investment Bond, - 172 Investment Companies, - 56 -, - 307 Investment Letter:, - 325 Investment Planning, - 54 Investment policies, - 174 Investment Strategies, - 66 Investor Accreditation, - 244 IPO, - 274 IRA Rollover, - 325 IRR, - 325 Issued Shares, - 329 Key Employees, - 272 Knowledge-Based Investing, - 21 Land Use Regulation, - 159 Land Zoning, - 159 Later Stage, - 273 Lead Investor, - 273 Lenders, - 35 Level-load fund, - 312 Leveraged buy out, - 275 Leveraging, - 9 Licensed Firms, - 55 Life Annuity, - 194 LIMIT ORDER:, - 44 Limited Partner (LP):, - 273 Limited Partnerships, - 273 Limited Pay Whole Life, - 175 Liquid CDs, - 117 LIQUIDITY, - 80 Liquidity Event, - 272 LOAD, - 312 Loaners, - 6 Lock-up Period, - 329 Long Term Investing, - 13 Low Correlation, - 287 Invest - 356 - Invest- 55 Assets That Grow Savings and Earn Passive Income LP, - 273 Management Team, - 272 Margins, - 125 Marked-To-Market, - 201 Market Capitalization, - 266 MARKET ORDER:, - 44 Market Participants, - 165 Mark-ups, - 286 maturity date, - 78 Merger, - 277 Merger and Acquisition, - 276 Mezzanine Financing, - 274 Mining Companies/Gold Stocks, 232 money maanger,, - 56 Money Market Account, - 60 Money Market Deposit Account (MMDA), - 60 Money Market Funds, - 323 Money Market Investment, - 110 Money Markets, - 39 Monthly income preferred stock, - 70 Mortgage Backed Securities ABS/MBS, - 107 Movable Property, - 144 Municipal Bonds, - 82 Munis, - 82 Mutual fund fees, - 313 NASDAQ, - 329 Net Asset Value (NAV), - 300 -, - 329 Net Financing Cost, - 330 Net income, - 330 New Issue, - 331 Newco, - 331 No Shop, No Solicitation Clauses, 331 No-Load Annuity, - 193 No-Load Fund, - 312 Non accredited, - 331 Non-Callable, - 105 Non-cumulative preferred stock, - 70 Non-Income-Producing Properties, 145 Non-Real Estate Property Investments, - 144 Offering Documents, - 331 Oil & Gas Investment Fraud, - 244 - Oil & Gas Royalties, - 244 Oil Partnerships, - 243 One-off fees, - 313 Ongoing Investment, - 246 Online Commodity Trading, - 216 OPEN ORDER, - 45 OPEN OUTCRY, - 34 Open-end Fund, - 331 Open-End Funds (Mutual Funds), 311 option on a swap, - 138 Option Pool, - 331 OPTION PREMIUM, - 135 Options, - 133 Ordinary Endowment Assurance, 182 OTC, - 331 OUT-OF-THE-MONEY, - 135 Outstanding Stock, - 71 Oversubscription, - 71 Oversubscription Privilege, - 71 Over-the-Counter, - 331 OVER-THE-COUNTER (OTC):, - 39 Over-The-Counter Options (OTC options, - 135 Owners, - 6 Par value, - 77 Pari Passu, - 71 Participating Preferred, - 331 Participating Preferred Stock, - 70 -, 331 Partnership, - 331 Partnership Agreement, - 331 Pay outs in the Industry, - 245 Penny Stocks, - 331 Periodic fees, - 313 Personal Branding, - 25 Personal Financial Planner, - 53 Personal Pension Plan, - 185 Physical Delivery, - 201 Piggyback Registration, - 332 PIK Debt Securities, - 332 PIPE:, - 332 PIV, - 332 Placement Agent, - 332 Poison Pill, - 332 Pooled Investment Vehicle, - 332 Invest - 357 - Invest- 55 Assets That Grow Savings and Earn Passive Income Port folio Companies, - 332 PORTFOLIO, - 16 Portfolio Diversification, - 15 Post - Money Valuation, - 266 Pre - Money Valuation, - 266 Precious Metals (gold, diamond, silver, platinum, & palladium), 228 Preemptive Right, - 71 Preference Preferred Stock, - 70 Preferred Dividend:, - 71 Preferred Stock, - 68 Preferred Stocks (Types), - 69 Primary Bonds, - 86 Primary Market, - 41 Primary Market Transaction Process, - 43 Prime broker, - 334 Prior Preferred Stock, - 69 Private debt, - 158 Private equity, - 156 Private Equity, - 27 -, - 259 Private Equity Funds, - 261 Private Equity Investment, - 259 Private Equity Investment Products, 261 Private Investment for Public Equity, - 332 private market, - 164 Private Offering, - 274 Private Placement, - 274 Private Placement Memorandum, 274 Private Placement:, - 274 Private Securities, - 274 Professionally Managed Investment Schemes, - 307 Promissory Note:, - 332 Property, - 26 -, - 143 Prospectus, - 332 Protection policies, - 174 Provident Fund, - 186 Public Company, - 332 public debt, - 157 Public equity, - 156 public real estate market., - 164 Put option, - 332 - Putable preferred stocks, - 70 QPAM, - 332 Rare-Earth Metals (Lanthanum, Cerium, Praseodymium, etc), - 225 Real Estate, - 143 Real Estate Agents, - 165 Real Estate Brokers, - 165 Real Estate Investment, - 145 Real Estate Investment Groups, - 166 Real Estate Investment Trusts (REITs), - 167 -, - 339 Real Estate Market Players, - 165 Real Estate Markets, - 164 real estate security, - 164 Real Estate Trading, - 166 Recapitalization, - 274 Reconfirmation, - 332 recoupments, - 314 Red Herring:, - 332 Redeemable Preferred Stock, - 332 Registered Offering, - 343 Registration, - 343 Registration Obligation, - 343 Registration Rights, - 