When stock markets are going through a boom phase, you’ll not stop hearing about IPOs.

But what is an IPO? Are they worth your money, or are they City scams designed to rip you off?

The answer is that just like every other investment, IPOs can be good or bad. You have to consider each IPO on its own merits.

This post will tell you what is an IPO. Future posts will look at how you can take part in an IPO, and what to look out for when investing in one.

What is an IPO?

IPO stands for Initial Public Offering. An American term that became popular during the Dotcom boom, it has pretty much replaced the old UK equivalent, ‘new issue’, and is steadily replacing the other alternative, ‘flotation’.

As the name suggests, an IPO is when a company first comes to the stock market (that’s the ‘initial public’ bit) and issues a tranche of its shares to be traded (the ‘offering’).

A company might decide to be listed for many different reasons. By far the most common are:

• Money: The company founders or backers want to realise some of their investment, by selling their shares to the public. (This is known as an ‘exit’).

• Funding: The company needs cash for expansion or takeovers, and raising it through equity is seen as a better option than taking on debt. Once listed, a company can also use its shares directly to fund takeovers.

• Encouraging staff to stay: Listing on the stock exchange creates a market for the company’s shares. With this is in place it can more credibly issue share options. Staff can later convert these into shares, to sell at a profit.

• Going broke: The company may simply need more money just to stay in business! Usually IPOs are only possible here if the company is a great prospect in an exciting growth sector like biotech or the Internet, where there’s the potential for big rewards.

Note that a company rarely lists all its shares on the stock market in one go in an IPO. Usually only some portion of the share capital becomes publicly traded, with founders and other investors (or even the company itself) retaining ownership of the rest. But once a company is listed on a stock market, it can raise more money by issuing more shares. Known as a ‘rights issue’, this gives the company further flexibility, even if it doesn’t need the money right away.

An IPO is an expensive undertaking. Banks, lawyers, and City advisers are required to facilitate an IPO, and their trophy wives / manicures don’t come cheap. As much as 10% of the money raised may go on their fees. Some pundits have scurrilously suggested that excessive banks are put on the IPO ticket just to encourage favourable coverage of the newly-listed company!

Even once the IPO bills are paid, life after flotation is more expensive for the company than before. Its accounts must be more rigorously audited, and all kinds of other regulation comes into play, as well as fees for remaining listed. There’s also greater public scrutiny, and pressure from City funds and other shareholders for a regular dividend and a rising share price.

Given these hassles, you must ask yourself what is an IPO really being undertaken for, and who will benefit? Is it merely the founders cashing out, or will being listed help the company going forward?

You don’t want to spend your money making the founders rich, but leaving you with a dud investment!

Further reading:

1. How to invest in an IPO

A little known way to potentially increase your returns is to buy subscription shares.

These shares are effectively options on specific investment trusts.

A particular subscription share gives you the option – but not the obligation – to buy new ordinary shares¹ in a particular trust by a particular date (the conversion date) at a particular price (the conversion price).

High risk, high reward

UK investors can buy subscription shares for the going market price through their usual stockbroker.

Occasionally, you may also be issued them by an investment trust that you already own, as sort of a bonus. You can then either decide to hold them, or else sell them in the open market.

Some examples include:

• JP Morgan Emerging Market Subscription Shares (Ticker: JMGS)
• Blackrock New Energy Subscription Shares (Ticker: BRNS)
• Aberdeen New Thai Subscription Shares (Ticker: ANWS)

Each of these subscription shares offers geared exposure to the investment trust of the same name. I’m not sure exactly how many different ones are out there in total, but I’m aware of at least 30.

How do they make you money?

If you are holding a subscription share when its underlying investment trust’s price moves above the conversion price, then you can potentially make a lot of money (depending on what price you paid for the subscription shares). Returns of 3-4x the increase in the underlying trust’s share price are typical.

How do they lose you money?

If you own a subscription share where the conversion price is less than the underlying share price on the day the subscription share must be exercised, then your subscription share will expire worthless, since the option granted by it is useless (since nobody will buy it, because nobody will want to pay more than the going market price for the investment trust).

In-between these two extremes, you might lose some portion of your invested money if the underlying investment trust’s share price falls between you buying its subscription shares and the day those subscription shares must be exercised – but not by enough to render the subscription shares worthless.

Subscription shares are very risky investments. They are far riskier than conventional investment trust shares, let alone cash or bonds. Any investor must fully understand what he or she is buying, and be ready to lose all the money invested in them. For sophisticated investors only.

Subscription shares are not super simple

The maths may be relatively straightforward at first blush, but subscription shares still fail my KISS rule. Compare:

• Normal investment trust shares: You are buying into a portfolio of shares or other assets, all of which have a market value. In most cases you can hold the trust for the long term to ride out volatility and benefit from the growth of those assets. You may also be paid a nice dividend.

• Subscription shares: You buy the right to buy other shares, by some date. In plain speak, you basically buy a piece of paper with a promise written on it. Critically, you can’t hold on indefinitely to ride out any volatility, since subscription shares have a use-by date!

So the first kind of share is a time-honoured investment in a nicely diversified portfolio, the second is basically a bet on stock market prices.

I’m not saying don’t ever buy subscription shares – I own a couple myself – but please do be aware of the risks you’re taking.

