This is guest post on spread betting tax avoidance strategies from Andy Richardson of the Financial Spread Betting website.

Before you find yourself packing your bags for an extended stay at Her Majesty’s pleasure, let us remind ourselves that tax avoidance (arranging your affairs so as to pay no more tax than is necessary) is legal whereas tax evasion (failing to pay tax that you actually owe) is definitely illegal.

Some people have argued that tax avoidance is a moral duty. And of course some tax avoidance schemes are state-sponsored – think about National Savings, Individual Savings Accounts (ISAs), and pensions.

If we treat tax avoidance as a legitimate pursuit (and you can make your own mind up about that) then how might spread betting be used as a vehicle for minimising tax liability – specifically avoiding capital gains tax (CGT) liability?

Let’s think about why spread betting is tax-free in the first place.

Why is spread betting tax-free?

The fact that spread betting proceeds are (usually) free from income tax and capital gains tax seems to rest on the fact that for most participants it is classed as gambling rather than investment.

(Editor’s note: How long this will last after the arrival of the potentially more mass-market Halifax Spread Trading service, we’ll have to see!)

With spread betting, you don’t invest in companies by buying shares. You merely make a bet with a bookmaker on whether you think a company’s share price will go up or down. The bookmakers (i.e. the spread betting companies) pay tax on their profits, but you don’t pay tax on your winnings.

So suppose the HMRC did make spread betting proceeds subject to tax. What do you think would happen?

It is said that HMRC would then have to let you offset your spread betting losses against other investment gains, which would be a net loser for the Exchequer because – as we all know – there are substantially more losers than winners in the spread betting game.

But measures can be taken to make spread betting safer.

The logical conclusion of this article is that it may be possible to run a tax-free spread betting portfolio as an alternative to a traditional investment portfolio. But this doesn’t help anyone facing a potential CGT bill due to crystallising a profit in their existing portfolio.

So let’s consider that first, after a quick reminder from Monevator‘s editor.

Wealth warning: While this article explains more sensible ways to spread bet, doing so is still more risky than buying traditional shares with cash – especially if you get your sums wrong! Spread betting on margin can rack up big losses quickly, and you can lose more money than you thought you were risking. This article is aimed at experienced traders and investors. We take no responsibility for your losses in any circumstances.

Hedging a potential capital gains tax liability with a spread bet

One of the features of spread betting is that it is just as easy to take a short position (i.e. bet on a falling price) as it is to take a long position.

This raises the possibility of offsetting an existing position – perhaps in a share you own in the traditional way, or even in a company Sharesave scheme – with a spread bet that neutralises any future fall in price, without you having to trigger a CGT liability by crystallising the profit in your initial portfolio.

Suppose you were lucky enough to ten-bag your shareholding in Penny Stock Corporation (not a real company!) so that your £10,000 investment has become £100,000. With the price so toppy, you want to take your money and run, without having to hand over a proportion of it to Her Majesty’s Revenue and Customs in the form of capital gains tax.

Rather than selling the shares, you might place an equivalent opposing ‘short’ spread bet on the same stock, to the effect that any subsequent fall in your traditional long position is offset exactly by the tax-free rise in the value of your short spread bet.

To help you get your head around this, let’s say Penny Stock Corporation is now priced at 1,000p-per-share (the company is no longer a ‘penny stock’ but at the time you bought it – before it ten-bagged – it was!).

1. A £100-per-point short spread bet should therefore exactly offset your ongoing £100,000 investment.

2. To effectively ‘insure’ the value of your investment in this way, the spread betting company will ask you to deposit a much smaller sum than £100,000 – but obviously you do need some spare cash with which to place the bet.

3. When the tax implications become more favourable, you can close all or part of your traditional long position and the matching short spread bet, so as to release your gains tax-free.

There are some other variations on this ‘hedging‘ theme, like closing a position in your traditional portfolio to fully utilise your annual CGT allowance at the end of the tax year, while at the same time taking out an equivalent long spread bet to ‘keep you in position’ tax-free until such time (after 30 days, according to the HMRC rules) that you can legitimately re-establish your original share holding.

You might even want to crystallise a loss in your traditional portfolio to offset another CGT gain, but to stay ‘in position’ via a spread bet in the same company, just in case the price of the loss-making share recovers.

Spread betting as an alternative to traditional investment

So much for minimising CGT events in your traditional portfolio – do you actually need a traditional portfolio?

