How to make the bank invest its money and pay you the dividend: the case of the Baltics?

After spending some time on Delfi, I have once again faced an eye catching idea: Sampo Bank (one of the banks, operating in the Baltic states) offers its clients an amazing 18% annual rate on their half-year deposits, while regular time deposits for the same period earn around 4.3%. However, as a rule, there also should be some nasty things, which the bank takes for additional privileges it grants. And I was prepared for that. This time, it was an obligation to invest 75% of your portfolio in Danske Fund Global Emerging Markets, and the rest into the amazing deposit.

As a usual person, I was also interested what people think about this gift of gods and moved to the comments section. Some rationally had started to calculate the real return on the deposit. Assuming you invest a quarter of your assets into deposit, you only receive the same 4.3% of the portfolio plus a small premium of 0.2%. One might say the premium is a trick to gain higher market share of the bank in this innovative category of investments, but who knows what these banks really do. And this is neither the topic I would like to discuss. Further in the article I am simply going to show how the new practice can legally be exploited to gain extra advantage (small, but free) for individual risk-neutral investors, and how Baltic banks have adopted new investment theory, surprisingly passing over that of Markowitz.

What is Danske Fund Global Emerging Markets?

Some words about the fund seem relevant, at least for me. During the last complete 4 years, the funds have showed returns not less than 20% on the annual basis, making an average annual growth of 32%. The whole thing seems quite impressive, with reasonably low volatility (17%) and high Sharp ratio. The fund invests in big well-known but risky companies of quite standard industries. Also, what is made to be noticeable is the graph with historical returns, according to which the fund have always been outperforming MSCI Emerging Markets with substantial difference. In total, this is not the worst fund I have ever seen.

What people, especially financial speculators, are currently afraid of is the global downtrend of the financial markets. This is the main reason to blame banks in such fraud-like activity. They say, if they give it, it is bad. In other words, if the bank offers 18% for a deposit if you buy their fund, it is a sign to sell the fund. Probably, this is right risk-averse opinion and people who accept it will never loose. I also partly support the opinion: banks will never harm themselves, especially in the Baltics. Nevertheless, some also like drinking Champaign, at least sometimes.

What are the benefits for the bank?

Simply, no long comments needed. The possible benefits for the banks are:

· Possibility to modify their liquidity positions, increasing short term assets;
· Increase of private banking market share;
· Increase attractiveness of the funds;
· Blur short term fund’s fluctuations with obvious benefit of risk free return;
· Expect further strong decrease in financial markets;
· Increases money supply for credits;
· Has no obligations about fund’s prospects.

What are the benefits for investors?

Mainly, how can a typical investor use this offer to achieve something that previously wasn’t achievable? To see that, let’s use some simple math. Now assume an investor has 300 money. According to the obligation, he invests 75 into amazing deposit and 225 in the investment fund. The reasonable yearly (note yearly) expected return and variation of new portfolio, according to Markowitz, is (with the given volatility and adjusted fund’s average annual return due the present market fall):

R bank portfolio = 18% * 0.25 + 28% * 0.75 = 25.5%
σ bank portfolio = 17%*0.75 = 12.75%
R fund = 28%
σ fund = 17%

Then assume an investor takes a credit of 115.69 (38.56% of the portfolio) in another bank for the same period, and pays according to the contract the regular 6% interest rate, it is simply more profitable to use another bank rather than Sampo. But before that, he invests 25% of his new credit into amazing deposit, and the rest in the fund. Then, according to the investment theory of Markowitz, we get:

R leveraged = 18% * 0.25 + 28% * 0.75 – 0.386 * 6% + 18% * 0.097 + 28% * 0.289
= 18% * 0.347 + 28% * 1.039 – 0.386 * 6% = 33%
σ leveraged = 17%*1.039 = 17.66%

Seems logical and usual, you increase expected return through leverage, thus, you bear more risk. However, according to the new theory of the Baltic banks, we have:

R leveraged = 18% * 0.347 + 28% * 1.039 – 0.386 * 6% = 33%, but
σ leveraged = 17%

And the question is why with increased leverage, the risk of the 3-item portfolio is equal to the risk of the fund alone. Moreover, with the same risk, expected return rises by 5%. The answer is simple, banks became so keen that they invest their money and pay you the dividend. At last somebody has started to care about us, and does it without remuneration.

Why risk does not increase?

To be more systematic I shall explain what I see in such type of investment. Actually, the initial benefit of described operation comes from so called carry trading, when you buy financial resources cheaper than you sell them. You take cheaper credit than you receive from your deposit. It seems strange that banks have introduced such free-to-use opportunity, and I shall better examine all legal aspects of the agreement, before entering it, and even have suspicions about the future of Danske Fund Global Emerging Markets. However, on this point, I am not going to discuss the fund’s prospects, but I can simply see relatively free access to finance, even if the use of the finance is limited. So, the whole scheme looks like that:


Since the amount of deposit by the end of the period is equal to the sum of debt that you are obliged to cover, the new portfolio is becoming free from leverage risk. On the other hand, the expected return of 3-item portfolio rises significantly, by 5%. This spread comes from the fact, that part of the credit, which will fully be repaid with your deposit, is invested into the fund, creating its total weight >1. Here comes the main trick: your deposit and debt balance creates the total value of 0 in the future, but your fund will be larger than your initial investment by 11.77 money already now. And the best thing is that this additional amount of investment also generates an expected return of 28%. In total, this results in 33% expected annual return of the total portfolio. To check: 311.77 * 1.28 = 399.0656 = 300 * 1.33.

Conclusions

To make the final note, one shall compare mean-variance and sharp ratios of 3 investment opportunities.

As we see, the scheme of fund-deposit-debt portfolio has both higher mean-variance and Sharpe ratios comparing to the fund alone, and is approximately equal to the fund-deposit portfolio. The latest two portfolios are incomparable and the choice of investor simply depends on his or her risk preferences. But what I can say for sure, the Baltic banks created a great opportunity for investors who prefer more risky assets, particularly the given fund. Opposing to the theory of Markowitz, the leveraged portfolio has higher expected return with the same risk. Surprisingly, this time the banks do not require any additional compensation for such a gift, and investors who sometimes accept risk can be thankful for that.

PS

To calculate how much debt to take in any specific case, use the following formula:


x : debt in % of your initial portfolio
w : percentage of initial portfolio invested in the deposit
r1 : annual deposit interest rate
r2 : annual debt interest rate
t : the period of deposit/debt in terms of one year

Finally, you will be able to calculate the extra expected return from the leverage similarly as it was done above.