Complex investments

Types of complex investment

Warrants

A warrant gives the owner the right, but not the obligation, to buy shares in the company issuing the warrant at a fixed price – the exercise price – at any time until the warrant expires. Because of this, a relatively small movement in the price of the underlying security results in a disproportionately large movement (favourable or unfavourable) in the price of the warrant. The prices of warrants can therefore be volatile. Companies typically issue warrants as part of a share offering, or as a performance-related incentive for company executives. 

It is essential for anyone considering purchasing warrants to understand that the right to subscribe, which a warrant confers, is invariably limited in time. This means that if you fail to exercise this right within the predetermined timescale, then the investment becomes worthless.

Subscription shares

Subscription shares are similar to warrants, in that they offer shareholders the right to purchase shares at specified future dates or during predetermined conversion periods, at predetermined prices. However, unlike warrants, you may be able to invest in subscription shares using a stocks and shares ISA or a self-invested personal pension (SIPP). As a holder of subscription shares, an investor can decide whether to subscribe for new ordinary shares on these dates.

Subscription shares represent a geared investment, so a relatively small movement in the market price of the ordinary shares may result in a disproportionately large movement (positively or negatively) in the market price of the subscription shares.

In addition, the price may not move in line with that of the ordinary underlying share price, for reasons such as supply and demand and because of the remaining time period for which they are in existence. You could lose your entire investment as the subscription shares could expire worthless if their net asset value is below the final exercise price.

Securitised derivatives

These instruments may give you a time-limited right to acquire or sell one or more types of investment, which are normally exercisable against someone other than the issuer of that investment. Or they may give you rights under a contract for difference (CFD), which allow for speculation on fluctuations in the value of  an index, such as the FTSE 100 index.

In both cases, the investment may be referred to as the ‘underlying instrument’. These instruments often involve a high degree of gearing or leverage, so that a relatively small movement in the price of the underlying investment results in a much larger movement (favourable or unfavourable) in the price of the instrument. The price of these instruments can therefore be volatile.

Each securitised derivative product will be different, so carry different risks. Investors must understand what these products are made up of and the method by which they are traded.

These instruments have a limited life, and may (unless there is some form of guaranteed return to the amount you are investing in the product) expire worthless if the underlying instrument does not perform as expected.

Convertible bonds

A convertible bond is one which has an equity convertible element contained within it. This allows you the option to convert the bond into a given number/ratio of shares in the underlying company at a given price.

Throughout the specified life of the bond, you receive a regular dividend income, albeit generally at levels lower than those associated with non-convertible bonds. However, at the specified point in time, holders have the right to convert into the said number of shares. The conversion is at the holder’s choice and cannot be forced by the issuing company. Having the option to convert to shares, the bonds are often seen as having an embedded ‘call’.

Convertible preference shares

This form of investment is similar to that already outlined for convertible bonds. You have the option at a pre-defined date or dates, to convert the holding of preference shares into the class of underlying ordinary shares. Since you have the option to convert, they are seen to have an embedded ‘call’ option.

The risk exposure which you should be aware of is general market volatility. As with convertible bonds, the option to exercise the ‘call’ is entirely at the discretion of the holder, subject to the specified conversion dates. Like convertible bonds, the convertible preference shareholder is ranked higher than ordinary shareholders in terms of repayment, although they are outranked by bond holders.

Exchange-traded commodities (ETCs) 

Exchange-traded commodities are investments (asset-backed bonds) that allow you to track the underlying performance of a commodity index, including total return indices. Trading is exactly the same as any normal share, in that prices are available throughout the trading day, with market maker support, thereby stimulating liquidity.

ETCs themselves will either focus solely on a single commodity or on an index, examples being gold, silver or lean hogs for individual commodity exposure, or energy and livestock for index exposure. Exposure via an ETC allows you to invest in an asset class previously thought to be off limits to the retail investor.

Commodities have formed a key part of institutional investment strategies historically. However, inherent risks such as contingent liability (where your liability may be greater than the initial purchase price of the investment), margining requirements (where you are required to make a series of payments against the purchase price, depending on whether the underlying investment or index is moving in your favour) and international exchanges (which can mean a reduced level of investor protection, as well as currency fluctuation if the investment is not traded in sterling) meant these were out of reach.

In terms of risk, due to the very nature of the underlying commodity in which the ETC invests, this asset class is not for the faint hearted, as sudden swings and drops in worldwide demand will immediately impact the share price. The commodity investment will be either directly within the physical product, or be priced on the futures market. If the investment is based on the futures market, the risks associated with this form of investment include gearing or leverage.

Short and leveraged Exchange Traded Funds (ETFs)

Exchange Traded Funds aim to track a sector, market or index. In general, they trade like shares in that they are bought and sold on recognised investment exchanges. But unlike individual shares, they offer wider exposure to a particular asset class or index. Short and leveraged ETFs use complex financial techniques to increase the potential return of their investment. 

Short ETFs aim to deliver inverse performance to an underlying index through the use of derivatives and short-selling techniques. Leveraged ETFs amplify gains and losses relative to the underlying index.

Nil paid rights

Sometimes, companies may decide to raise further funds from its shareholders in return for the issue of further shares. This is known as a ‘rights issue’. Should an entitled shareholder decline to take up the rights allocated to them, they have the opportunity to sell these rights to the new shares ‘nil paid’ (i.e. without paying anything further to the company) or let them lapse (where the company sells the ‘nil paid rights’ on the investors behalf and remits any realising proceeds to the relevant investors).

A purchaser of nil paid rights in the open market will then have the opportunity to take up the shares at the discounted rights issue price. The new investor has effectively purchased a short dated (maximum 21 days) ‘call’ option, which can only be exercised within this given period.

Structured products

Structured products have been created to allow investors to meet needs not met through standard financial instruments available within the markets. They are typically fixed-term investments where the returns are determined by the performance of the underlying asset. They are used as an alternative to direct investment in an asset and as part of an asset allocation process to help reduce risk and exposure within a portfolio.

The general concept is based around investment within derivatives (normally options, but with the ability to utilise ‘swaps’ i.e. when one investment is temporarily exchanged for another) but with the added feature of protection if held to maturity. Due to the varying combinations of derivatives and financial instruments within the structures, there are significant risks involved, which should not be underestimated.

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Advanced investing and complex instruments