There is little that is fundamentally different about holding equity positions in a spread betting account and holding shares in a traditional brokerage account.

• There is no limit to how long you can hold ‘rolling’ equity spread bets.

• You can collect dividends on those positions, albeit at a reduced rate.

• Just like in a traditional share dealing account, when the price of a stock goes up you make money .

• When the price goes down, you lose money.

Which begs the question: why bother with a traditional brokerage account when you could run your ‘investment’ portfolio in a spread betting account, tax-free?

For smaller accounts, this could make perfect sense, because a trader or investor with limited funds can get more bang for his trading buck due to the leveraged nature of spread betting.

You may be able to take a £10,000-equivalent position with a margin deposit of only £2,000, providing you have the balance held elsewhere (in case the spread betting company demands it) or providing you have a very tight risk-management policies using stop orders to limit your potential downside.

For larger account holders, it may not be so easy or advisable to squirrel away a substantial proportion of net worth in a spread betting account.

Still, it could provide a good home for surplus funds beyond the annual ISA and Self-Invested Personal Pension contribution limits, especially if your portfolio that you have sitting outside of these tax shelters seems likely to run up against the capital gains tax-free allowance any time soon.

There are some caveats, of course.

Whereas you pay a one-off dealing fee (plus stamp duty reserve tax) to open a traditional share holding position, a rolling spread bet incurs ongoing financing charges that are levied by the spread betting company in exchange for it ramping up your position size through leverage.

Therefore, your rolling spread bet positions are not so much owned as mortgaged.

For a long spread betting position held overnight, you will normally be charged financing at LIBOR (currently 0.5%) plus 2.5%.

i.e. At (0.5%.+ 2.5%)/365 days, you’d pay 0.008% for each day you held the position.

Of course, in the present low interest rate environment – with many companies trading at what some think are historically low valuations that could multi-bag in short order  – the financing charges could pay for themselves. It’s your call.

(Editor’s note: If you do not want to use leverage, but simply want the tax free benefits of spread betting, you can offset some or all of the financing charges by holding an equivalent cash balance in a high interest savings account. Whether it’s possible to match your costs with interest earned (after tax) will depend on prevailing interest rates at the time. Remember you’ll also need access to ready cash to meet any margins calls).

What about dividends? Well, although you receive dividend-equivalent adjustments on spread bets sooner than on traditional share holdings (i.e. at the ex-dividend date rather than a later payment date) those dividend adjustments are typically 80%-90% of the actual dividend. (For more on this, see the advantages and disadvantages article on my website).

Finally, spread bet positions in individual equities bestow no voting rights or other benefits upon the holders of those positions, unlike share holdings.

Remember: You don’t actually own the shares. You’ve simply made a bet with a bookmaker as to whether they will go up or down in price.

What about index tracking?

Many investors don’t buy individual shares at all, of course. They rely instead on index-tracking funds or exchange traded funds (ETFs) to simply follow the market up and down.

Spread betting may provide a more efficient way of doing this, because I’d argue that a spread bet on a stock index is far more transparent than the tracking errors and Total Expense Ratios (TER) associated with traditional index funds.

If the underlying index rises, your index spread bet position will rise by exactly the same amount, and likewise if it falls. There’s no obfuscated tracking error or TER to worry about –  just the simple bid-ask spread and the ongoing cost of financing your position.

In addition – and perhaps more importantly – tracking overseas markets or shares via spread betting eliminates currency risk. All your positions will be quoted in pounds sterling, as will your profits and losses.

Let’s suppose you’re trading the crude oil contract, which trades in USA dollars.

You opt to buy, staking £1 a point. If oil then rises 400 cents to $104, your profit is 400 times £1 or £400.

If you had bought a USA crude oil futures contract or an ETF, by contrast, your trade and profits would have been in USA dollars. So, if the dollar went down by 5% against the pound during your trade, your profit on oil would have transformed into a loss!

You will find a very wide range of domestic and international indices that you can spread bet, and best of all, the proceeds from this form of index tracking are currently CGT-free!

• Further reading: See my website for other ways to make intelligent spread bets.

Disclaimer: Due to the nature of this article it is important that we include a specific disclaimer. The author of this article is not a tax advisor or investment advisor, therefore you should treat the information given here as for educational purposes only and seek independent professional advice on matters of tax planning and investment.

