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.
Morningstar and Investment Trends would like to invite you to share your views on the platforms and business tools you use and other aspects of how you run your business.
This anonymous survey is open to all financial advisers, paraplanners and adviser group or network managers, and the results are used by industry regulators, leading platforms and planning software providers to help them improve their offerings to you and your clients.
In thanks for your time in completing the survey, you can elect to receive any or all of the following benefits:
- Entry to the draw for one of **two 16GB Apple iPads WiFi + 3G valued at** **£**529 each**.
- Highlighted survey findings, a great tool to benchmark your business against other adviser practices.
- Complimentary one month subscription to **Morningstar Adviser Workstation valued at approximately** **£**170**.
- In addition, the most comprehensive answer as judged by Investment Trends will receive an **Apple iPad Wi-Fi + 3G (16GB) valued at** **£**529**.
If you would like to participate, please click here to complete the survey.
Depending on your answers, the survey should take between 15 and 25 minutes to complete. We’d appreciate it if you could complete your entry by 6pm on Friday, 12th of November.
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.
It appears that model portfolios and IFAs who use them are the latest targets of the independent vs. tied debate which continues to gain momentum as 2013 approaches. If advisers can’t use model portfolios and remain independent what’s next? Will they have to build their own investment products?
Fay Goddard, chief executive of the Personal Finance Society (PFS), said there is a grey area concerning the use of models and she warned that IFAs who use them could jeopardize their independent status. The Citywire article can be found here. Whether she really believes this or just thinks it’s an angle the FSA is considering is not entirely clear but the article does beg the question: If model portfolios, constructed by independent investment professionals are not independent, what is independent?
Supporters of models (and sanity) were lauded by Holly Mackay from the Platforum who posted “a restricted rant” in response to the article. I think Holly makes some great points while advancing the debate. There seems to be a lot of fear mongering and emotion in the online forums recently so Holly’s response was a breath of fresh air.
This issue will continue to be debated, as will every other facet of the advice industry, from here to eternity – or at least until 2013 – whichever comes first. Using model portfolios to deliver a consistent, quality (and yes, independent) advice process has proven itself. I speak with advisers every single day who are able to provide better quality advice to more people than they could otherwise do on their own. I don’t see anything wrong with an adviser recognizing where their strengths are and outsourcing areas where they are not experts. The ultimate measuring stick is the client’s experience of course so the onus still lies on the adviser to deliver the process and provide the advice. Model portfolios can increase the quality of that process (investment selection by experts) and make it easier for an adviser to deliver the service.
Not all models are created equal though and they are certainly not a one-size fits all solution. Any adviser worth his salt knows this and it’s patronizing to use this as an argument against the independence of models. This is why our Adviser solutions can accommodate “home grown” models, 3rd party models and bespoke portfolios. Independent advice can stem from a model, or use a model as part of its process (a means to an asset allocation end) but there are other links to the chain that seem to be missing from the discussion. An independent adviser needs access to the whole-of-market as well in the event the models do not provide a complete solution for a client’s needs. Research and analytical tools are needed to dissect existing portfolios and consider products for niche investing. Independent, qualitative investment analysis provides a valuable second opinion or the needed conviction when it comes time to make an investment decision. And tools are needed to deliver a transparent, consistent service to the client while monitoring the progress of their portfolios.
Independent advice is not dead and it is not going to disappear. How independent advice is provided will continue to be tweaked though. The demands on advisers will grow and independent advisers will be held to a higher standard but I see this as a good thing for the end user – the client.
The client web portal can be used as a secure delivery method and archive for client reports. Posting reports to the web portal allows the client 24 hour access to their reports and gives you a seamless, paperless delivery method that can add value to your service proposition. Click here to view a short demonstration video.
We’ve just returned from Glasgow where our latest adviser event took place on October 13th. Dr. Paul Kaplan, Morningstar’s head of quantitative research for Europe, and Jackie Beard, director of investment trust research joined the team for a very informative morning of presentations.
Adding value to your service, streamlining your processes and mitigating your regulatory risk were the primary focuses of the Adviser Workstation presentation, which kicked off the morning. These are areas the system can help and advice firm I’m now offering training in these areas as well. If you would like to register for one of these classes, you can here.
