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Personal Equity Investment In 2012 - Not Just For Expats?

by Investors Offshore Editorial, April 2012
13 April, 2012

Under this particular heading of equity investment we will deal with direct, personal investment into publicly-quoted equities, other than through conventional stock exchanges, whether from an onshore or offshore base, and whether by an individual, or through a corporate vehicle or a trust. We will cover direct equity purchase through a dealer, spread betting, contracts for differences, and hedge funds insofar as they specialize in very directed equity investment.

There are other routes for direct equity investment, of course: a private banker may well advise and supervise equity investment; investment or mutual funds invest in equities more often than not; and pension arrangements are often based on equity investment. See the other InvestorsOffshore special features for relevant details.

 Choosing an Investment Base

The first decision any direct equity investor ought to make is where to base her trading. Probably, few investors actively consider this question until it's already too late, and the tax damage has been done. That's understandable if investment begins with a few thousand dollars or equivalent, almost as a hobby, and gradually builds up. The investment range we are dealing with here is bigger (from $100,000 to $5m) and forethought is essential if more than $100,000 is to be put into equities.

The decision where to base equity trading or investment does not necessarily have to follow a general decision about a personal investment base, and the different tax profile of equity investment may require that it doesn't. Thus, low-yielding Internet stocks held for the long-term are a capital gains tax problem, not an income problem, whereas money-market investment is the reverse.

There is a vast range of individual situations, and this section will concentrate on finding and buying investments, rather than on location. See the investorsoffshore.com DIY investment selector for investment guidance based on specific residential and investor profiles.

 The Benefits of Offshore Equity Investment

This is not the place for a survey of the development of equity markets, or their current prospects, which are well covered in many types of publication, but it is worth focussing on the virtues of emerging and offshore listings, at least for those individuals who can make use of them. Equity investment used to mean investment in one's local stock market, to the more or less complete exclusion of foreign stocks. There were good reasons for this:

  • Capital controls prevented or complicated the purchase and sale of international securities;
  • Absence of double tax treaties resulted in double taxation of dividends and sometimes even sale proceeds;
  • Research on foreign equities was poor or completely absent;
  • Brokerages did not offer foreign stocks, or charged very high commission rates on their purchase;
  • Currency risk was not easy to lay off.

All of these factors have more or less disappeared, except to a degree the last one, and it is far easier nowadays to hedge a foreign exchange exposure if one needs to.

It has traditionally not been all that easy to buy foreign equities, but this has changed somewhat, although not initially thanks to the established stock exchanges and their parochial dealers. Perhaps it is unfair to blame the dealers, because they are hamstrung by regulation in the same way as are other types of financial provider and intermediary. Most countries employ the concept of 'recognised exchanges', whereby stocks listed on a foreign exchange can be sold provided that the foreign exchange in question has a regulatory regime that is up to international standards.

As is also the case with private banking and fund management, this means that share dealing in high-tax (= highly regulated) countries tends to be constrained by regulation, and excludes shares offered on unrecognised exchanges. The high level of regulation needed to become 'recognised' inevitably tends to increase costs both for listed companies and for dealers. Partly for this reason (but mostly because the growth of the mutual fund sector created demand for tax-efficient listing regimes) offshore jurisdictions began to open stock exchanges.

This was the situation when the Internet began to make it possible for an electronic dealing network to bypass national regulatory regimes altogether, and rapid growth took place in electronic share-dealing networks which offer freedom from stamp duty (still applied at 0.5% in the UK, for instance) and access to a very wide range of international securities.

It is impossible at this stage to tell where this process will end. At present, most share offerings are made through geographically-fixed exchanges, but it may happen in the future that this trade moves elsewhere. Certainly, recent years have seen dramatic growth in issuance of various specialized types of equity in such markets as the CISX (Channel Islands Stock Exchange), and in the issuance of emerging markets stocks in such places as Hong Kong.

 The Taxation of Offshore Equity Investment

An important consequence of the nation-state-based model of share trading was that countries could and did apply withholding taxes to dividend payments without hurting their exchanges. Most shareholders were nationals, and could offset withholding tax against their total tax liabilities. Foreign buyers mostly lived in other high-tax areas, and double tax treaties offered them an equivalent tax credit on foreign dividends. Mostly, withholding tax rates in high-tax countries vary between 10% and 20%.

Almost universally, offshore jurisdictions with stock exchanges exempt non-residents from withholding taxes on dividends, thus encouraging companies to list. www.lowtax.net contains full details of the withholding tax regime in all 40 offshore jurisdictions covered (within each jurisdiction, in the section Offshore Legal and Tax Regime). As liquidity develops outside the 'legacy' exchanges, so companies and their shareholders are likely to want to transact their business away from withholding taxes, leading to an explosion in offshore corporate listings.

