Morningstar’s Director of Investment Trust Research, Jackie Beard, discusses the characteristics of investment trusts and what Morningstar will be providing in terms of research for investors considering these resurgent investment products. Click here to view the short video.
Join Richard Romer-Lee and Nigel Whittingham for a discussion about quantitative and qualitative research, the process behind the harmonization of OBSR and Morningstar ratings and what’s in store for the future. Click here to register for this BrightTALK online event.
Investment Company Warrants offer investors the option to buy into a fund at a pre-determined price, and can result in outsized returns for clued-up investors. After a period in the doldrums, this asset class (and their Isa-able cousins, Subscription Shares) have been staging a come-back with many new investment company shares being issued with warrants attached. In this article, I explain what warrants are, why funds issue them, how they can be valued, and the opportunities and risks involved for investors.
Warrants are non-voting, non-dividend paying listed securities issued primarily by Investment Companies. They offer the holder the right, but not the obligation, to purchase the Company’s ordinary shares (Ords) at a pre-determined price at specified points over the warrant’s life. To encourage early exercise and get the flow of new money into the fund, many of the new subscription shares have a stepped exercise price structure, where the strike price increases to pre-specified amounts at certain dates.
Unlike call options, they are (almost always) issued at no cost to the shareholder and will dilute the value of a fund’s ordinary shares when exercised. As they are listed, holders can realise their investment in two ways: by exercising their warrants and receiving Ords in return, or by selling their warrants on the Stock Exchange. By exercising rather than selling, the investor can save on stamp duty, brokers’ commissions and spread costs; but, it means having to stump up a chunk of cash.
The Cost of Warrants: An Example
Let’s consider Aberdeen New Thai Investment Trust (ANW), which issued subscription shares in early December 2009 with an expiry date of 31 January 2013. Holders are entitled to subscribe for ordinary shares on the last business day of each month up to expiry at a price of 200p per share. As I write, the Ords trade at 261p, so holders of subscription shares here are “in-the-money”.
With the subscription shares currently available to buy at 78p, the effective cost of buying the Ords via the subscription shares is 278p (200p+78p), versus buying them directly at 261p. This premium exists because of the time value placed on the subscription shares by the market: that is, the value attributable to the chance that the underlying Ords will move further “into-the-money” at some point over their remaining life.
In turn, this time value depends on the expected volatility of the Ords and the length of time left to expiry. The greater these two variables are, the greater the chance of the warrants moving into or further into-the-money. All else being equal, the time value should fall as time moves closer to the warrant expiry date, a phenomenon known as time decay.
As the cost of a warrant is also going to be less than for the underlying Ord, investing through warrants offers geared exposure. In the example of Aberdeen New Thai, an investor would achieve gearing of over 3 times by buying warrants at their current price (261p/78p). Put another way, you could invest £3,333 and achieve the same exposure as if buying £10,000 of Ords. Of course, gearing works both ways: both market increases and declines will affect the warrants 3.3 times more in percentage terms than they will the Ords.
Why Bother with Warrants?
The warrants sector has enjoyed a renaissance in recent years, and currently has an aggregate market cap of £237m. In the last three years, 28 of the outstanding 46 London-listed Investment Company warrants/subscription shares have been issued, of which 19 were bonus issues, three were associated with recapitalisations or reconstructions, and six were issued at new fund launches.
So what accounts for this? Why would a company issue these securities?
Investment Trust warrants were historically issued at launch to “compensate” investors for the launch costs; as long as the warrants traded at a price of more than a couple of pennies, that was usually enough to cover those costs.
Clearly there are benefits of spreading fixed costs over a larger asset base, but let’s look at the magnitude of this. Take Fidelity Asian Values, which issued subscription shares in March 2010 on a 1-for-5 basis so the company’s total shares in issue would increase by 20% if all the warrants were exercised.
If we adopt a simplified approach in which we increase management fees pro-rata but hold all other costs constant, we find that that its 2009 TER would have decreased from 1.66% to 1.57% if its net assets were 20% larger. Another reason put forward for issuing warrants include the increased liquidity that may arise from having more shares in issue. Cynics may point to the extra management fees levied on a greater pool of assets as being an incentive to issue warrants, but the presence of the independent board and the fact that the issuance requires shareholder approval should act as safeguards.
Other justifications for bonus issues of warrants are more spurious. Examples from various literature include: “an attractive way for investors to participate in any future NAV growth in the Company” and that shareholders “will receive securities with a monetary value that may be traded in a similar fashion to their existing Ordinary Shares”. On the face of it both are true, but these assertions could lead warrant-holders to believe that there’s a free lunch to be had.
