Diversification using Instalments portfolio study - Explanation & rules

Diversification using Instalments is a passive, long term investment strategy.   We start with a portfolio of 4 shares - Commonwealth Bank (CBA); Woolworths (WOW); Telstra (TLS) and Insurance Australia Group (IAG).  These 4 shares were purchased through the initial public offerings (IPO) with an initial capital investment of $25,000 in each stock.  Over time some shares have performed well whilst some have under-performed.  To gain exposure to the overall market and following the principles of diversification we aim to reduce the risk of the portfolio by purchasing Instalments over units in two index Exchange Traded Funds (ETFs).

To avoid the need of committing new capital to the market, we employ the Cash Extraction (shareholder application) strategy and convert our existing shares into Self Funding Instalments (SFIs).  The cash extracted will be used to re-invest into SFIs over index ETFs, namely the StreetTracks S&P/ASX 200 Fund (STW) and the StreetTracks S&P/ASX Listed Property Fund (SLF).

On July 3, we implement two mock portfolios and compare their performance over a 10 year time frame from the 2006 to 2016 financial year.  The share portfolio on 30/06/2006 was worth $489,262.  The half-yearly results will be available on our website and in the monthly ASX Traders Update.  Subscribe to this free monthly newsletter on the MyASX homepage. 

Objectives of the study

The objective of the portfolio study is to compare the long term performance of a portfolio of SFIs versus the original share portfolio after implementing the Cash Extraction strategy.  We will also aim to reduce the risk of the portfolio in one transaction through diversification by the purchase of index ETFs. 

What type of investors will this strategy suit?

This portfolio is a passive investment strategy aimed to track a long-term SFI investment portfolio and does not require monitoring on a regular basis.  Due to the leveraged nature of  SFIs and the set and forget structure of the product, this strategy may suit investors with a moderate risk profile. 

Expected results of this study?

Our expectation is that the SFI portfolio will outperform the share portfolio during the 10 year period.  At maturity it is envisioned the SFI portfolio would have grown more in value than the direct share portfolio where the share price remains neutral (or rising) during the 10 year period.  Conversely, we expect the instalment portfolio to under-perform when the share price or overall market falls strongly due to adverse company or market conditions.

What shares were selected?

Portfolio 1 : Share Portfolio - The shares selected are based on popular IPOs that retail investors are assumed to have taken up.  As the shares selected are in the S&P/ASX 50 index, it is assumed investors will hold some or all of the selected shares.  Should investors hold none of the selected shares, the principles of diversificaton to reduce portfolio risk, still apply.  This strategy should be of interest to any investor who may be overweight shareholdings in their portfolio. 

Table 1: We value the share portfolio on the listing date of the last investment, IAG, on 08/08/2000.  At this time the portfolio was valued at $273,387.94 with CBA representing 47.43% of the portfolio.  At this time, the standard deviation (a risk parameter) of the portfolio was 1.60.

Table 1 ASX code Listing date Issue price Capital invested Shares held Price 08/08/2000 Value 08/11/2000 Weight
Commonwealth Bank of Australia CBA 12/09/1991 $5.40 $25,000 4,629 $28.01 $129,658.29 47.43%
Woolworths Ltd WOW 12/07/1993 $2.45 $25,000 10,204 $6.35 $64,795.40 23.70%
Telstra Corporation Ltd TLS 17/11/1997 $3.30 $25,000 7,575 $7.12 $53,934.00 19.73%
Insurance Australia Group Ltd IAG 08/08/2000 $2.75 $25,000 9,090 $2.75 $25,000 9.14%
$100,000  $273,387.94 100.00%

Pie chart showing portfolio value as at 08/11/2000

Table 2: At the start of the portfolio study on 03/07/2006 the share portfolio is worth $489,262.78 indicating significant capital gains with CBA and Woolworths each representing just over 40.00% of the portfolio.  Over time the standard deviation has increased to 1.74, indicating the risk of the portfolio has also increased.

