Introduction
This page provides a glossary of common investment terms used by MJW. The purpose is to create a reference for clients. Rather than just provide definitions, we have included discussions where appropriate.
Collateralised Debt Obligation (CDO)
A Collateralised Debt Obligation is a type of Asset Backed Security (ABS). Their value is tied to a portfolio of underlying fixed interest securities. They often consist of multiple tranches.
For example, it was common for subprime mortgages to be securitised into CDOs as the income stream of a single subprime loan would be extremely risky. The top tranche of the CDO would be paid income in the first instance, while the lower-rated subordinate tranches would be paid with decreasing certainty. In this way it was intended to create a “whole that was greater than the sum of the parts”. Unfortunately the assumptions underlying the construction of these products turned out to be overly optimistic, leading to higher than expected defaults and contributed to the credit crisis.
Commodities
A commodity is a good that can be supplied without qualitative difference across a market. Precious metals (such as gold, silver and copper), fuels (such as oil), and building materials (such as steel and timber) are examples of commodities.
Commodities have been a popular area of investment as, due to their real asset nature, they provide a natural inflation hedge. However, due to changes in demand (driven, for example, by global risk appetite) prices can fluctuate largely over the medium term.
There are diverse ways for gaining access to the commodity asset class. For example, take an investor wanting to gain exposure to gold. The most straight forward way would be to buy a physical supply of the metal and this can be done by buying gold coins or bars. However, this method comes with shipping and storage costs. Rather, one of the easiest ways would be to buy into the GLD exchange traded fund - a share investment where the price is linked to the price of gold. Even more abstractly, the investor could buy into a portfolio of gold mining stocks (that is, shares in companies involved in mining the precious metal). While not strictly investing in gold, these types of investment are sometimes also classed as commodity investments as the share prices will be linked closely to the demand for gold.
Currency Hedging
Currency hedging is an arrangement where the effects of changes in the New Zealand dollar are partially or fully removed from returns in an international investment.
Consider an investment of NZ$100 into the US share market which goes on to rise 10%. When the investor invests, the exchange rate is NZ$1 = US$0.50, and so the investment converts to US$50 and rises to US$55. Now if over the investment period the NZ$ rises to US$0.60, the investment (now worth US$55) only equates to NZ$92, and the NZ investor has taken a loss despite the underlying asset appreciating.
Obviously if the currency had moved in the other direction, the NZ investor would have made a large gain.
Currency hedging will eliminate currency fluctuations to the investor. In effect the investor receives a return in their domestic currency that is equivalent to what an investor in the foreign country would have received.
Additionally, as long as NZ maintains higher interest rates compared to the rest of the world, a hedged investor picks up a slight gain from the interest rate differential.
Leverage
Leverage just means borrowing in order to invest. This has the effect of magnifying the potential return or loss.
For example, consider the following contrasting investors both with wealth of $100. Let’s assume the share market either returns 20% or -10% with equal likelihood and there is the facility to borrow at 3% pa (we are in a low interest rate environment). Investor A invests all $100 into the share market while Investor B employs leverage and borrows an additional $50 so as to invest $150 into the share market.
Investor A’s expected return is $5 whereas Investor B’s is $7.50. However, Investor B has to service his debt to the tune of $1.50 and so has a net return of $6. This is still higher than Investor A since financing costs are lower than the expected return from the share market.
But what are the ranges of results? Investor A could get a return of $20 or see a loss of $10 - a range of $30. After interest, Investor B will gain $28.50 in a good year, but in a bad year he loses $16.50 - a range of $45.
Prudent Person Rules
The relevant sections of the Trustee Act 1956 state
13B Duty of trustee to invest prudently
Subject to sections 13C and 13D of this Act, a trustee exercising any power of investment shall exercise the care, diligence, and skill that a prudent person of business would exercise in managing the affairs of others.
13C Duty of certain persons to exercise special skill
Subject to section 13D of this Act, where a trustee's profession, employment, or business is or includes acting as a trustee or investing money on behalf of others, the trustee, in exercising any power of investment, shall exercise the care, diligence, and skill that a prudent person engaged in that profession, employment, or business would exercise in managing the affairs of others.
13D Provisions in trust instrument relating to duty of investing trustees
(1) The duty imposed on a trustee by section 13B or section 13C of this Act shall apply to a trustee if and so far only as a contrary intention is not expressed in the instrument, if any, creating the trust or any Act, and shall have effect subject to the terms of that instrument or Act.
(2) Any rules and principles of law relating to any provision in an instrument that purports to exempt or limit the liability of a trustee in respect of any breach of trust, or to indemnify a trustee in respect of any breach of trust, shall remain in force and apply in respect of any provision in a trust instrument that expresses a contrary intention for the purposes of subsection (1) of this section.
Securitisation
Securitisation is the process of pooling and repackaging cashflow-producing assets into new vehicles (“securities”). See Collateralised Debt Obligation for further discussion.
Shares vs bonds
Issuing shares or bonds are ways that businesses can raise capital.
Shares provide a stake in the business along with (usually) voting rights and a share in the profits which are paid in dividends. Additionally holders of shares may gain from appreciation in the share price.
Bond holders are creditors to the firm. Unlike shares, their dividend payments are (usually) known in advance and fixed. So the bond holder will not see any growth in dividends should the company grow. The flipside however is that debt holders will be paid before equity holders meaning that their income stream is more stable. Additionally debt holders rank ahead of shareholders in the event of a windup of the company.
Both shares and bonds have varying degrees of security. Bond investors can invest in government debt (which is viewed as risk-free) right down to high yield (or “junk”) bonds. Investors into the share market have the choice of well-established, large companies or start-ups with short track records but offering scope for good growth.
Swaps
A swap is an instrument where two parties exchange one cashflow for another.
For example, in an interest rates swap one counterparty may have access to a stream of payments linked to a floating interest rate and desire more certainty in the payments. He may then enter into a swap agreement where he exchanges his stream of interest payments for a fixed cashflow. Note that while the cashflows are calculated on a principal amount, this value does not actually change hands. Thus there is no risk of loss of capital, only that the corresponding party may default on their payments.
Melville Jessup Weaver has taken every care in preparing this glossary. However this glossary is intended to just provide an introduction to the terms listed and is not intended to be a definitive statement on each term. Melville Jessup Weaver does not guarantee the accuracy of the information and strongly recommends that appropriate professional advice be obtained before any investment activity is undertaken.