Advisory Brokers and Investment Funds

Q.: Would you recommend using an advisory brokers service?

A: A trade advisory a brokerage service that not only buys and sells stocks and shares (and some also deal in CFDs) but also recommends clients on what shares should be bought and sold for the portfolio. A good advisory broker will guide you on the size of your positions and levels where to place stop losses. No doubt controlling your exposure and timing exits is as important as knowing what to buy and sell.

If you ask me if I have or whether I would use a CFD advisory broker my response would be a firm NO. For one the relationship is too easily open to abuse. This is because there is a conflict of interest between the client and the advisory broker - as the broker's business model is based on making money from commissions. Also, trade advisory services charge a considerable fee (around 0.3% to 0.5%) for each advisory trade as well so the broker may be encouraged of making too many trades on your behalf.

I haven't ever used one but a friend of mine had this to say about them 'over 30 trades in a month with only 50% success rate where they netted over 2k in commission against a trading loss of 1k (ex-commission). So it is clear to see who wins... and why some advisory brokers want to bet with your money - not theirs.'

Remember that all an advisory broker is going to do is to just you what their in house or, more likely, 3rd party analysis service has stated - a broker doesn't know how to trade any more than your granny knows how to trade. There are plenty of advisory stockbrokers around, to name some UK trade advisory services there are Montaguepitman, Galvan Research, Accendo, BlueIndex or JN Financial...etc All are white labels. For instance Blue Index and JN use CMC and Accendo use GFT. And they will charge 0.5% on the deal size! So for a margin of £100 you pay £10...10% madness before the spread is taken into account.

And be sure to steer far way from advisory brokers (bucket shops) who use pressurise you in making as many trades as possible or who generally use high pressure tactics in selling you shares (such as repeat calls or urging you to try them out with a small amount or that you will miss the boat if you don't act now or try to continually persuade you in selling stocks you own and re-invest the proceeds in another). On the other hand a good advisory broker will tell you the rationale for a trade and explain you the risk-reward rationale and the expected timeframe for the trade.

Do not rely on the regulators to protect you against dubious stockbrokers. Some sharp operators slip through the cracks!

Q.: Are there any funds which use CFDS in their investment portfolio?

A: In the past investments funds have been restricted from investing in derivatives but the introduction of the Undertakings for Collective Investments in Transferable Securities (UCITS iii) directive (passed in the European Parliament) has provided fund managers with more room to take advantage of these powerful instruments. The main distinction between hedge funds and Ucits vehicles is the restriction on shorting in Ucits funds, which means managers have to mirror such positions using CFDs.

Today, quite a few aggressive investment funds looking to profit from the volatility or short-term trading opportunities use contracts for difference as a trading tool. Other funds, especially in the current market turmoil have lately been making use of short selling to eliminate as much market exposure from their portfolio and preserve their investors' capital. These funds known as 'Absolute return funds' allow managers to make use of derivatives in their porfolios and aim to provide positive returns in both rising and falling markets.

It is worth noting that fund managers in Absolute return funds can invest in shares, bonds, foreign exchange, equity indices, metals, agriculture contracts, interest rates, energy and even multi-asset funds or a combination of these assets in a local or global scale. These funds are subject to a maximum 200% leverage and have to adhere to the 5/10/40 rule, under which no single asset can represent over 10% of net asset value and the total number of holdings exceeding 5% cannot add up to more than 40%.

Colin Harte, who runs the Barings Absolute Return Global Bond fund was quoted to say - 'Going long or short duration government gilts by up to eight years is a macro-driven decision, and the Treasury is hardly like to take offence at a manager's long-term view of the effects of quantitative easing on monetary policy'.

One of the funds which have been especially making use of the facility to sell short is BlackRock UK Absolute Alpha, which fund was launched in 2005 and aims to achieve positive returns in all market conditions. The BlackRock UK Absolute Alpha fund benefited from being the first Absolute Alpha fund in the UK retail market and is targeted to investors who are able to tolerate a medium degree of risk. Other market entrants include Argonaut, Gartmore, Cazenove, Liontrust, SVM and Odey and GAM while companies including GLG, Brevan Howard and Man Group all have similar offerings either in the market or expected for launch in due course. Even other funds like the 130/30 fund (example: Resolution International Cartesian UK Equity 130/30) maintain a net 100 per cent exposure to the market, but can go up to a 130 per cent on the long side while holding up to 30 per cent of the portfolio in shorts. This allows the fund manager more flexibility in that he’s able to gear his favoured stocks while short selling securities which he believes are likely to fall in value. This doesn't mean that these funds are fail proof. A problem of Absolute return funds is that whilst tending to do well in an underperforming market, they tend to underperform in major market rallies. Not to mention that Absolute return funds often come with higher fees than other traditional 'long only' funds.

Another innovative offering using CFDs is the 'Skandia UK Strategic Best Ideas' fund which offers a long-short portfolio managed by ten top investment managers who each select ten UK shares and up to five of these can be short positions. The selections are then combined into a 100 stock portfolio.

Other managed funds use borrowed money to invest. Investors contribute to their portfolio on a monthly basis, and an additional amount is added from a margin loan facility to increase the overall size of the investment. These geared funds typically match every $1 of the investor's money with $1 of borrowed money, which implies bigger gains in good times and heavier falls in the bad times. Over the long term they can still perform well.

'We hope that as long as we express our views with clarity and they're well-argued, management will acknowledge that they are sensibly constructed views. But it definitely does introduce another layer of complication to the relationships we have with corporates, and we are incredibly sensitive to that' - Nick Osborne, BlackRock UK Absolute Alpha fund manager.

Q.: Why are CFDs not permitted in the USA?

A: It is interesting to point out that contracts for difference are not currently permitted to by USA residents (and citizens?), which is kind of odd given they rule trading in many other markets in the global market place now and replaced much of the need to trade options for leverage, so in part it's to protect the options market revenues in the USA I guess, and protect them from those 'evil derivatives that will be the end of the world', CDO's are much safer huh. Given the current overreaction on regulations on trading in the USA it's not expected CFDs will get the green light anytime soon as the leverage provides the potential to stuff up in spectacular fashion if you get it wrong, as in futures.

Trading in CFDs is often compared with spread betting and it is important to make a distinction between the two. The main difference is that CFD spreads are market-determined, while betting spreads are set by bookmakers and therefore tend to be wider.

Q.: Will CFDs ever be allowed in the USA?

A: Well, in the States you have the exchanges that are protected by the government and who have a very strong lobby there as well, so a private client has to trade a product traded on an exchange. Currently the USA regulatory regime excludes the availability of CFDs. The answer on whether this will change will probably be that if they do not allow CFDs then the USA exchanges will continue draining liquidity and volume as USA equity trading moves to more favorable centers (for instance Goldman quotes US equity CFDs to some CFD providers out of London but cannot do the same for their USA clients in the States!). This when the USA prides itself on its capitalistic outlook... I think the simple fact that revenue is being drained away from their exchanges may eventually lead to changes in their laws to permit CFD trading at some point...

The only exception in the USA is forex trading as there is no regulated exchange there for foreign exchange. So you can actually trade foreign exchange in the States in practically the same way that you can trade them in Europe in terms of the CFD full risk that's involved in the product. But if you wanted to trade gold, oil, commodities or securities you have to trade them on an exchange in the USA.

Trading in CFDs is often compared with spread betting and it is important to make a distinction between the two. The main difference is that CFD spreads are market-determined, while betting spreads are set by bookmakers and therefore tend to be wider.