Murky matters

Subscription shares also half-fail my suggestion that we avoid opaque or exotic financial products.

True, compared to guaranteed income bonds, subscription shares are probably superior – you can see all the prices in the open, buy and sell as you see fit, and take a view on the underlying trust’s investments.

But I’m not giving them a gold star, for two reasons.

• First, as we’ll see in a future post, the maths is slightly complicated (though it’s easy to work with rough approximations).

• Secondly, I don’t think there’s a good reason for subscription shares to exist!

As far as I can see, they are a wheeze dreamed up by fund managers to increase the total size of their funds under management.

True, existing shareholders shouldn’t lose out provided they hold onto any subscription shares they’re given AND they subscribe for new shares when conversion time comes (if appropriate). But I’m still not convinced the whole malarkey is of great benefit to anyone but the manager.²

A safer way to take a high risk

Arguably though, that is all of academic interest to most investors. Most will buy their subscription shares on the open market and sell them if the price goes up, long before the conversion date becomes due.

What that means for shareholders in the underlying investment trust isn’t very relevant to such trading!

Subscription shares are a potentially useful tool for the advanced investor. They allow you to gear up your returns if you have a strong conviction about where the market is heading, while crucially your maximum losses are capped to the amount you invest.

I plan to post more on subscription shares in the weeks to come, so subscribe to get future installments. I’ll look at the maths of how subscription shares can magnify your returns, consider more of their advantages and disadvantages, and take a quick look at a few examples currently trading in the market.

1. Technically you get the right to subscribe for the new shares, hence the name.
2. Managers would also point out that a larger pool of assets under management usually reduces the TER. Which is true, but their fees still go up!

Further reading:

1. How subscription shares multiply your gains
2. Pros and cons of subscription shares
3. Good shares to buy now

Like most others, the UK government borrows money by issuing bonds. In the UK, these government bonds are called gilts.

The name ‘gilts’ hints at their antiquity. Back in the day, gilts were pretty certificates with gold-leaf trimming. These certificates are the origin of the phrase gilt-edged security.

Today gilts are bought and sold electronically. Given that the cash-strapped British Government has been raising more than £200 billion a year by auctioning off new supplies of gilts, that development is perhaps to the relief of postmen across The City.

Back in 1997, the entire stock of outstanding gilts was a mere £275 billion! By October 2010 it had surpassed £1,000 billion.

Gilts are the safest form of UK investment

An investment in gilts has long been considered about as safe as investing gets. The British Government has never defaulted on its debts in its several hundred years of raising money. Only US Treasuries and the bonds of a few other countries are considered as secure.

This perceived security is reflected in the UK’s AAA-rating for its debt. The AAA-rating has so far survived even the sharp deterioration of the UK’s financial strength in the wake of the credit crisis and recession of 2008/09, as well as quantitative easing.

The UK Treasury (via the Debt Management Office, or DMO) has skilfully taken advantage of our excellent reputation by issuing gilts with a very long life. Gilts have been issued with as long as 50 years to run until they’re redeemed.

Investors will only buy such long-dated securities if they’re confident the government will still be honouring its debts in 50 years time!

The UK has its own currency, of course, which in principle makes paying its debts a formality – unlike you, me, or a company, the government can simply print money to meet its debt payments.

Investors in gilts aren’t idiots, though, and they’re well aware of this. The trust placed in gilts isn’t just that the UK government will honour its debts in full, but also that it will manage the public finances in such a way that high inflation won’t erode the value of their investment.

The average maturity of UK gilts is around 14 years. This is the main reason why we have so far avoided the sort of sovereign debt panics that struck Greece and Ireland. The markets can take a sanguine view, knowing we’ve years to come up with the money to pay out debts.

Gilts: The basics

If you buy a gilt when it’s issued for exactly its nominal value and hold it to its redemption date, you know exactly how much money you’ll get over the years.

• You’ll be paid the interest rate (the coupon) every year plus you’ll be repaid the nominal value of the gilt when it matures.

For instance, a gilt called Treasury 5 pc ’30 will pay £5 a year until 2030 for every £100 nominal (also called the face or par value) that you buy and hold.

Gilts are generally sold by the government for a little more or less than their nominal value, however.

• The price investors pay for new gilts is determined by an auction. This means they may pay more or less than the nominal value (say £101 or £99), which reflects the annual yield they’re demanding for holding the gilts.

• If investors pay more than the nominal value to own the gilt, they’re accepting a lower yield. And vice-versa.

• The coupon payment is split across two payments a year.

When the redemption date is reached, the government pays you back the nominal value of the gilt. This makes it almost impossible to lose money with gilts in cash terms, provided you hold until redemption and the government doesn’t default, though inflation can easily erode your real returns.

Note that this doesn’t mean you’ll necessarily get back what you paid for your gilts. You might pay £105 in the open market, and receive just £100 back when the gilt is redeemed. However this capital loss will have been taken into account by the market and reflected in the income you’ve received for holding the gilt. This total return is the key.

Some gilts are undated. For instance, there’s a nearly 100-year old gilt called War Loan 3 1/2 pc.

Undated gilts payout their coupon forever. They can be considered a bet on very long-term interest and inflation rates.

Gilts are traded, which introduces risk

Once issued by The Treasury, gilts can be bought and sold on the secondary market until they mature, just like shares and other securities.