No Such Thing as a Free Lunch?
However, a free lunch is not what’s on offer here. Any increase in shareholders’ wealth from the issue of warrants is expected to be offset by a fall in the price of the Ords to reflect the future potential dilution, or claim on future growth. While shareholders receiving bonus warrants won’t lose out as long as they exercise when “in-the-money”, they are not expected to directly gain.
To illustrate this point, let’s take two hypothetical ungeared funds that are identical in all respects except that one has issued warrants. Each fund is trading at 80p and has a NAV of 100p, placing it on a discount of 20%. The fund that issued warrants has had 20% of its share capital covered by warrants with a strike price of 101p.
Suppose that both portfolios grow by 30%. The NAV for the fund unencumbered by warrants grows to 130p, but the diluted NAV for the fund with warrants only increases to 125p. In an efficient market, this restriction on the latter fund’s future growth should be reflected in a share price of less than 80p, with the difference comprising the market price of the warrants.
In effect, an issue of warrants can therefore be looked upon as a deferred (transferable) rights issue, and if shareholders sell or exercise their warrants when in-the-money, they would be expected not to lose out. In practice, however, the price of the ordinary shares of many recent fund launches with warrants attached have moved to a premium – effectively offering a free lunch after all. That said, it is difficult to ascertain what the demand for these Ords may have been in the absence of warrants.
A key advantage of warrants over call options is that they tend to be much longer-dated, giving the investor a longer time-horizon for his investment ideas to pan out, without short-term volatility having such an effect on their payoff. The average time to expiry at issue of the 46 warrants currently in issue is 4.5 years, with one being as long as 15 years.
In the Market for Warrants
Investors looking at buying warrants in the open market need to assess whether they offer good value or not at their current price. Using an option pricing formula, a Theoretical Option Value can be calculated for warrants for comparison with the warrant price. On this basis, 10 of the 46 warrants could be said to be cheap and 36 expensive.
The cheapest warrants are those issued by Aberdeen Asian Income (AAIF). Launched in 2005, this fund invests in a high conviction portfolio comprised of just 39 holdings operating in the Asia Pacific region. At the time of writing, its warrants are exercisable at 120p up to 31st May 2013 and are quoted at an offer price of 38p, giving a total cost of 158p. With the Ords currently available to buy at 162.5p, it would seem that a risk-free profit of 4.5p is available to anyone astute enough to take advantage – unfortunately, the warrants can only be exercised twice each year (on the 20th business day after the annual or semi-annual report is released).
Other warrants looking particularly cheap include those issued by Raven Russia (RUS) (a company investing in Russian warehouses), Schroder Asia Pacific (SDP), 3i Infrastructure (3IN), and Polar Capital Global Healthcare (PCGH).
The investment policies followed by even this small sample of funds highlights just how diverse the opportunities are for investors prepared to take the time to look into the darker corners of the investment world.
This article first appeared in Investment Week on October 13, 2010.
We have just released the latest month-end figures for London-listed closed-end funds and what struck me instantly is how much it contrasts with this time last year.
In September 2009, year-to-date inflows into the sector were a measly £73.6 million; fast-forward to September 2010 and this figure is significantly more impressive at £1.88 billion. Much of this is attributable to the launch of Anthony Bolton’s Fidelity China Special Situations as a closed-end fund – this alone raised £460m at launch in April.
Even when we take Fidelity out of the equation, that still leaves another £1.4 billion that has been invested in the sector this year. This has been raised in several ways. Groups such as JPMorgan, Aberdeen, Aberforth and Polar Capital have all had successful launches this year. We have also seen a new fixed-income investment company brought to the market, by Neuberger Berman, specialising in distressed debt.
There has been a raft of new VCTs issued and these come before legislative changes that were introduced on 1 October, which allow these specialist companies to invest outside the UK.
Other investment companies have raised additional monies through further issuance of shares.
This makes me think the sector is very much alive and kicking and seeing a well-deserved resurgence of interest. Granted, it’s not comparable with the flows that open-end funds and ETFs are seeing, but the fact that investors are recognising the merits of the closed-end structure and participating in new issues is music to my ears.
We have a long way to go in our mission to demystify closed-end funds and help investors have a good experience with them, but this fills me with hope that the sector will continue to thrive.
A recent study done by Morningstar in the US has found that low cost funds outperform high cost funds. You can read more about these findings here. Is this counterintuitive? Are your clients getting what they pay for?
Many believe high expense ratio should result in better performance over the long term as it implies a higher level of skill. Unfortunately this does not always hold true.
