What is the best way to invest a lump-sum? Investors sometimes face this question – for example when they sell their business, when they inherit a significant sum of money, or perhaps when they win a lottery. In either case, they are dealing with a lot of liquidity that needs to be put to work.
Let’s assume our investor has USD12 million that they wish to invest for the long term. To keep things simple without a loss of generality, we will assume that the investor wants to allocate the entire sum to the global stock market.
There are many ways in which this can be done, but they can be classified in three main categories:
- simply investing everything immediately,
- dollar-cost-averaging, and
- waiting for a good entry point before investing.
In our example, dollar-cost-averaging would be done by splitting the 12 million into equally-sized tranches and deploying them over a period of 12 months.
On the other hand, those waiting for a good entry point will typically wait for the markets to correct by, say, 10 per cent before investing. To remove the risk of waiting for too long, they will invest the entire sum at whatever the price, if the dip does not occur over a certain period, say 12 months.
At this point, it is important to observe that, at the end of the 12-month period, the portfolio is fully invested in all three scenarios. Therefore, when comparing the effectiveness of these three approaches, we only need to compare the difference in performance over the first twelve months.
In our first chart, we can see the overall growth of USD12 million under all historical 12-month periods, starting from December 1969. In total, that is almost 600 different scenarios. Across all these 12-month periods, the average total return would have been around 10 per cent, or USD1.2 million for a USD12 million investment. Of course, due to market volatility, the range of outcomes could be anywhere between +USD7.8 million and -USD4.7 million.
Knowing that market returns have been positive historically, it should logically follow that any strategy that delays investment (such as tranching-in or waiting for a dip) should be expected to underperform in this backtest. Specifically, tranching-in delivers an average return of 5 per cent (compared to 10 per cent for immediate investing). This should not be surprising, as in this scenario, on average only half of the sum is invested during the tranching period.
The third chart shows that waiting for a dip would have generated an average return below 2 per cent. This is mainly because when you wait for the dip, you can keep waiting for a long time.
So, how do these three strategies compare? If our investor decides to wait for a dip instead of investing immediately, they should be expecting to be by around USD1 million less wealthy in 12 months. Of course, from that point onwards, this difference will continue to compound over time.
Tranching in versus investing immediately means that we are foregoing around half a million, simply by being only partially invested in the first year. Tranching in therefore is not as disadvantageous as waiting for a dip.
The conclusion should be intuitive. If investors are expecting the markets to rise, both logically and statistically (when we look at the data), investing immediately has the greatest expected return. Tranching in is the second best, and waiting for a dip is the worst option, from the expected return perspective.
That being said, anyone can imagine a horror scenario of investing at the worst possible time, just prior to a substantial market crash. While these are rare and unlikely events, due to their severity it is not difficult to understand the fear of deploying a large sum immediately. But, those who still wish to gradually deploy their money need to be aware of three main lessons:
- There is an expected cost to delaying investment, which is equal to the expected return of your strategy.
- This cost can be controlled by reducing the period over which they tranche in or wait for a dip. Phasing in over 3 months is generally less costly compared to phasing in over 3 years.
- There will always be a risk of an immediate selloff once the lump-sum is fully deployed, whether that’s done immediately or over a certain period of time. Therefore, this risk cannot be eliminated - it can only be delayed to a different date.
Risks of investment in fixed income
There are several key issues that one should consider before making an investment into fixed income. The risk specific to this type of investment may include, but are not limited to:
Investor is subject to the credit risk of the issuer. Investor is also subject to the credit risk of the government and/or the appointed trustee for debts that are guaranteed by the government.
Risks associated with high yield fixed income instruments
High yield fixed income instruments are typically rated below investment grade or are unrated and as such are often subject to a higher risk of issuer default. The net asset value of a high-yield bond fund may decline or be negatively affected if there is a default of any of the high yield bonds that it invests in or if interest rates change. The special features and risks of high-yield bond funds may also include the following:
- Capital growth risk - some high-yield bond funds may have fees and/ or dividends paid out of capital. As a result, the capital that the fund has available for investment in the future and capital growth may be reduced; and
- Dividend distributions - some high-yield bond funds may not distribute dividends, but instead reinvest the dividends into the fund or alternatively, the investment manager may have discretion on whether or not to make any distribution out of income and/ or capital of the fund. Also, a high distribution yield does not imply a positive or high return on the total investment.
- Vulnerability to economic cycles - during economic downturns such instruments may typically fall more in value than investment grade bonds as (i) investors become more risk averse and (ii) default risk rises.