An easy way to think of how their price fluctuates is to imagine what you’d pay to own the aforementioned War Loan 3 1/2 pc:

• What would you pay if interest rates on savings were 6%?

• What would you pay if interest rates on savings were 2%?

All things being equal, an investor would obviously pay more for a 3.5% coupon when interest rates on cash are lower than that, and substantially less when interest rates on cash are higher.

The investor’s calculation is complicated by the fact that an undated gilt is never redeemed. This means his view of interest rates (and inflation, and UK solvency) must extend far into the future.

Dated gilts are less risky investments. You know you’re going to get the nominal value back (not the price you paid, remember!) when they are redeemed, regardless of how their price fluctuates in-between. This makes it possible to calculate a yield to redemption, which takes into account both the annual coupon you’ll be paid for owning the gilt, and the capital gain or loss you’ll make when the gilt is redeemed.

This assumes you hold the gilt until it’s redeemed, of course. If you sell it before then, you might make a trading gain or loss.

You don’t have to calculate redemption yields and so on for yourself. Prices and yields are listed in newspapers like the Financial Times, and on websites like Fixed Income Investor.

A few other useful things to know about gilts

• The interest payment from gilts is treated as taxable income.

• Any capital gains that arise from disposing of gilts are tax-free.

• You can buy gilts directly through your broker or invest via a fund.

• Gilts can go in an ISA provided you buy them with five years until redemption.

• Index-linked gilts are a special kind that offer inflation-proofing. Both the coupon and the principal payment are adjusted in line with RPI. You might not get much on top of that though, depending on the mood of investors when you buy.

Further reading on bonds

I have written extensively about bond pricing and yields on Monevator in the context of corporate bonds. Gilts are priced and traded in exactly the same way, only the risk of default is far lower.

Here’s some articles to help you understand more about bonds:

• How to calculate bond yields
• What causes bond prices to fluctuate?
• Where to find bond prices and yields
• Government bonds and asset allocation

For yet more information on gilts, check out the DMO’s official lowdown on gilts.

Further reading:

1. What are corporate bonds?
2. At what yield are government bonds a buy?
3. Buy government bonds – eventually

Tracking error is often cited as a key factor in tracker fund selection. Tracking error is to tracker funds as goal tally is to a Premiership striker – a fundamental measure of how well the job is being done.

A tracker’s role is to deliver the returns of its benchmark index. In an ideal world, if the FTSE All-Share index returns 10% a year, then a FTSE All-Share tracker will also return 10%. But the world is rarely perfect (mine isn’t anyway), and tracking error shows just how wide of the (bench) mark the performance is.

That’s important information for passive investors because it can reveal the hidden cost of owning a tracker. There’s no point choosing a fund with a Total Expense Ratio (TER) 0.2% cheaper than its rivals, if its returns consistently lag the same benchmark by an extra 0.5%.

What exactly is tracking error?

Like so many investing terms, there are many different versions of tracking error and ways of calculating it. It’s therefore often difficult to be sure that two different sources are talking about the same measure.

That said, a reasonably common definition of tracking error is:

Tracking error = the standard deviation of returns relative to the returns of the index.

The lower the tracking error, the more faithfully the fund is matching its index.

When comparing funds, choose the lowest tracking error possible. A tracking error above 2% indicates the fund is doing a bad job.

What causes tracking error?

An index tracker is like an impressionist. It mimics its benchmark but can never quite be a dead ringer, chiefly because of:

• Costs

Index returns aren’t dragged down by operating expenses, but tracker fund returns are. Therefore you’d always expect a fund to lag its benchmark by at least its TER. The TER is deducted from the fund’s net asset value (NAV) on a daily basis, so the lower the TER, the lower the tracking error, and the better the expected fund return, all things being equal.

• Replication

Full replication funds that hold every stock in their index should offer zero tracking error as they are the index. (Except that transactions costs incurred when rebalancing ruin the beautiful dream).

Partial replication funds that sample a portion of their benchmark’s securities (because the cost of holding them all is too high) will inevitably generate tracking error, being only a representation of the index rather than a perfect clone.

Synthetic funds use swap-based contracts to guarantee they match their indices’ performance. But the swap fees and collateral costs incurred by the contracts drag down fund performance against the benchmark.

Taxes and transaction costs like brokerage fees and trading spreads add to our tracking error woes, no matter which replication model is used.

• Turnover

The more trades a fund makes, the greater the trading costs, which ultimately undermines performance and adds to tracking error.

• Management experience

Although index funds are popularly thought to be so simple that they can be run by VIC-20 computers, better management can rein in tracking error. Look for funds with a long record of tight tracking error.

• Enhancements

This one actually works in our favour. Funds can earn extra revenue that closes the performance gap (or even turns it positive). Typically this income comes from two sources:

1. Fees earned by lending out fund securities to short-sellers.
2. Dividend enhancement – lending out securities to tax-benign territories when dividends pay out.

Now what?

So that’s tracking error in a blog-style nutshell. And everything would be hunky dory if fund providers published tracking error on their factsheets just like TER. But they don’t, and there’s no regulatory requirement for them to do so.

Clean comparisons of funds by tracking error are nigh on impossible in the real world. You might work tracking error out for yourself, if you love equations, but that doesn’t sound like many couch-potato investors I know.