All this to explain why investment into companies listed offshore may be a major component of future corporate financing, and can be used now to a limited extent by investors who have the ability to take in gross dividends without incurring further taxation.

 How To Make Emerging Market And Offshore Equity Investments

Anyone can buy equities from anywhere, but if there is to be an offshore dimension, then there are two components that can be optimised: dealing costs, and taxation.

Dealing costs are a combination of trading fees, stamp duty, and making sure that one gets best execution.

Nothing in life is simple, and these three factors interact with each other. It seems obvious to avoid London stamp duty, but if execution is 1% better in London on average, then the stamp is saved back twice over. The situation is volatile, and no direct advice can be offered here, other than to stress that an investor should consider all three factors before deciding how to deal.

On the surface, it seems that one of the brokerages offering Internet service may be the best route - but delays, crashes and other obstacles often get in the way.

In order to optimise taxation, it is necessary either to have residence in a low-tax area, or, for a high-tax resident, to have an offshore structure that distances income and capital gains from the investor's domestic tax regime. Either way, the ownership of equity assets is going to be offshore, and the main question is, where to base it?

The choice of an offshore jurisdiction is in itself a difficult, and to some extent a circular task. You will not find it easy to distinguish between the merits of different offshore jurisdictions, or the facilities they offer, until you have got to know them quite well. This is the point at which you might think that an onshore adviser in your own home country can help you - and it may be so, but remember that only a very skilled, knowledgeable and above all, objective, adviser is going to be useful. Such a person is hard to find.

www.lowtax.net is designed to help people who do not have access to the perfect adviser we just described.www.lowtax.net is not an investment adviser, and is no substitute for professional advice, which is an absolute necessity for anyone planning a move offshore. But the www.lowtax.net site does contain a wealth of information about 40 offshore jurisdictions, which is designed to help you to make a preliminary choice of one or a few offshore jurisdictions suited to your circumstances, which you can then explore in depth.

The choice of an offshore or low-tax jurisdiction as a base needs to be guided mostly by your own particular circumstances, but if investments are to be made into companies (or funds) listed offshore, or if an offshore brokerage is to be used, then these aspects need to be borne in mind when making a choice.

Purely as a factual guide, here is a list (in alphabetical order!) of those offshore jurisdictions with stock exchanges and, in the case of those that belong to IOSCO, you may want to assume, a fairly high level of sophistication in terms of investor protection.

Bermuda (BISX)
Cayman Islands (CSX)
Dubai (NASDAQ Dubai)
Guernsey (CISX)
Hong Kong (HKEx)
Ireland (ISE)
Labuan (LFX)

www.lowtax.net has information on the stock exchanges and the regulatory regime for each of the above jurisdictions.

Many emerging markets have their own stock exchanges as well, of course, but these can be treacherous and it may often be best for a non-expert to invest in even high-profile emerging markets such as the BRICS countries (Brazil, Russia, India, China and South Africa) through specialized funds, or at least with plenty of expert advice, as offered by the private wealth departments of major banks.

Spread betting

This flexible technique for speculating on financial markets and sporting events has grown in popularity hugely in recent years, and has spread (sorry!) far beyond its original UK base to become a popular investment technique in many countries world-wide. Many spread-betting operators are well-capitalized and regulated gaming companies, often themselves publicly listed and sometimes based offshore. Obviously a prospective spread-bettor should carry out due diligence on a firm before using it. Many firms allow both online and telephone betting.

Although the services, markets, and events that the client can access through each bookmaker may vary, all spread betting is based on the same principle. Basically, the bookmaker makes a prediction as to the result of a future event in the form of high and low estimates (the difference between these two figures is called the spread, or the difference between the price the bookmaker will sell to you, and the price he will buy from you), and if you think the result will be higher than their spread, you 'buy' at the top end, whereas if you predict that the result will be lower, you 'sell' at the low end. Having decided whether you are going to bet down or up from the spread, you must then decide how much money you are prepared to risk per point of the bet. For example, if the spread quoted was 6000-6012 on the FTSE 100 index, a GBP1 a point bet would make GBP1 in profit for every point that the FTSE exceeded the upper figure at the expiry of the bet (and sadly, it works in exactly the same way for losses).