Paul Kaplan then spoke about the history of stock market crashes, putting the most recent crash into perspective. Looking at the historic data, these types of events are actually not that rare and need to factor more into current risk models. To view Paul’s presentation slides click here.
Jackie Beard then offered some insights into the current investment trust market and how investment trusts can be a useful tool when construction client portfolios. In an RDR world, investment trusts are likely to play a prominent role in portfolio construction so Jackie is keen to help investors understand investment trusts and see their potential. To view Jackie’s presentation, click here.
Our next event will be in Manchester on November 10th – for a complete list of upcoming events, click the Events tab above.
P.S. I even managed to pick up a souvenir. The scarf, not the kilt.
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.
Aviva’s September report into the European pension gap made for some pretty gloomy reading—just what we need as the dark nights are drawing in—but is the situation really as bad as reported?
The claims that not only are the British suffering from the largest pension deficit in Europe but also that we need to save on average £10,000 per year to retire comfortably hit headlines hard. But this £10,000 figure is based on an income replacement rate of 70%, and though there are doubtless those who want to spend their retirement years on back-to-back cruises wearing Hermés and Dior, there are many of us who might have slightly less extravagant plans for old age.
The idea that we need to aim for 70% of our annual working income per year of retirement is clearly a ballpark figure, and little research can be successfully carried out without making at least some generalisations, but each to their own: not only will some of us be very ‘comfortable’ on something closer to 50%, we may also want to fill many of our retirement years doing something productive that not only entertains but also pays. One of my grandmothers was an accomplished artist and with time on her hands managed to produce numerous paintings that attracted buyers—they weren’t selling for millions but the extra funds helped cover the costs of occasional luxuries.
Taking the idea of working in retirement one step further, the idea of pushing back the national retirement age has been met with uproar in certain areas, but what’s the problem? We’re living longer these days so working longer doesn’t mean a shorter retirement: you could still find yourself with a good three decades of ‘free time’ even if you retire at 70.
I don’t know about you, but I get itchy feet if I don’t do anything for much more than a few days, let alone a third of a lifetime. And talk of 70-year-olds being too old to be able to do their job successfully seems overblown, not to mention ageist. My remaining grandmother is soon to become a nonagenarian (allegedly—no one’s known her exact age since she started celebrating her 30th on an annual basis around 59 years ago) and though she might not be able to outrun you, she’ll certainly outwit you. 20 years ago she could probably have done both, while whipping up some potato dauphinoise, knocking back a whisky, and completing the crossword in her head.
Times are changing, yes, but that’s because we’ve changed. To me it’s a logical next step that we update our pension system to cater for our updated lives.
I’m back from beautiful South Wales and the 2010 IFP Conference, just in time to make way for a few more American golf enthusiasts. So what was taken from the conference this year? For me it was a focus on ways advisers will be successful in a rapidly changing industry. Interestingly enough, conversations usually started and ended with process.
Charlie Ellis and Mark Tibergien started the 2
nd day with challenges to advisers. Mr. Ellis posed a compelling argument that advisers should be more focused on risk management than playing a loser’s game of trying to beat the market. A nearly impossible feat given the players in the game (institutional investors) and human nature (emotion).
Mr. Tibergien challenged advisers to grow their businesses efficiently by implementing smart, scalable processes. As an advice firm grows, people and process (technology for example) are keys to ensuring a profitable future.
It was incredibly refreshing to hear a business focused discussion about ways to succeed as opposed to the many ways the FSA is supposedly trying to ruin the advice business. Whether you believe that or not (contrary to what some Lib Dems think) we can all agree IFAs have a critical place in the future of personal finance in the UK.
I was also fortunate to hear Tim Hale speak about business practice and advice process, but from a much different angle – defending yourself in a court of law. He also stressed the need for a robust, consistent investment process and the lack of this as one of the most common weaknesses of an IFA firm. Without a sound process, the tactical operations of a firm will struggle as well – fund selection, use of asset classes and portfolio construction.
If you’ve read any of my posts before you probably know why I’m taking note of these presentations. I’ve had the process conversation many times with our clients so it was fantastic to hear different approaches and opinions. I even wrote about earlier this month! Every single presentation I attended at the IFP Conference reiterated the need for a good process with technology as the delivery mechanism so we are very excited to be in position to provide a key piece of this to the IFA community. For help implementing a process send me an email or if you have something to share, please do so in the comments below.