Using derivatives to obtain returns


  • In certain large and developed markets, you find that the liquidity of financial derivatives [such as options, warrants and swaps] is very high, sometimes even close to the liquidity of the actual shares, so there are no liquidity issues. > Devan
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This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on December 19 - 25, 2016.

 

Devan Linus Rajadurai, founder of Malayan Traders Capital (MTC), has a global mindset when it comes to investments. In fact, almost half of his investment portfolio focuses on stocks in the US, while the rest is invested in various instruments in countries like the UK, South Korea and China. 

Most globally competitive tech companies, which have dominated the world and will continue to do so, are listed on the bourses of these countries, says Devan, a fund manager who invests heavily in technology companies, mainly blue-chips such as Apple Inc, Alphabet Inc, Samsung Electronics Ltd, LG Corp and Tencent Holdings Ltd, he says.

In South Korea and China, which restrict access to many individual investors, Devan uses derivatives to access their bourses. “These derivatives consist of stock options, warrants and equity swap contracts,” he says.

An equity swap is a contract provided by investment banks to investors, says Devan. The banks and the investors take a different view on a certain stock. If one party takes the view that the price will go up and it goes down instead, the other party will gain from the price difference or vice-versa.

He adds that equity default swaps can be “naked” or “non-naked”. A non-naked swap is a contract with underlying shares as collateral, in case of a default, while naked swaps have none.

“In the case of non-naked swaps, some investment banks in China know their clients own certain stocks that foreign investors do not have access to. At the same time, they know their clients do not want to sell the stocks. So, the banks approach their clients and ask them to ‘rent out’ their stocks to them and provide a swap contract for foreign investors like us,” he says.

By doing this, Devan’s portfolio gains exposure to the South Korean and China markets, which he otherwise would have no access to.

“In certain large and developed markets, you find that the liquidity of financial derivatives [such as options, warrants and swaps] is very high, sometimes even close to the liquidity of the actual shares, so there are no liquidity issues,” he says.

“However, we only use swaps for specific reasons, which is gaining access to blue-chip stocks in companies we otherwise would not have access to. We are not gambling on it.”

He adds that he allocates not more than 10% of his investment portfolio in trading swaps as it can be risky. 

However, Devan says retail investors are unlikely to trade equity default swaps as the minimum trading amount is huge. Equity default swaps are  generally used by institutional investors as the contract size can go up into the tens of millions.

Devan, who is MTC’s chief investment officer, says he is able to trade swap contracts because he is managing two funds under the firm, where he puts most of his own money.

He says this is a normal practice within the hedge fund industry as hedge fund investors like their interests to be aligned with the fund manager’s. 

MTC’s main fund, which Devan is managing and invested in, is the MTC Absolute Return Fund. He calls it a hedge fund as it aims to generate returns, regardless of market conditions, by utilising financial derivatives and leverage.  

The fund, established in July 2012 and domiciled in the Cayman Islands, is an actively managed global equity fund that uses a bottom-up investing approach. It employs the value investing approach and invests long term in blue-chip companies globally.

As at June this year, the fund had generated total returns of 38.3% with about RM100 million in assets under management (AUM). “The fund is up about 10% as at this month from the beginning of the year, in US dollar terms. In ringgit terms, it is up about 15%,” he says.

In July this year, MTC launched its Meranti Fund, which allows local sophisticated investors to invest with them. The fund will adopt the same investment strategy as the Absolute Return Fund. Devan says local investors who do not have access to the firm's offshore fund (the Absolute Return Fund) can now invest via the Meranti Fund, a wholesale fund lodged with the Securities Commission of Malaysia.  

Another strategy Devan applies to his investments is leveraging. He leverages up to 50% of the AUM of his funds.

While some may see this as too risky and aggressive, he says it is a matter of perspective, it depends on each investor’s investment strategy and risk appetite. For instance, hedge funds in the US typically employ leverage of up to 400% of AUM.

“And, if you compare it with taking a loan to buy a house, where a person usually takes 80% of the value in a bank loan, it is 500% leverage,” he says.

There are two ways to leverage his investment, says Devan. The first is the plain vanilla way of investing in the options and warrants of a certain stock. Options and warrants usually fetch one 10th of the price of the mother shares and buying into them allows Devan to leverage. 

“If you buy RM1 million worth of warrants of a stock with RM100,000, you gain 100% if the price of the mother share goes up 10%,” he says.

The second way, is to take bank loans and invest in the shares of blue-chip companies he has confidence in. For instance, Devan has taken loans at low interest rates in the US and Singapore in the past and reinvested the money in blue-chip stocks globally. 

“Let’s say I have RM10 million worth of shares, I take a RM2 million loan with them and buy an additional RM2 million worth of shares. So I have RM12 million worth of shares in total and pay back the loan later with the returns I have earned,” he says.

Moving forward, Devan says having a global viewpoint will continue to be an important investment theme, especially for Malaysian investors. This is because the Malaysian market will not provide investors with good returns compared with some other stocks listed globally.

Devan says this is because commodity prices, such as crude oil and crude palm oil, will remain suppressed and this will have a trickle-down effect on the Malaysian economy in the years to come. Under such circumstances, the growth of the property sector, which is another competitive sector regionally, will remain sluggish.

“The oil price is not going back to its high of over US$100 per barrel and crude palm oil prices are expected to remain suppressed due to the oversupply situation. It is already having a trickle-down effect on the country’s economy and the property sector is also affected. 

“Rental rates in the Kuala Lumpur area once approached RM1,600 psf and some people are now is renting at RM1,000 to RM1,200 psf. This will lead to two things, slowing economic growth and a weakening of the currency.

“Our local political scene has issues too. The ringgit can drop further if we don’t resolve these issues,” he says.  

On Dec 7, Dr Jomo Kwame Sundaram, a prominent economist, said the weakness of the ringgit cannot be blamed solely on the slump in oil prices. The loss of confidence in the  government is also among the key factors contributing to the decline of the ringgit. 

The ringgit is now 4.425 against the US dollar. On Nov 30, it hit 4.4662, lower than on June 30, 1998, when the Asian financial crisis erupted, according to Bloomberg. 

Following the weakening ringgit, Bank Negara Malaysia has initiated a series of measures to strengthen the ringgit, including clamping down on the non-deliverable forward trade (NDF) and for exporters to convert 75% of their proceeds into ringgit. The ringgit rebounded slightly after the central bank’s announcement. 

Investors who do not invest globally and focus too much on the local market will see their returns take a hit on the currency side. 

“The fall of the ringgit is a reminder that Malaysians should diversify [their investments globally immediately]. The majority of people will always say the ringgit will come back up as they refuse to accept ringgit losses or justified reasons as to why the ringgit is low and will remain low or lower. We call it loss aversion,” says Devan.