Instead, you can use tracking difference as a substitute for tracking error when you want to compare rival funds.

Take it steady,

The Accumulator

Further reading:

1. How to use tracking error to uncover the true cost of an index tracker
2. Should tracking error sway the choice between ETFs and index funds?
3. Tracking error: How to measure it and what it tells us

The personal finance sections of the newspapers regularly showcase hapless folk who’ve come unstuck with a fund, share, pseudo-bond or moneymaking scheme.

Rarely is the hapless punter aware of the investing risks they were taking. More often it seems the purported victim – whether Phil, a 52-year old school teacher, Camilla, a 33-year old care worker, or Basey, an 19-year old student of uncertain gender – didn’t think very hard about the deal or investment at all.

They wanted easy gains, and to hell with the investing risks they faced.

I’m not saying the financial services industry isn’t out to get us (or at least our money). It really, really is! But we have to take responsibility, too.

As I look at these doleful portraits – a scammed housewife mournfully holding a tomcat or being hugged by a supportive but excessively bearded spouse – I have some sympathy… but only so much.

The truth is most people spend more time deciding how to cast their vote for X-Factor than they do thinking about investing their money. Their lack of vigilance makes it harder for the rest of us.

One investing risk or another

Very often Phil, Camilla, Basey or whoever sees one risk, but ignores the others:

• Scared of the risk of inflation, Phil invests in a higher-yielding offshore bond, not realizing it’s held in a different territory or that he can’t get his money out with less than 12 months notice.

• Worried about penny shares, Camilla decides to start investing in safer stocks like utilities for the dividend, but is oblivious to newspaper reports about tougher government regulation.

• Terrified that High Street banks are going bust, Basey opens a Zopa account and looks forward to a higher returns, but is surprised when struck by bad debts.

The plain fact is all investments are risky and can lose you money. If you can’t identify the risk with an investment, you shouldn’t go near it.

Types of investing risks

There really are innumerable investing risks, and if you stick around Monevator, I’m sure I’ll cover them all by 2017.

Until then, here is a bluffer’s guide to the main ones. Next time you consider making an investment, think about which of these risks you’re taking, whether you’re comfortable with it – and whether you’re getting a sufficiently attractive reward to compensate.

The presence of any of these risks does not mean an investment is a bad one. All investments have at least one of these risks. What matters is whether price is right for the risk, and whether you understand what you’re getting into.

Note: I’m aware these aren’t textbook definitions of types of investment risk. They’re meant to get the point across quickly to everyone, not stand up in a court of law.

Business risk

This term is sometimes used to refer to what I call ‘stock specific risk’ below: that is, the specific risks pertaining to one company’s operations. But others use it to describe risks affecting all companies operating in a particular sector. For example, all fishing boats in the same port are affected by periods of bad weather, however skilled their captain or hearty their sailors. I think ‘sector risk’ describes that better.

Currency risk

The risk that comes through changes in the exchange rate between one currency against another. If you invest in European companies, say, and the Euro collapses versus your currency, then your investment will be worth less in local terms when you bring the money back home (unless you’re hedged, which costs). Similarly, your repayments on a foreign mortgage will rise as your currency weakens. It can work the other way, too, of course.

Counterparty risk

This is the risk that someone with whom you’ve entered into an agreement will default or otherwise screw-up. It’s often not immediately apparent when you make the investment. For instance, that fancy Guaranteed Equity Bond your bank sold you might involve contracts underwritten by an American bank you’ve never heard of that goes bust. Don’t laugh – it happened.

Credit risk

Some people don’t pay the bills they promise. Nor do some companies. Even some countries fail to cough up. If you’re a good credit risk, that means that banks and others think you’ll pay what you owe. If you’re a sub-prime borrower, they generally don’t – unless you happen to want a mortgage on a shack in a swamp in 2003-2007. Credit risk is sometimes called default risk.

Inflation

Ever increasing prices is the reason why nobody ever got rich keeping all their money under a mattress (except perhaps the makers of sufficiently flexible mattresses). And it’s not just the low but steady inflation we’ve got used to in recent years – and that you planned for – that erodes your returns. A couple of years of double-digit inflation can come out of the blue to crush fixed interest savings. Just ask the nearest nonagenarian German.

Interest rate risk

The risk that the value of your asset – usually a bond, but also to an extent stocks and other securities – will change in response to changes in interest rates. For instance, if you buy a long-dated corporate bond yielding 6% when base rates are 3%, it will likely fall in price if base rates are raised to 4%. Any potential new purchaser would demand a higher yield (that is, would pay a lower price) given the risk-free rate was now 4%. A related risk is when you put cash in a fixed rate savings account, or take out a fixed rate mortgage. Your fixed rate will be less or more attractive, when the base rate changes.

Liquidity risk

Liquidity is a measure of how easy or hard it is to sell an asset. Cash is very liquid; a house is illiquid. Some small company shares can be easy to sell – just log into your online broker and place the order – but if you try to sell more than an expensive sofa’s worth, the price will plunge, which is another risk of poor liquidity. Money tied up for a year in a fixed rate bond is also illiquid, but it’s a known issue when you invest; the risk is that interest rates move against you, or that you need your money before the term is up.