It’s hard to find friends of Facebook’s Initial Public Offering (IPO). Commentators are lining up to poke the social network’s prospects with a stick, and most aren’t hitting the like button.

From Reuters:

Here’s the thing about the big, honking 187-page prospectus Facebook filed late Wednesday. Once you dig past those headline numbers, the company itself ends up looking pretty unremarkable.

From Wall Street analysts:

Retired Neuberger Berman value investor and present CNBC commentator Gary Kaminsky observed that at similar multiples as Facebook, Google would be trading at $850 and Apple trading at $1250.

From CBS News:

At $5 per customer, Facebook is really bad at making money off its customer base.

And so on. Wearing my passive investor’s Helm of Much Smugness, I let the furore rage over my head. Whatever will be, will be – let the index decide.

But wait!

Facebook is going to be worth billions. It’s the pump primer for the tech bubble part II. Am I predestined to scoop up tons of the stuff as my tracker robotically swings into action, like an ASIMO sent to clean up a nuclear accident?

Most index trackers hold securities in proportion to their presence in the index that is followed by the fund. Give or take a few quirks in replication strategies it’s a financial game of Simon Says.

But what happens when an index tracker has to deal with big new IPOs?

Your exposure to Facebook

Any passive investor with a globally diversified portfolio is likely to hold an index tracker that covers the US market. How big a splashdown Facebook makes in your world will depend on:

• What index your tracker tracks.

• How the index admits new entrants.

• The size of the index.

• Your portfolio’s size and exposure to that tracker.

• Facebook’s market cap. ¹

So how much Facebook action would a regular 60:40 equity/bond portfolio get, in raw moolah terms?

Here’s one possible calculation, assuming:

1. Portfolio size = $100,000
2. US equity allocation of 50% = 30% of a 60:40 portfolio
3. Facebook’s market cap = $100 billion = 0.5% of index being tracked

Then:

(Portfolio size) x (US equity exposure) x (index exposure) = Facebook held

Substituting in:

$100,000 x 0.3 x 0.005 = $150 ²

That’s equivalent to 0.15% of our notional $100,000 portfolio. I reckon I can stand that kind of punt on one of the planet’s best known brands.

Signing up

Facebook (Ticker: FB) won’t hit the New York Stock Exchange (NYSE) or NASDAQ for another three to four months.

Even then it’s not going to instantly pop into your index tracker in a puff of hype.

The indices will take some time to grind into action and admit Facebook into the ranks. How that affects you depends, as mentioned above, on the index you track and its rules on new members.

UK passive investors may well get their US exposure from one of the following:

Index tracker	Index it replicates
HSBC American Index Fund	S&P 500
Vanguard US Index Fund	S&P Total Market Index
iShares MSCI World ETF	MSCI World
Vanguard FTSE Developed World ex-U.K.	FTSE Developed ex UK Index

Each index has its own brand method of carving up the investable US market.

Facebook’s impact upon a global index like MSCI World will be diluted by the fact that this benchmark monitors an investible universe worth $22.5 billion.

Facebook’s influence will be around twice as large in the well-known S&P 500 index that concentrates on US large cap companies worth over $11 billion.

Platinum membership: The S&P 500

If your index tracker follows the S&P 500, then you may well have to wait a while before you own a piece of Facebook. Google went public on August 25, 2004 but it didn’t gain entry to the S&P 500 until March 31, 2006.

Facebook only needs a market cap of $5 billion to get into the S&P 500, which is much less than its currently guesstimated valuation of $80-100 billion. But size alone is no passport to entry.

S&P 500 companies must also have a public float of 50%. That means half of the company’s shares must be tradable on a public exchange.

It’s thought only 5% of Facebook’s shares will be made publically available through the IPO. The rest will be controlled by management, employees, and early investors. Most are subject to various lock-ups.

Even when enough Facebook paper millionaires/billionaires cash out and start building rocket ships to Alpha Centauri, the final decision on entry is made by the S&P index selection committee. Its members stuff their pipe with a company’s financials, liquidity, and trading volume numbers, smoke it, and then make an announcement if the company gets in.

And even if a company has all the right chops, its industry sector mustn’t be over-subscribed and an existing member must be fit for elimination.

It all reminds me of the time I tried to get into the Gentleman’s Beefsteak Club.

Tufty Club membership: The S&P TMIX

In contrast, Facebook’s entry into the Vanguard US Equity Index fund is likely to be far swifter, because getting into its S&P Total Market Index (S&P TMIX) is about as tough as getting through the doors at McDonald’s.