343 Registration Rights Agreement, 343 Registration Statement, - 343 REGULAR WAY SETTLEMENT, - 45 Regulation of Commodity Markets, 220 Regulators (SEC/CMA), - 56 Regulators Levy, - 42 reimbursements, - 314 Re-Investing, - 23 Reporting Company, - 343 Repos, - 114 repurchase agreement, - 114 Resale Registration, - 343 Residential Property, - 155 Restricted Securities, - 343 Restricted Shares, - 343 Retail Property, - 154 Retirement Planning, - 54 Retirement plans, - 185 Invest - 358 - Invest- 55 Assets That Grow Savings and Earn Passive Income Retractable Bonds, - 89 Revenue bonds, - 83 Reverse Merger, - 280 Reverse Takeover, - 280 Right of First Refusal, - 52 Rights of Co-Sale, - 75 Rights Offering, - 180 Risk, - 180 Risk Management and Insurance Planning, - 54 Risk Tolerance, - 19 Saving, - 11 Savings Accounts, - 59 Secondary Bonds, - 86 Secondary Market, - 41 Secondary Market Transaction Process, - 43 Secondary Sale, - 75 Securities, - 75 Securities and Exchange Commission, - 75 Seed Money, - 274 Seed Stage Financing, - 274 Self-Help, - 25 Senior Securities, - 75 Series A Preferred Stock, - 75 SETTLEMENT DATE, - 45 -, - 124 Shell Corporation, - 180 Significant Participation Test, - 310 Single Premium Whole Life, - 175 Soft Commodities (Plant & Livestock), - 253 Sovereign Bonds, - 100 SOVEREIGN DEBT, - 100 Sovereign Wealth Fund (SWF), - 330 Speculators, - 125 Sponsors, - 55 Spot trading, - 218 Staggered Board, - 180 Standardization:, - 127 Statutory Voting, - 180 Step Down CDs, - 118 Step Up CD, - 118 Stock Analysis, - 66 STOCK CERTIFICATE, - 63 Stock Exchanges, - 38 Stock Markets, - 40 - Stock Options:, - 75 Strategic Investors, - 50 Stretch Annuity, - 194 Strip’ Bonds, - 100 Subordinated Debt, - 50 Subordinated Note, - 50 Subscription Agreement, - 50 Swaps, - 137 swaption, - 138 Syndicate, - 50 Tag-Along Rights, - 75 Take down Schedule:, - 274 Takeover, - 276 Tangible assets, - 144 Tax - free re-organizations, - 50 Tax Planning, - 54 TECHNICAL ANALYSIS, - 31 Technical Analysis (forex), - 195 Tender offer, - 50 Term Sheet, - 50 THE AGE METHOD, - 15 TIER 1 CAPITAL, - 70 Time Deposit Account, - 59 TIME HORIZON METHOD, - 15 Time Value of Money, - 52 total return swap, - 138 Trading, - 33 Trading Account, - 199 TRADING VENUES, - 131 Traditional Assets, - 26 Treasuries, - 98 Treasury Bills, - 98 Treasury Bills (T-Bills), - 99 Treasury Inflation Protected Securities (TIPS), - 102 Treasury Stock, - 75 TreasuryDirect., - 80 Trust Indenture:, - 52 trust manager), - 56 Types of Orders, - 44 Types of Risk, - 19 Types of Stocks, - 67 Underwriter, - 71 UNDERWRITING, - 41 Underwritten Offering, - 71 Unit Investment Trust Funds (UITF), - 336 Invest - 359 - Invest- 55 Assets That Grow Savings and Earn Passive Income Unit Offering, - 75 unit trust trustee, - 56 Unitised Insurance Funds, - 172 Value Added Mortgage (VAM) Protection Assurance, - 177 Value Added Term (VAT) Assurance, 176 Value Investing, - 66 Variable Annuity, - 193 Variable Rate CDs, - 118 Variable Universal Life Insurance, 175 variance swap, - 138 Venture Capital Financing, - 273 Venture Capital Firms, - 262 - VOLUME, - 48 Voting Right, - 75 Waivers,, - 314 Warrant, - 52 Whole Life Assurance, - 175 WITHHOLDING TAX, - 51 Workout, - 52 Write - down, - 266 Write - off, - 266 Write - up, - 266 YIELD TO MATURITY, - 79 Zero Coupon, - 100 Zero Coupon CD, - 118 zone, - 159 - Invest - 360 - Invest- 55 Assets That Grow Savings and Earn Passive Income …multiply your money! Invest - 361 - Invest- 55 Assets That Grow Savings and Earn Passive Income Invest- 55 Assets That Grow Savings and Earn Passive Income This book is for me who wants to become rich through investing, through applying my savings to earn me passive income. The book takes me through the various investment products; the markets where I can buy and sell such products and the market players, including regulators, associations and brokers. The book concludes by introducing a prospective investor to fundamental principles of economics and economic institutions. Ojijo, The Author, Speaker & Doer Ojijo, a lawyer, author of 55 books, public speaker, investor, entrepreneur, and Inua Kijana Fellow, believes contract work is the best way to create employment and impart job skills and believes people who have (won) contracts deserve an efficient way to access finance to fulfil the contracts. He founded GoBigHub.com, a platform that connects people who have (won) contracts to people who have money to finance the contracts. Ojijo has previously worked as communication skills consultant; guest lecturer on law; and collective investment schemes advisor. He is also a performance poet, armature pianist, armature guitarist, and a believer in open religion. E: ojijo@ojijobooks.com M: +256 776 1000 59. Invest - 362 -