This issue of fees was also discussed in a recent episode of the BBC investigative program Panorama. The program focused on pension fees and their affects on the overall “pension pot” once a person hits retirement. It was pretty one-sided journalism to say the least but Morningstar’s research on the affects of fees was cited.
This idea of cheap funds outperforming expensive, flashy products has certainly generated lots of discussion on IFALife.com – an IFA website I visit regularly. The link to the thread can be found here. Perception is obviously still mixed yet the notion that you have to pay more to get better returns is unfounded, as our research has proven.
In the wake of the financial crisis there has been a call to re-evaluate risk measurement in financial models to better predict economic downturns. Morningstar’s Director of Quantitative Research, Dr. Paul Kaplan, discusses his current work in developing new risk models in a post-crisis world. The article on FT Adviser can be found here.
Last week I was up in Scotland at a conference aimed specifically, but not exclusively, at the investment trust community. Attendees included fund managers, board directors, chairmen of individual trusts, representatives from the Association of Investment Companies (AIC) and key industry figures from the world of investment trust research.
It was a fascinating experience on a number of levels, but what struck me hard was the average age of the attendees. I stress “average” because – as we know – there are always outliers, but I couldn’t get away from the apparent absence of an entire generation of participants from these vehicles.
There was a wealth of information and experience in that room, including some highly influential individuals (current and past). However, their shared bank of knowledge doesn’t seem to be passing down to new participants, as financial advisers have shied away from investment trusts since the split-capital trust scandal of the early 2000s.
Yet everyone with whom I spoke at the conference extolled the virtues of closed-end funds at the cost of open-ended funds. And cost is a key word here – not only do investment trusts tend to be cheaper than OEICs, but their costs are more transparent, too. So an investor can see clearly how the fees are comprised – a transparency that’s left wanting much of the world of OEICs.
Over the coming weeks and months, we’ll be creating a series of articles and presentations to help advisers demystify investment trusts and overcome their long-held fear that stems back from the split-cap debacle. Many investors have lost out on superior returns from investment trusts over the last decade and those who weren’t active in the market at the time are prone to fear of the unknown. We need to change this misconception that investment trusts are “damaged goods” and help the next generation of investors to consider for themselves where investment trusts have merit.
We need to change the attitudes at the board level, too. We want directors to embrace renewed interest from younger investors and we need them to impart their knowledge and help continue their path into history. After all, without the first investment trust in 1868, who knows how the industry would have developed?
Morningstar.co.uk today announced the results of our first exchange-traded funds survey. We spent six months quizzing professional and individual investors about their attitude towards, understanding of and experience in ETFs, and will be asking the same questions at six-month intervals to build up a picture of how this relatively new asset class is being used and viewed by UK investors over time.
Over 1,000 investors responded to our first survey, 15% of which were professional and 85% individuals, and we were surprised to see few surprises in the results.
Exchange-traded funds are known for their low costs but trading too often can quickly turn this low cost into a high one—something we had feared some investors may have been unsuspectingly tempted into. Instead, it seems that current ETF investors are not using them for fast-trading, risky bets, but instead as longer-term allocations to overweight a specific sector, country, or inflation protection.
Overall, the number of individual investors and advisers across Europe who use ETFs is still extremely low, and of those who remain wary of this asset class our survey revealed more education is in high demand.
Of professional investors who are unsure whether they want to invest in ETFs, 67% cited a lack of information about exchange-traded funds as the primary reason for their caution. Among individual investors, it was an incredible 77%.
Having trawled through the data and analysed the results, Morningstar’s associate director of European ETF research, Bradley Kay, commented that there is a stark split between respondents who are in need of more information about ETFs and those already familiar and the product’s key features. “Even among active investors, we found ETFs are being used in quite a passive way, for example to overweight in a particular asset class and with infrequent trading thereafter.”
We’re certainly encouraged to see that investors are already putting ETFs to sensible use in their portfolios, but— as expected — there’s an ongoing need for further information and education…something Morningstar is only too happy to accommodate!
If you’d like to know more, you can download the synopsis of our first ETF survey results here, and participate in the second ETF survey here.
Morningstar held a well-received webinar yesterday on Investment Trusts. Titled “Investment Trusts: Back in Vogue”, the session was hosted by Jackie Beard, Morningstar’s Director of Investment Trust Research, and myself, Tom Treanor, Investment Trust Specialist . Investment Trusts have been largely passed over by non-institutional investors in favour of open-ended funds, but they have a number of advantages that we believe make them an attractive addition to any investor’s portfolio.