Management risk

When you put money into a fund or an investment trust, you take on the risk related to the manager’s performance. He or she may do better than the market, or do worse. Using index funds gets rid of management risk. The price (which for most of us is worth paying) is you’ve no chance of beating the market.

Market risk

This is the risk you take for simply showing up and investing in a market. The stock market, the property market, even the market for antique hobbyhorses – all move in their own broad trends, which affect all the assets in that market. You can’t get reduce market risk when hobbyhorse investing by buying two different hobbyhorses, but you could buy one hobbyhorse and spend the rest of your money on a vintage bottle of wine to diversify. Market risk is sometimes called systemic risk – particularly by pompous people like me.

Political risk

There’s a reason why the Russian stock market usually trades on a lower valuation than Western markets, and why London-listed conglomerate LonZim has assets worth £33m but is valued at less than £10m: The Russians invented the appropriation of personal property, while LonZim operates in Zimbabwe, a beautiful country blighted by a nutcase at the helm.

Regulatory risk

This is a bit like political risk for Western economies. It’s the risk of politicians or other lawmakers introducing new rules to govern an industry or sector that hurts your investment. Domestic solar power installations are being touted at the moment in the UK, for instance, and thanks to generous new feed-in tariffs they do look financially attractive. But if a future government scraps the incentives, the maths may no longer add up.

Stock specific risk

This is the risk that a particular company you invest in goes bust, even while the market sails on regardless, leaving your crappy stock floating lifeless in its wake. Companies can fall in price or go bust for all kinds of reasons, from fraud to poor management, though in most cases it amounts to running out of money. This sort of specific risk is also why fund investors (including passive investors) should spread their money between different companies as their portfolio grows, and why you should even keep some cash in different banks.

Volatility

In simple terms, volatility is the range over which the value of an asset moves over some time, usually a year (technically, the standard deviation over the return rate). If the price moves a lot, it’s a high volatility asset, whereas if it doesn’t go anywhere quickly, it’s low volatility. Low volatility usually seems more attractive, but higher volatility typically delivers superior returns to compensate. Diversification can reduce volatility without denting returns to the same degree. (Volatility risk has specific meanings, to do with options or currencies, beyond the scope of this piece).

Remember, diversification – both horizontal and vertical – is usually your best friend when trying to reduce investing risks.

Further reading:

1. The risks of buying mark to market investments on margin
2. The risks of Venture Capital Trusts (VCTs)
3. Crisis investing: Specific news events

When Germany decided to ban the naked short selling of European government bonds, credit default swaps and the top ten German financial institutions in response to the escalating Eurozone crisis, it was following a long tradition of indignant bureaucrats.

Regulators love to blame short sellers for exacerbating market turmoil, if not for downright causing it.

Most politicians are technocrats. They truly believe that clocking up 2.5% GDP plus inflation – year in, year out – is a credible aim for a market. Why all this Sturm und Drang? No more boom and bust!

By definition, politicians also like to score political points – such points are free, and the voters love them. Down, evil short-sellers, down!

The Americans already banned naked short selling

Still, Germany’s ban on naked short selling is hardly outrageous if you consider that the U.S. introduced such controls in the banking crisis in 2008, and never rescinded them.

Why should Europe alone face the locust hordes?

Yet just as Lehman Brothers’ collapse wasn’t caused by short sellers (they might have finished it off, like hyenas tearing apart a sick animal) so the gyrations in European securities haven’t arisen in a vacuum.

Weaker European countries have borrowed too much, and lived high on the hog for too long. Germany has been too stingy. Something had to give.

That said, one can understand the politicians’ frustration. I heard last week that French banks, having just been underwritten by the enormous Euro-aid package, were among the first to begin shorting the Euro in response!

I guess asking traders not to take profitable trades would be like asking a baker not to bake after you’ve paid him insurance for burning down his bakery.

Naked short selling versus everyday short selling

If you’re going to ban short selling, then it’s certainly the naked form that’s the most dubious.

Short selling means borrowing a stock or other security from someone, selling it, and hopefully buying it back more cheaply later. Like this, you turn a profit from the price difference (after paying interest to whoever you borrowed the stock from). But if the stock’s price rises after you sell it, you lose money.

Naked short selling differs in that you never actually borrow – or even arrange or intend to borrow – the security you sell short. In theory, this could mean that it’s possible to drive down the price of a security beyond the normal relationship of supply and demand for the underlying asset. That said, someone is still taking a real money risk in wagering the price will fall, so in that sense it still represents real price information in the market.

There’s much dispute amongst market watchers as to whether naked short selling can unduly disrupt markets, or even whether it can be effectively banned. I don’t profess to have a clue, let alone an expert opinion.

What’s clear though is in the short-term, actions such as banning naked short selling by the authorities can ironically stoke more fear, rather than calm the markets.

A traders’ immediate reaction to any sudden change will always be: “What don’t I know now, and what’s being hidden from me?”

And that’s not a recipe for a stable market.

Further reading on naked short selling

• Germany’s ban on naked short selling runs until late March 2012
• A detailed US-centric Wikipedia page on naked short selling
• The FSA says the German ban won’t cover such instruments traded in the UK

Okay, about that picture above… He’s a naked short seller who is going to clean up. Geddit? Sorry!

Further reading:

1. Video: The short simple history of the credit crisis
2. What The Big Short teaches the little guy

A preference share is like a halfway house between an ordinary share and a corporate bond.

