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.