The S&P TMIX offers exposure to large, mid, small, and micro cap companies that trade on the NYSE and NASDAQ.

In this case there is no:

• Minimum market cap
• Worries about the public float
• Bother with financial viability nonsense

The index is rebalanced quarterly, so it will only be a matter of weeks after Facebook’s IPO before it will be ushered into the S&P TMIX.

Facebook could be a relative lightweight

The weighting of Facebook in the indices may not match the heady $100 billion valuation being put on the company by the media, however.

Most indices – including the S&P 500 and S&P TMIX – calculate a company’s market cap using what is known as a ‘free-float methodology’.

The company’s share price is multiplied by the number of shares freely available in the market to determine its free-float market cap. It excludes shares sat on by company insiders, other public companies, and governments.

If only 5% of Facebook’s outstanding shares are made publicly available, then the impact on index trackers governed by the free-float methodology will be a fraction of the valuations hitting the headlines now.

Market impact costs

The mechanical responses of trackers to index changes make them easy pickings for hedge fund sharps and arbitrage bandits.

They lie in wait knowing exactly when a fat caravan of index trackers is coming down the road to buy and sell.

The arbitrageurs nip in first, driving up the prices of securities that the trackers must buy.

Worse, the tracker funds will have to sell the securities kicked out of the index (which the arbitrageurs have been furiously selling) and so they earn depressed prices on exit and pay inflated prices on entry.

When Berkshire Hathaway entered the S&P 500 in 2010, the price of its shares jumped almost 12% between the S&P’s announcement and the couple of weeks it took for the index trackers to make their move.

This index turnover cost is calculated by New York University Professor Antti Petajisto to equate to a drag on performance of 0.21-0.28% a year, between 1990 and 2005.

This isn’t a cost that would show up on any fee schedule, but would stealthily chip away at returns through tracking error. (Of course, a great many active funds are closet trackers enrobed in high fees, and so they suffer the same malaise).

You can avoid this problem with a synthetic ETF – mostly because it’s unlikely to hold any shares in the companies it notionally tracks – but then it may well be stuffed with Japanese small-caps, so you really need to know what you’re jumping into bed with.

Poke me, I must be dreaming

Of course, we’ll all be smiling if Facebook turns into the next Google.

And even if it doesn’t, the ponderous reflexes of index trackers will at least help passive investors avoid a Day One bloody nose if the internet giant, like so many IPOs, dives like a paper dart.

Take it steady,

The Accumulator

1. Most indices are weighted by market cap so that individual companies impact the index in proportion to their size. So a company that makes up 10% of the index will move the value of the index by 1% if its own share price moves by 10%.[↩]
2. Approximately £95.[↩]

Good reading from around the Web.

I had no sooner published this week’s article questioning expensive university degrees when the emails and comments started to arrive.

That’s gratifying if you’re a writer, and most were very nice. One or two weren’t happy, and thought I was suggesting everyone had to start a business. (I’m not! I’m really not!)

Equally, it also turns out I have more entrepreneurial subscribers than I knew about before I wrote that article. Apparently more millionaires, too.

Several doubters asked where all this free learning I alluded to could be found.

I’m not quite sure how they managed to email me – what with them not having had access to a computer and the Internet since 1993, presumably 🙂 – but anyway, it’s out there, on the Web.

It’s everywhere!

Just this week I discovered (from the Simolean Sense blog) an upcoming free lecture course from the top table of US academia on model thinking.

This kind of model thinking isn’t: You can never be too rich or too thin.

Rather it refers to the mental frameworks extolled by Charlie Munger, the sidekick of Warren Buffett.

From the course outline:

We live in a complex world with diverse people, firms, and governments whose behaviors aggregate to produce novel, unexpected phenomena. We see political uprisings, market crashes, and a never ending array of social trends. How do we make sense of it?

Models. Evidence shows that people who think with models consistently outperform those who don’t. And, moreover people who think with lots of models outperform people who use only one.

Why do models make us better thinkers?

Models help us to better organize information – to make sense of that fire hose or hairball of data (choose your metaphor) available on the Internet. Models improve our abilities to make accurate forecasts. They help us make better decisions and adopt more effective strategies. They even can improve our ability to design institutions and procedures.

The lectures come from Coursera, a new initiative from Stanford University.

Yes, that Stanford. I’ve already signed up.

[continue reading…]