Theoretically, spread bets can be placed on any event for which there can be an upper or lower limit, but in practice the majority of bookmakers providing spread betting services tend to limit themselves to sporting and political events and financial markets. This, however, is not much of a limitation, as there are a wide variety of options open to clients in these areas. For example, one leading spread betting enterprise allows bets on stock indices, share prices, currencies, interest rates, commodities, and options, while its sporting arm allows customers to place bets on such diverse events as soccer, horse racing, rugby, cricket, golf, tennis, American football, motor racing (deep breath…), greyhound racing, snooker, and boxing.

Most specialist bookmakers providing a spread betting service will offer both deposit and credit accounts, but in either case, you will need to be aware of the Notional Trading Requirement. (Yes, it is as dull as it sounds, but you need to know about it, so don't skip this bit. Here goes…) The NTR is the minimum amount of money required by the bookmaker to open a new position, and is a risk figure applied to each market that the bookmaker quotes, and it is what they see as a fair reflection of the potential daily volatility of that market. The figure varies from market to market, but if, for example, you wanted to bet GBP5 per point on the FTSE futures market, the NTR could be 300 times your stake, which would make the minimum deposit required to run that position GBP1,500.

Spread betting is appealing to ever greater numbers of investors for several reasons, not least of which is the absence of capital gains tax on profits (unlike conventional share trading, where CGT applies to trading gains in many countries), and the lack of stamp duty on transactions (most interesting in the UK; strictly speaking, the transaction is a bet, rather than an investment. Hence the name.) Not all countries treat income from spread betting the same way however; a ruling by the Australian Tax Office in 2010 for example stated that gains from spread betting were assessable income under the relevant income tax legislation. For this reason, spread betting has not taken off in a big way in Australia, unlike in the UK, where it is thought that there are close to 1 million people users of these services (and as a result, spread betting is regulated by the Financial Services Authority rather than by the country's gambling authorities).

However, by its very nature spread betting is more risky than traditional, fixed odds betting, or conventional domestic investment, where participants are usually a little more protected. If you judge wrong, you are likely to lose a great deal, and any losses made on a spread bet cannot be offset against capital gains on ordinary investments (although this may be possible in countries were spread betting income is taxable).

Spread betting, to conclude, is not suitable for long-term investment, or for placing your hopes, dreams, and life savings in, but can potentially be very profitable in the short term. The rules regarding residential restrictions do not seem set in stone as yet, perhaps due to the removal of geographical restrictions facilitated by the Internet. However, every organisation offering spread betting recommends that their customers should examine the taxation laws of their country of residence before making any decision, so it may well be worth seeking professional advice.

 Contracts for Difference (CFDs)

On a more international note, some bookmakers also offer Contracts for Difference (sometimes known as Margined Equity Contracts), which are a type of equity derivative designed to give active traders extra leverage in their share trading. CFDs are rapidly becoming popular both in the UK and internationally as a mechanism for large but short term speculation.

Institutions and qualifying private investors can use a CFD to go 'long' or 'short' of a share (as with spread betting), and positions are taken on margin - typically, only 20% of the contract value has to be maintained in the CFD account (although account minimums vary between CFD providers). This allows users to establish much larger positions than would usually be possible, and in effect, the investor is able to speculate with much more money than he actually has by borrowing from his broker, and using the shares he has bought as collateral.

If the share price moves in the investor's favour, the CFD provider is obliged to pay margin each day to him/her, but conversely, if the share price moves against the investor, he/she will then have to pay 'variation margin' to the broker. For example: Say you were to decide to take a long position on 10,000 BP shares at a quoted price of 500p (it must be firmly stated here that this is a fictitious example, as opposed to a recommendation). This is the equivalent to a GBP50,000 exposure, on which a GBP10,000 initial deposit is payable. If the shares rise to 550p in the next 3 days, you should receive GBP5,000 from your CFD provider, minus whatever interest charges are payable. If you then decide to close the CFD on the fourth day, when the price quoted is 555p, you should have made a total profit (before dealing commission and interest charges) of GBP5,500. At the moment, there is no stamp duty payable on this type of transaction, as there is no physical stock transaction. Indeed, research conducted by the Tabb Group suggests that more and more investors are turning to CFDs as a means to escape UK stamp duty, with more than 50% of UK equity trades conducted through these instruments in 2010. But profits made on CFDs are liable for Capital Gains Tax.

Sounds good, doesn't it? But although it is possible to get rich quickly trading Contracts for Differences, because of the highly margined nature of this type of transaction, it is also possible to get poor quickly - if the share price goes against you, the margin payments (which have to be paid in cash) can prove crippling. CFD trading is not for novices, and regulatory authorities insist that investors only trade in this way if they have experience of both equity and margin trading. Indeed, the regulatory authorities in some countries, notably the US, do not allow their citizens to trade CFDs. The high minimum deposit is also (deliberately) prohibitive, and most CFD providers will only do business with investors who can prove substantial liquid assets. Minimum transaction sizes can sometimes be as high as GBP25,000. In conclusion, then, CFDs may be the most economical option for large, short-term trades, executed by qualified investors, but should probably be avoided by the newer investor.