If that sounds like something from Alice in Wonderland, you’re not far wrong.

The risk versus return profile of preference shares can be hard to work out due to their hybrid nature.

They often seem to deliver just a little extra yield over corporate bonds, but for a much greater risk.

But occasionally such shares  (known as ‘preferred stock’ in the US) can offer attractive opportunities for investors who do their homework.

What are preference shares?

Like shares and corporate bonds, preference shares are a way in which listed companies raise money.

They differ in terms of the rules about how owners must be paid an income, and what happens if they’re not.

First, the good stuff.

• Preference shares are listed on the stock market, like ordinary shares.

• Holders receive a fixed dividend, just like bondholders.

• The running yield you get depends on the price you pay in the open market.

• Their dividends must be paid before any ordinary dividends can be paid.

This fixed income can seem a very attractive alternative to the fluctuating dividend payments from ordinary shares.

Remember though that because your income is fixed:

• The preference share price will fluctuate with interest rates and inflation.

• Over the years the dividend in real terms will be eroded by inflation, just as with all fixed income securities, which will severely cap long-term returns.

This is very different situation to ordinary share dividends, which in aggregate tend to go up over time – which means that ordinary share prices can continue to grow indefinitely.

The other risks of owning preference shares

As I said, preference shares are riskier than bonds.

If bondholders aren’t paid their interest, they can bankrupt the company. The same is not true of preference shares – companies can skip such dividend payments, just as with ordinary dividends.

Most preference shares are cumulative. In theory this means that if holders aren’t paid their dividend in some particular year, then they must be paid in full if and when the company is subsequently able to.

• Those are important ifs – if the company goes bankrupt, you’ll never get your lost income.

In such circumstances, preference shares rank ahead of ordinary shares in terms of the company’s capital structure – but behind bondholders.

In practice, when a company goes bust – and the ordinary shares become worthless – then even bondholders seldom get all their money back.

In such circumstances, preference shareholders get nothing.

Tax treatment

In the UK, preference share dividends are treated tax-wise the same way as ordinary dividends.

That means lower-rate tax payers have no more tax to pay on their income, while higher-rate taxpayers are effectively taxed at 25%.

The bottom line

In my view, the extra security of having to be paid a dividend before ordinary shareholders – and the cumulative payments if you’re not paid – are attractive benefits of preference shares. But I think the ability to claim company assets is pretty useless in practice.

Preference shares are certainly unusual instruments, and tend to be issued in unusual times. Warren Buffett bought some in Goldman Sachs during the banking crisis, for instance.

During the same period, investors who bet that UK banks wouldn’t go bust by buying their preference shares saw their investment double or triple in just a few months. Some locked in a yield on the purchase price of as much as 30%!

But usually investing in these special shares is more about getting a slightly better income, in return for forgoing the chance of equity-like gains.

Further reading

• Fixed Income Investments – This is a site run by a private investor which at the time of writing (May 2010) is probably the most up-to-date source of data out there for preference share investors.

Further reading:

1. The bewitching appeal of Lloyds suspended preference shares
2. What first attracted me to the 9%-yielding Natwest preference shares
3. Back into bank preference shares?

Until they start taxing sex, in the UK capital gains tax (CGT) is the most annoying tax to find yourself paying.

CGT is a tax on any profits you make when you sell or transfer assets like shares in your portfolio, rental properties, or even your own company.

In the UK capital gains tax is much simpler than it used to be. UK capital gains tax is now a flat 18% tax rate, and fiddly nonsense like taper relief has been abolished. It no longer matters whether you’ve owned your shares for a day or a decade when calculating your taxable gains.

Even with the new flat rate, like a fly in your soup CGT can really spoil the fun of making money.

Unlike inheritance tax, which is a tax on your good fortune, or income tax, which is a cost of having a job, UK capital gains tax is a tax on success!

Of course, sometimes you won’t make a profit when you sell. That’s called a capital gains loss, and unfortunately you don’t get money back from the government for losing money (not unless you make cars or you’re a bank…)

However, you can offset capital gains with capital losses to reduce the total gain you will pay tax on.

The good news is in the UK capital gains tax is a fairly avoidable tax for most investors. (Remember, you’re allowed to avoid paying taxes where possible, but tax evasion is illegal.)

UK capital gains tax: What’s charged and when?

When: You are charged CGT on asset sales generated in a particular tax year (which runs for 12 months starting every April 6th).

What: Most capital gains are taxable, but in the UK capital gains tax is NOT charged on these assets:

• Your main home (in 99% of cases)
• UK Government bonds (gilts)
• ISA holdings
• Personal belongings worth £6,000 or less when you sell them
• Betting, lottery or pools winnings (including spreadbets)
• Money which forms part of your income for Income Tax purposes
• Venture Capital Trusts

That still leaves many key assets liable for UK capital gains tax when held outside of an ISA, including:

• Shares
• Corporate bonds
• Funds
• Antiques
• Buy-to-let property
• Land

Finally, you have an annual allowance of taxable gains that you can make in a year before you have to pay CGT. This is currently £10,100.

Capital gains are pooled together

Note that all capital gains and losses go into the same ‘pot’ from the Inland Revenue’s point of view.