Risks associated with subordinated debentures, perpetual debentures, and contingent convertible or bail-in debentures
- Subordinated debentures - subordinated debentures will bear higher risks than holders of senior debentures of the issuer due to a lower priority of claim in the event of the issuer's liquidation.
- Perpetual debentures - perpetual debentures often are callable, do not have maturity dates and are subordinated. Investors may incur reinvestment and subordination risks. Investors may lose all their invested principal in certain circumstances. Interest payments may be variable, deferred or canceled. Investors may face uncertainties over when and how much they can receive such payments.
- Contingent convertible or bail-in debentures - Contingent convertible and bail-in debentures are hybrid debt-equity instruments that may be written off or converted to common stock on the occurrence of a trigger event. Contingent convertible debentures refer to debentures that contain a clause requiring them to be written off or converted to common stock on the occurrence of a trigger event. These debentures generally absorb losses while the issuer remains a going concern (i.e. in advance of the point of non-viability). "Bail-in" generally refers to (a) contractual mechanisms (i.e. contractual bail-in) under which debentures contain a clause requiring them to be written off or converted to common stock on the occurrence of a trigger event, or (b) statutory mechanisms (i.e. statutory bail-in) whereby a national resolution authority writes down or converts debentures under specified conditions to common stock. Bail-in debentures generally absorb losses at the point of non-viability. These features can introduce notable risks to investors who may lose all their invested principal.
Changes in legislation and/or regulation
Changes in legislation and/or regulation could affect the performance, prices and mark-to-market valuation on the investment.
The uncertainty as to the coupons and principal will be paid on schedule and/or that the risk on the ranking of the bond seniority would be compromised following nationalization.
A decline in interest rate would affect investors as coupons received and any return of principal may be reinvested at a lower rate. Changes in interest rate, volatility, credit spread, rating agencies actions, liquidity and market conditions may significantly affect the prices and mark-to-market valuation.
Risk disclosure on Dim Sum Bonds
Although sovereign bonds may be guaranteed by the China Central Government, investors should note that unless otherwise specified, other renminbi bonds will not be guaranteed by the China Central Government.
Renminbi bonds are settled in renminbi, changes in exchange rates may have an adverse effect on the value of that investment. You may not get back the same amount of Hong Kong Dollars upon maturity of the bond.
There may not be active secondary market available even if a renminbi bond is listed. Therefore, you need to face a certain degree of liquidity risk.
Renminbi is subject to foreign exchange control. Renminbi is not freely convertible in Hong Kong. Should the China Central Government tighten the control, the liquidity of renminbi or even renminbi bonds in Hong Kong will be affected and you may be exposed to higher liquidity risks. Investors should be prepared that you may need to hold a renminbi bond until maturity.
Risk disclosure on Emerging Markets
Investment in emerging markets may involve certain, additional risks which may not be typically associated with investing in more established economies and/or securities markets. Such risks include (a) the risk of nationalization or expropriation of assets; (b) economic and political uncertainty; (c) less liquidity in so far of securities markets; (d) fluctuations in currency exchange rate; (c) higher rates of inflation; (f) less oversight by a regulator of local securities market; (g) longer settlement periods in so far as securities transactions and (h) less stringent laws in so far the duties of company officers and protection of Investors.
Risk disclosure on FX Margin
The price fluctuation of FX could be substantial under certain market conditions and/or occurrence of certain events, news or developments and this could pose significant risk to the Customer. Leveraged FX trading carry a high degree of risk and the Customer may suffer losses exceeding their initial margin funds. Market conditions may make it impossible to square/close-out FX contracts/options. Customers could face substantial margin calls and therefore liquidity problems if the relevant price of the currency goes against them.
Currency risk – where product relates to other currencies
When an investment is denominated in a currency other than your local or reporting currency, changes in exchange rates may have a negative effect on your investment.
Chinese Yuan ("CNY") risks
There is a liquidity risk associated with CNY products, especially if such investments do not have an active secondary market and their prices have large bid/offer spreads.
CNY is currently not freely convertible and conversion of CNY through banks in Hong Kong and Singapore is subject to certain restrictions. CNY products are denominated and settled in CNY deliverable in Hong Kong and Singapore, which represents a market which is different from that of CNY deliverable in Mainland China.
There is a possibility of not receiving the full amount in CNY upon settlement, if the Bank is not able to obtain sufficient amount of CNY in a timely manner due to the exchange controls and restrictions applicable to the currency.
In the case of investments for which there is no recognised market, it may be difficult for investors to sell their investments or to obtain reliable information about their value or the extent of the risk to which they are exposed.
The following may be subject to local requirements.
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