Warrants, like many things in the investment world, go in and out of fashion and are viewed by many investors as being extremely high risk. However, they do have the potential to generate larger gains than would be made by simply investing in the underlying share.

‘Warrants can be fun,’ insists Tim Cockerill, head of research at Rowan & Co Capital Management. But he also warns, ‘Investors can make some money and they can add a little bit of spice to a portfolio, but one has to be aware of what they are getting into.’

Option trading
Warrants are essentially a form of traded option, which gives the investor the right to buy a given number of shares at a future date and at a predetermined price.

In the context of the investment company sector, they generally confer the right to acquire ordinary shares. Some ITs try to attract investors at launch by awarding ‘free’ warrants with each ordinary share purchased. This enables the trust to raise additional capital by setting the issue price at a slight premium to the trust’s net asset value (NAV).

However, warrants are somewhat out of fashion at the moment. Cockerill suggests that ‘There is not really a great choice these days and investors do really need to tread carefully and know what they are buying. So, as well as carrying out research into warrants as an investment tool, it is equally important to look at how the shares of the trust are, performing because that is what the warrant is attached to.’

Delve a little deeper
So how should the private investor approach the market in IT warrants? Well, you have a couple of choices when it comes to warrants, depending on whether you already hold them as the result of a capital raising exercise by a particular investment company, or you are looking to buy in the open market.

Firstly, the exercise price (the predetermined price at which you can buy the underlying share) is usually cheaper than the underlying share price and, as a result, you could have the opportunity to gain a profit by exercising the warrant.

In very basic terms, if you have a warrant that has an exercise price of 100p and the share is trading at 120p, exercising the warrant would be profitable. Alternatively, you can sell the warrant on the open market, providing the share price is higher than the exercise price and the cost of the warrant combined – to make it worthwhile for another investor to purchase it.

But, warrants expert Andrew McHattie, of McHattie Investment Management, points out that it is sometimes better for an investor holding an investment company warrant to do nothing. ‘If an investor happens to hold warrants and doesn’t really know what they are, the best thing is probably to do nothing at all. They have a right to exercise them into shares at some point in the future, but generally shouldn’t do anything until the final opportunity.’

The choice is yours
McHattie points out that ‘It is possible, but very rare, for someone to exercise their warrants and take up their subscription rights before the expiry date. Some investors choose to learn a little bit more about them, perhaps buy some more and others will sell them in the market because you can trade them at any time, such as you can with ordinary shares.’

Cockerill agrees that ‘For a lot of investors that are given warrants through new issues, the amount is not going to be that meaningful and, therefore, the best thing to do would be to just hang on to them with the expectation that they are going to rise in value.’

He adds, ‘One of the key things to bear in mind, however, is how long the warrant has to run because they all have a finite life on them. The danger, or risk, of warrants increases the closer you get to the exercise date.’

Make it count
Warrants issued by investment companies tend to be on a one-to-five basis – meaning one warrant entitles the holder to buy five shares. When a warrant is issued, it comes with an expiry date, and if the warrant isn’t exercised by then, it becomes worthless. This is what often happens to those that are given to investors through a new issue – you receive it, think about it, put it in a drawer and forget about it.

With shares, if things aren’t going your way you can opt to hold on to them and make your, once short term, investment into a long one. Warrants however, don’t work like this and if you hold on too long, or invest at the wrong time in the cycle, they can expire worthless.

For example, if the share price is 50p and the exercise price on the warrant is 100p, you will have to wait for the share to more than double in value before the warrant will be worth anything to you.

Current opportunities
But, Cockerill believes that there are some trusts that could be of interest. In particular, he points to the Henderson Opportunities Trust, with a portfolio managed by James Henderson, and warrants that expire in February 2014.

In fact, the ‘warrants’ issued with this trust are actually classed as ‘subscription shares’, which have similar characteristics to warrants but with the additional benefit of being qualifying investments for the purposes of being held within the stocks and shares component of an individual savings account (ISA) or an existing personal equity plan (PEP) portfolio.

‘The Henderson Opportunities Trust is in a part of the market that has been quite badly hit because it holds a lot of AIM quoted stocks and smaller companies,’ says Cockerill. ‘The subscription shares are now 24p, having fallen from 194p, which gives you an idea of the type of fall you can expect. The exercise price is 936p and the IT is now 413p so before the warrant has any chance of being worth something, the trust’s price has to move closer to the subscription price. However, it is at this point that the warrant will begin to look much more attractive.’

He also points to the warrants on Perpetual’s Income & Growth share, which have got until 2012 to run, and the Impax Environmental Markets warrant, which, despite having an expiration date of June 2010, focuses on an area of the market where the returns from shares should be very strong.

Taking a risk
IT warrants do, however, have a downside. They are regarded as being very high risk simply because, as well as having the ability to make you a lot of money, they can also multiply your losses too, particularly in volatile markets such as we are currently experiencing.

Andrew McHattie explains that ‘One of the main advantages with warrants is gearing, which effectively means that you can get more bang for your buck. It is all about multiplying your gains and making sure that when you make a profit it’s a big one. When it works well it multiplies your gains, but, of course, when it goes badly for you it multiplies your losses, so you do have to be very careful.’

He adds, ‘In bull markets, investors can make a great deal of money very quickly because of the level of gearing which tends to exaggerate the percentage movement, and actually, there have been some tremendous examples over the years where
investors have made more than ten times their money.’

McHattie concludes, ‘Warrants can provide outstanding profits at times and if you believe that this is pretty much the trough of the bear market and that the only way from here is up, then warrants could be worth finding out about now.’