For example, if you made a gain of £15,000 selling shares and £8,000 selling an antique wardrobe, your total capital gain would be £23,000.

Here losses can help you out – for example, if you make a taxable gain on your shares but a loss on selling your buy-to-let property, you can use the loss to offset or even wipe out the tax due on the gain.

See my article on avoiding capital gains tax for ten ways to reduce your UK capital gains tax bill.

Further reading:

1. Avoiding capital gains tax on your investments
2. AIM shares lose their 10% Capital Gains tax perk
3. Capital Gains Tax now charged at a flat 18%

A lot of people confuse tax avoidance and tax evasion. It can be a dangerous mistake to make!

As the former British Chancellor of the Exchequer Denis Healey said:

“The difference between tax avoidance and tax evasion is the thickness of a prison wall”.

What can’t be stressed enough is that the two terms – and the actions each entails – are definitely not the same thing.

• Tax avoidance involves using whatever legal means you choose to reduce your current or future tax liabilities.

• Tax evasion means doing illegal things to avoid paying taxes. It’s the Al Capone path to financial freedom.

Unfortunately for any criminals who Googled ‘tax evasion’, I’m not about to give you a masterclass in laundering cash or doctoring a passport.

I’ve never evaded taxes, I don’t condone it, and I couldn’t tell you how it’s done.

Tax avoidance is another matter. With taxes likely to rise in the West to pay down public debt regardless of what party in power, it makes sense for investors to do what we can to reduce our tax burden without overly compromising other aspects of our lives.

Note that according to the bastion of all knowledge good and true – *cough* Wikipedia *cough* — the term ‘tax avoidance’ is currently in some dispute in the UK, with ‘tax mitigation’ being suggested as a better term for legal tax reduction:

The United Kingdom and jurisdictions following the UK approach (such as New Zealand) have recently adopted the evasion/avoidance terminology as used in the United States: evasion is a criminal attempt to avoid paying tax owed while avoidance is an attempt to use the law to reduce taxes owed.

There is, however, a further distinction drawn between tax avoidance and tax mitigation. Tax avoidance is a course of action designed to conflict with or defeat the evident intention of Parliament.

Tax mitigation is conduct which reduces tax liabilities without “tax avoidance” (not contrary to the intention of Parliament), for instance, by gifts to charity or investments in certain assets which qualify for tax relief. This is important for tax provisions which apply in cases of “avoidance”: they are held not to apply in cases of mitigation.

I suspect this is largely a courtroom debate, caused by the Revenue looking to close down schemes of dubious legality created by planners for wealthy individuals.

But I’m no legal expert nor a tax planner – just an everyday bloke who enjoys investing. So to be absolutely clear, what I’m talking about is reducing the taxes you pay, mainly on investments, by using legal and above board means.

I’ll outline a few such measures in part two. (Subscribe to ensure you see it!)

Be prepared to do some research about the tax regime in your country, though, and potentially to take professional advice.

Tax laws can be complicated, and you don’t want to end up on the wrong side of that prison wall.

Further reading:

1. Spread betting tax avoidance strategies
2. UK capital gains tax
3. Avoiding capital gains tax on your investments

The Alternative Investment Market (AIM for short) was set-up in 1995 as a sub-market of the London Stock Exchange.

AIM enables smaller companies to obtain a public listing for their shares at a fraction of the cost and with less regulation than on the main market.

Over 3,000 companies have been listed on AIM since it opened.

AIM can be a rich hunting ground for private UK investors looking for bargains, since shares listed on AIM are less well researched than on the main market, and many are too small for fund managers to bother with.

Beware though that the smaller size of AIM companies and the looser regulation means that they’re riskier than mainstream shares, too.

Also, many AIM shares are thinly traded, which means that investments in AIM companies can be illiquid.

AIM market ups and downs

The AIM market was originally aimed at UK companies, but today it plays host to hundreds of overseas companies, from Canadian oil explorers to Chinese tech startups.

These companies have undertaken a listing on AIM partly because of greater regulation elsewhere in the world, but also because a London-listing gives them exposure and potentially access to a large pool of international finance.

There’s also two-way traffic between the main market and the AIM market.

Smaller companies sometimes move down to AIM to cut costs, while some bigger AIM companies have moved up to full listing to improve the liquidity in their shares or to woo more institutional investors.

Who should invest in AIM shares?

Investing in companies on the Alternative Investment Market is best suited to experienced investors who understand the risks they are taking and who are well-versed in reading company reports, digging into news releases, and even contacting the companies directly.

Alternatively, there are some funds and investment trusts that focus on AIM shares, including several venture capital trusts. Their performance has been inconsistent (to put it mildly!) however.

Finally, you may have heard there’s a tax advantage to investing in AIM shares. This is no longer the case; changes in the UK tax regime mean all capital gains are now taxed at a flat 18%, including AIM shares.

There may still be advantages for inheritance tax planning purposes, but this is a fast moving area and you should definitely seek professional advice before buying for that reason.

You can keep track of news and companies via the London Stock Exchange’s official Alternative Investment Market market homepage.

Further reading:

1. AIM shares lose their 10% Capital Gains tax perk
2. Investment trusts explained
3. Getting an investment income from investment trusts

Mark to market is the act of valuing an asset at its current market price, as opposed to its book price.