With the first Investment Trust, Foreign & Colonial, launching way back in 1868 and still going strong today, they’ve certainly proved they have staying power.
We believe a few key trends are set to prompt a renaissance in retail ownership of these vehicles: the advent of the Retail Distribution Review will require advisers to take a “whole-of-market” approach, while the search for sustainable and diversified sources of yield in the face of historic low interest rates and well-publicised suspensions of dividends should also see a resurgence in interest in the closed-end structure. This not only offers unique benefits for those seeking yield but is also ideal for those who wish to diversify their portfolio through access to alternative asset classes such as private equity, property, hedge funds, or even forestry.
In the webinar, we took a closer look at these issues and discussed why we think these vehicles deserve a place in portfolios. We also covered a case study example of how to assess closed-ended funds and looked at some of the similarities and differences with their open-ended counterparts. The feedback from the audience was very positive, with several interesting questions posed: do we think the trend in new fund issuance is likely to continue?; how do we see investment trusts fitting into existing client portfolios? To hear the answers and view the webinar, please click here. If you’re not already registered with BrightTalk, you’ll need to do so but this is free and only needs to be completed once.
When it’s actually an equities fund.
This may seem rather obvious; however, it does address a common misconception that we at Morningstar have come across when discussing our approach to fund research with IFAs.
As many advisers have begun to add commodities exposure to their clients’ portfolios, a number have turned to the BlackRock Gold and General fund to provide the commodities piece of their asset allocation puzzle. The only problem is it’s not invested in commodities – it’s certainly not a gold fund – it’s not even a precious metals fund – and this is where the misconception lies.
An analysis of the complete holdings of the BlackRock Gold and General fund shows a portfolio full of shares in mining operations and companies whose business is the procurement of precious metals and natural resources.
No where in the holdings will you find actual gold bullion, silver bars, or sacks of diamonds. You won’t even find derivatives of these physical assets which artificially replicate the market prices of commodities.
The fund’s own objective even states an aim “to achieve long-term capital growth by investing in gold, mining and precious metal related shares.” The key here being “related shares.”
Commodities and equities are two different asset classes. They perform differently in various market conditions and they are subject to their own unique risks. And we at Morningstar think this is a critical piece of information for IFAs and investors.
So why the misconception? Why do some IFAs and investors consider this fund a play on physical commodities when it is actually an equities fund.
Surely, nobody is arguing with the fund’s impressive returns to investors – Morningstar included. Our analysts have given this fund an “Elite” rating, and looking at the Morningstar Qualitative Report for the BlackRock Gold and General Fund, there is plenty for investors to like.
In response to a client query, I recently discussed this report with Jackie Beard, now Morningstar’s Director of Investment Trust Research, and author of the report.
She noted several references to the fund’s rigorous approach to company analysis, the importance of good management at those companies and the type of companies in which the fund invests. She also added the fact that the fund even falls within the “Equity Sector Precious Metals” Morningstar Category for open-end funds.
But many IFAs see this as “a gold fund” or a way of diversifying a client’s portfolio with commodities. I have had several conversations with our Adviser Workstation clients who question our analysis of this fund and expect to see it as the commodities component in a portfolio.
Along the same line, I have also had this conversation about property funds and the difference between a fund that owns actual property and a fund that invests in the shares of real estate companies.
Both types of investments – owning physical assets and owning shares in the companies with exposure to those assets – have their own merit in a portfolio, but it’s important for investors to understand the difference.
Jackie’s comments were in response to an IFA who wanted some clarification of Morningstar’s classification of this fund as equities rather than commodities. She went to considerable length to provide a comprehensive answer to this question because it illustrates such a common misconception and is at the core of Morningstar’s value proposition to IFAs in terms of fund research.
Jackie also reached out to Malcolm Smith, Product Specialist for the BlackRock Gold and General Fund, to get BlackRock’s take on the question of commodities vs. equities and where their fund sits.
Mr. Smith, who was kind enough to provide a very prompt response, had this to say: “You have to remember it’s a gold equities fund with exposure to gold. We believe in the superior fundamentals that equities will outperform the gold price. Morningstar is right to have it in the equities category as that’s precisely what it holds.”
We relish these kinds of questions because it shows our clients are digging deeper and trying to fully understand the investments they recommend.
It illustrates the need for transparency and how access to quality data and analysis helps advisers make better investing decisions. Morningstar has grown on this principle and we feel there is much we can do in the UK to foster better understanding and further the interests of investors.
We always welcome a healthy debate and I look forward to similar conversations with our clients in the future.