 Hedge Funds

Hedge funds, in the popularly accepted sense, are investment partnerships that invest in a variety of securities and seek above average returns through active portfolio management. Traditionally, hedge funds have not generally been regulated by any of the domestic securities regulatory bodies (although this situation is changing), and therefore do not raise funds via public offerings, and are not allowed to engage in general solicitation or advertising.

Although hedge funds have long been popular in the US, all-encompassing regulation in the European Union has meant that their marketing has been severely restricted in many EU member states until recently, which have each had to repackage the funds in different ways, in order to make them palatable to regulators. However, recent agreements reached by the Council of Economics and Finance Ministers should eventually lead to a situation in which an investment product approved in one member state may be marketed anywhere in the EU, and where the range of approved products may be substantially extended to include hedge funds. This would give a tremendous boost to the funds' popularity in Europe.

The EU's UCITS III legislation has already allowed the development of a new range of compliant hedge funds, often dubbed hedge-lite. Hundreds of hedge fund offerings now comply with UCITS III guidelines, a number which has grown rapidly in the last three years, before which time few hedge funds offered UCITS III products to investors. Total hedge fund assets under management in UCITS III-compliant funds are now thought to be in the region of USD140bn, a figure that is likely to continue to grow in the near future. Indeed, assets in hedge fund-style UCITS III funds soared by 150% in the year to the end of June 2011, according to research by Hedge Fund Intelligence.

Undertakings for Collective Investment in Transferable Securities, or UCITS, are a set of EU directives that allow investment funds to distribute throughout the EU on the basis of a single authorization from one member state; UCITS III is the latest iteration of these directives. Despite the focus on EU investors, UCITS III compliant offerings are not limited to EU-located or domiciled hedge fund firms; in fact, firms across all regions have created investment vehicles which are compliant with the UCITS III standards. In some cases, firms are receiving UCITS III approval for existing fund vehicles, while in other cases, firms are launching new products which conform to UCITS III guidance.

“As the structural requirements of institutional investors continue to shape the landscape of the industry, funds conforming to UCITS III guidance have generated a significant amount of interest,” said Ken Heinz, President of Hedge Fund Research, Inc.

“UCITS III constitutes a compelling and tractable set of guidelines which serve to greatly enhance product transparency, cross-border distribution, and risk control, while at the same time providing an attractive alternative to other regulatory proposals under consideration by various financial authorities globally," Heinz observed.

It used to be the case that hedge fund investments were only available to high-net-worth individuals able to stump up USD1m or more; this may still be true of some types of fund, but UCITS funds are often available to institutional investors with a minimum investment of GBP30,000 and to retail investors with a stake as low as GBP7,000. These numbers are fairly typical of the more accessible types of hedge fund which have been launched since the hedge fund sector met its high noon in 2008 and early 2009, with asset values tumbling as markets crumpled and investors fled the rigid, unfriendly structures which seemed to benefit only their managers.

The regulatory framework provides a degree of reassurance to investors that fund managers wish to tempt back into the alternative investment markets after the shocks of the economic crisis. However, time will tell how the EU's controversial Alternative Investment Fund Manager (AIMF) directive, approved in 2010, will impact the industry and its relationship with investors globally.

The AIFM directive will impose registration, reporting and initial capital requirements on a financial industry sector which until now has been subject only to "light touch" regulation. It is hoped that, following its introduction, the enhanced regulatory oversight over AIFM will enhance investor protection and financial stability. Many industry representatives feel that the directive is a regulatory step too far however, particularly the 'passport' provisions, and will inhibit investors' freedom of choice.

A European AIFM with a portfolio of more than EUR100m (USD140m) will be required to obtain an authorization from national authorities to operate under the directive. This permit will entitle them to market funds throughout the EU single market. The most controversial proposal in the directive has been that AIFMs from 'third countries' would be able to obtain that EU permit, or ‘passport’, to sell their funds within the EU without first having to seek permission from each member state and comply with different national laws - a planned regulation the terms of which were widely awaited, for instance, by US funds wanting to continue to operate in Europe.