Table 2 ASX code Price 08/08/2000 Shares held Price 03/07/2006 Value 03/07/2006 Gain / (Loss)  Weight
Commonwealth Bank of Australia CBA  $28.01  4,629  $44.74 $207,101.46 $77,443.17 42.33%
Woolworths Ltd WOW  $6.35  10,204  $20.08 $204,896.32 $140,100.92 41.88%
Telstra Corporation Ltd TLS  $7.12  7,575  $3.72 $28,719.00 ($25,215) 5.76%
Insurance Australia Group Ltd IAG  $2.75  9,090  $5.40 $49,086.00 $24,086 10.03%
Portfolio Value   $489,262.78   100.00%

Pie chart showing portfolio value as at 03/07/2006

Strategy: Cash Extraction (Shareholder Application)

The Cash Extraction strategy was employed to realise cash without triggering a CGT event.  By employing the cash extraction strategy, the share portfilio was converted into Instalments (Table 3) with the remaining cash used to purchase equal dollar amounts of Instalments over the S&P/ASX 200 Fund (STW) and the SS&P/ASX Listed Property Fund (SLF) (Table 4).  These two ETFs provided overall market exposure and exposure to listed property trusts, the combination of which helped diversify the portfolio and reduce the overall risk of the protfolio.  The standard deviation of the portfolio subsequently reduced to 1.15.

Table 3 Listing Date Expiry Exercise Price Instalments Converted Price 03/07/2006 Capital Invested Cash Extracted
CBASMX 28/02/2006 30/06/2016 $28.139 4,629 $20.80 $96,283.20 $110,818.26
WOWSZB 26/04/2006 30/06/2016 $11.173 10,204 $11.15 $113,774.60 $91,121.72
TLSSWB 16/01/2006 30/06/2016 $1.937 7,575 $2.08 $15,756.00 $12,423.00
IAGSMX 28/02/2006 30/06/2016 $3.654 9,090 $2.70 $24,543.00 $24,543.00
Total $238,905.98

Table 4 Listing Date Expiry Exercise Price Instalments Purchased Price 03/07/2006 Capital Invested ETF Unit Price
STWSZB 26/04/2006 30/06/2016 $29.619 4,500 $26.55 $119,475.00 $49.94
SLFSZB 26/04/2006 30/06/2016 $10.78 13,053 $9.15 $119,434.95 $18.39
Total $238,909.95

Pie chart of instalment portfolio

Selection criteria for Instalments

Portfolio 2 : SFI Portfolio - The SFIs selected were all issued in 2006 with a life of 10 years due to expire on 30/06/2016.  The following criteria apply to all selected SFIs:
• SFIs are regular geared (i.e. < 65% loan-to-value ratio)
• All expire on 30/06/2016 (10 year life)

What happens to the dividends received?

All dividends will be re-invested into the loan amount (feature of SFIs), thereby reducing the loan amount over time.  Any special dividends will also be re-invested into the loan amount.

How will corporate actions be treated?

As this will be a long term strategy, the probability of corporate actions is high.  We will treat corporate actions according to the issuers terms as dictated by the relevant product disclosure statement (PDS) or as directed by ASX.   Should a corporate action have a significant impact to the portfolio, we will liquidate the ETF SFIs and use the proceeds to repay and residual loan amounts over the share SFIs and take ownership of the shares.

What if the share price falls?

The original shares purchased will not be sold at any time regardless of any adverse movements in the share price.  As such, the SFIs over the shares will be held until maturity.  The index ETFs, STW and SLF, will track the value of the S&P/ASX 200 index (XJO) and the property index respectively.  Any adverse movements in the XJO and Listed Property index will be reflected in the value of the STW and SLF.  The SFIs over both ETFs will also be held until maturity.

What happens at maturity?

We have four available options relating to the index ETFs:

  • Sell the SFIs on market and receive a cash payment equivalent to the value of the SFI. 
  • Exercise the SFI, repay any balance owing on the loan amount and take ownership of the shares.  We will receive shares proportionate to their weighting in the index.
  • Exercise the SFI, repay any balance owing on the loan balance and receive a cash payment.  The units in the ETFs will be sold on market and we will receive cash consideration.
  • Do nothing.  The issuer will sell the ETF on market and use the proceeds to repay any balance owing on the loan amount.  Any residual funds will be paid to the SFI holder.

At maturity we will elect sell the two ETF SFIs, using the proceeds to repay any outstanding balance owing on the loan amount on the share SFIs to take posession of the original shares.  

Brokerage charges

As this is a passive buy and hold strategy, no brokerage charges will be incurred.

Tax implications

All positions will be held until maturity.  As a result, the portfolio will eligible for the 12-month capital gains tax concession.  We will aim to provide a yealy audit on the tax implications of the portfolio study. View the 'Taxation treatment of warrants' prepared by Ernst & Young.