There are more hedge fund strategies available than it is possible to shake a substantially sized stick at, but for an equity investor the most interesting strategies would be :

  • Sector investing: This is where the manager focuses on specific industry sectors with favourable growth prospects, such as health or technology
  • Investment in emerging markets: Fairly self-explanatory really; this is when a hedge fund manager invests in debt and equity securities in countries with less well-developed financial markets which have strong prospects for rapid growth.
  • Long/short equity investing: This strategy focuses on long and short investing in equities which a fund manager feels are under- or overvalued at a particular time. These investments may be focussed on one particular sector, or diversified across several industries.

So now you know. As previously mentioned, due to their unregulated and potentially risky nature, hedge funds are not allowed to advertise to individual investors (at least not onshore), and therefore, are usually offered to limited numbers of affluent investors and institutional clients, who are subject to a lock-up period of at least a year before they can make withdrawals from the fund. It used to be the case that only those with very substantial net worth would be considered for hedge fund investment partnerships, and although the minimum deposit required for some funds is lower than it was (due to their rise in popularity in recent years), it is usually still quite steep, and consequently, direct hedge fund investment should really only be considered by those with substantial liquid assets that they can easily do without for a year or more.

Whichever way you choose to approach hedge fund investing, you should do some due diligence of your own, both before you get involved, and through the duration of your involvement with the fund. Below are some of the basic issues you will need to look at before investing in a hedge fund, or fund of hedge funds (although this is by no means comprehensive, so if you are thinking of investing in this way, professional advice is a must):

The Fund

  • Volatility: Look at the fund's monthly (or weekly) volatility, as well as its annual or quarterly returns, checking whether the annual return was generated fairly evenly through the entire year, or whether it was generated by large gains in one or two specific periods
  • Breadth: Check whether the manager turned in an even result on all issues, or whether one lucky trade accounted for the majority of the gains made in a particular period.
  • Repetition: Is the investment process easily repeatable, or was the fund's good performance caused by an isolated incident in the period under examination?
  • Strategy specific risk: Examine which strategies are commonly used by the particular fund manager in question, and look at the risks inherent in these strategies. Look at the risk management philosophy within the fund, and examine the precautions taken against currency exposure, interest rate exposure, technical and other problems, and marauding elephants. (Just kidding with the last one, although a fund manager that does have a contingency plan in the event of elephant attack is probably one to whom you can entrust your money!)
  • Leverage: Look at the fund's rationale for leverage, ascertaining the leverage caps, the average leverage used, and whether leverage has ever been revoked for any reason.

The People

  • Background: Look at the general background of the fund, including the division of responsibility amongst the principals, its formation and structure, fund terms and relationships, and possible conflicts of interest.
  • Manager profile: Look into the background, qualifications, and employment history of the fund manager, and obtain references and current investor testimonials.
  • Reporting: Ascertain who the custodian of the fund's assets is, and who the prime broker is. (An important point to remember is that a cheque, or wire transfer of funds should never go directly to the fund itself, but should always be sent to the prime broker, or custodial bank.)
  • Administration: Find out whether the manager uses a third party administrator to calculate monthly returns, and ask for background on the fund, their calculation and verification methods, where their data comes from, and what procedures they have in place for monitoring that the terms of the fund's offering are being upheld. 
  • Audits: Every fund should be audited annually, and if the fund is new, they should have an auditor under contract for the end of the first year. Check how experienced the auditors of your preferred hedge fund are at performing this type of audit, and contact them to obtain background knowledge of the fund and its manager.
  • Other investors: Finally, ask for information about the profile of the other investors; are they mostly individual, or institutional investors? Onshore or offshore investors? Look at their average net worth, if you can, and also the extent of diversification in their portfolios.

By now, of course, you may be wondering if you can be bothered with all that, and contemplating making yourself a nice cup of tea. That, of course, is also an option. Although hedge fund due diligence seems like a lot of work, it is worth remembering that if you are planning to invest in a fund of funds, a lot of this work (although not all) will be done for you. And if you are going it alone, chances are that you will not see this background research as a chore, because you are likely to be investing substantial amounts of money. Conventional mutual funds require somewhat less effort, because their more regulated nature means that some of the issues pertinent to hedge funds do not apply to them. However, lack of regulation (one of the reasons why this research has to be so comprehensive) is one of the factors which makes hedge funds so potentially profitable…

Here we get to the bottom line - if you are a wealthy investor with a fair tolerance for risk, and a desire to see your investments hedged against market volatility, hedge fund investment may be the way to go. If you have all of the above, but a slightly smaller liquid net worth, then you may want to consider investing in a fund of hedge funds, or some other similar vehicle. And if you want to know what's on TV tonight, and whether you can have your cup of tea yet, you may have come to the wrong place…!




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