Primarily an accounting practice, mark to market is relevant for private investors in several ways:

• If you borrow money to invest, you could face margin calls if your account is marked to market.

• You mark to market when working out your current net worth, by estimating the value of your home and other illiquid investments.

• Discovering assets owned by listed companies that are NOT marked to market — and so are being carried on the books too cheaply — can unearth hidden value.

Some blame mark to market for the credit crisis of 2007 to 2009.

As credit markets froze up in late 2007 and trading stopped, the prices available for some securities — especially mortgage-backed securities — became hugely suspect and a very poor indicator of fair value.

Yet following the accounting rules, banks continued to revalue their holdings by marking them to market.

Because prices had fallen, their assets were now worth less, and so the banks’ reported huge quarterly losses.

Yet in many cases the assets had NOT been sold, and in most cases they were expected to be sold for higher prices or to be repaid in full (in the case of debt).

Banks had to raise more equity or sell more assets to repair their balance sheets as a result of these writedowns. Both activities further hurt sentiment and price.

Mark to market rule relaxed

While some flawed companies were certainly exposed by the sub-prime crisis, it’s arguable the panic was made far worse by marking to market.

The Washington Post wrote of mark to market:

The accounting standard, known as fair value or mark to market, has been cited as a contributing factor in the collapses of American International Group, Freddie Mac and Lehman Brothers.

Accordingly, the accounting rule was eased in April 2009:

Changes to fair-value, or mark-to-market accounting, [...] allow companies to use “significant” judgment in gauging prices of some investments on their books, including mortgage-backed securities. Analysts say the measure may reduce banks’ writedowns and boost net income. Firms could apply the changes to first-quarter results.

Banking stocks rallied strongly for months after the change.

Mark to market and your portfolio

For assets that are traded regularly on open marketplaces, marking to market is very straightforward.

If you have a portfolio of listed stocks, you can find its current value simply by logging onto your broking account or by reading the Financial Times and doing some sums.

Your online broker will typically update the prices of your shares continually (albeit with a 15-minute reporting delay here in the UK).

Fund prices are updated daily.

In contrast, if you have a private pension, your provider may send you a valuation every 12 months. As far as you’re concerned, your pension is marked to market on the date of that valuation. (Between valuations, you guess!)

What if there is no market price?

Sometimes you might not know the market price of an asset unless you sell it.

• An obvious example would be the value of your house.

• An example in corporate finance would be the value of an unlisted start-up company backed by a venture capital fund.

In this case you (or the accountants) try to estimate or model the asset’s value.

This can be a complex process for the holdings of big institutions, so I’ll try to explain it simply via — get ready — pedigree cats.

Marking to market Siamese Cats

Imagine you own five pedigree Siamese cats.

You have no idea what your five cats are worth because Siamese cats aren’t listed in the Financial Times.

However you know that a Persian cat sold on eBay this morning for £100.

Now, let’s say you also know that Siamese cats normally sell for about 50% the prevailing price of Persian cats. (I have no idea if they do. It’s just an illustration.)

Inputting the recent Persian cat sale price into your Siamese Cat Price Model (i.e. Siamese cats cost half as much as Persian cats) gives you the fair value of the five cats you own:

• 5 x (£100/2)=£250

Mark to market and estimations

Sometimes there’s no accurate model for marking to market a particular asset, and so you have to be more creative.

For instance, imagine you bought your house ten years ago, and your mother-in-law wants to know what the house is worth today.

This situation is tricky, because every house is different, even in a street of similar houses. Some will be in better repair, while others may reek of Siamese cats.

You (or your estate agent) would therefore have to estimate the value of your house, by looking at the prices that other houses in your street had sold for recently, and comparing those houses to your own house.

They might also work published price trends into their estimate. For example, if the last house in your road was sold a year ago but Nationwide says prices have fallen in your area by 10% in the past six months, that will need to be taken into account.

The final figure should be fair estimate of the value of your home — but it isn’t an exact one.

Banks, insurers and other financial companies use complicated ‘black boxes’ to do the same thing for marking to market their holdings where no market price is available.

Such models are often not very transparent, and so can be controversial!

Further reading:

1. The risks of buying mark to market investments on margin
2. Spring bounce for falling UK housing market probably just a speed bump
3. Weekend reading: The bull market is one-year old, but the bear market is ten

Investment trusts are companies that invest money in other companies, both listed and private, and/or other assets like bonds, property and private equity. They are in the business of trading and holding these assets for profit.

The particular kind of assets an investment trust holds depends on the mandate of that trust.

For instance, a trust may specialise in smaller companies, fixed income, overseas stocks, or one of a host of other themes, enabling investors to take interesting positions on the market.

There are also specialised property investment trusts that get tax breaks called Real Estate Investment Trusts (REITS). These deserve a future article in themselves.

The first investment trust, the Foreign & Colonial Investment Trust, was launched way back in 1868:

“to give the investor of moderate means the same advantages as the large capitalists in diminishing the risk of spreading the investment over a number of stocks”

The F&C trust is still going strong today, as the largest global growth trust in the world.

Investment trusts differ from unit trusts and mutual funds in two important ways:

• Investment trusts are listed on the stock market and so are owned by their shareholders.

• There are a finite number of shares in issue; they are closed-ended funds. This is in contrast to open-ended funds such as unit trusts, whose managers can create or destroy shares on demand (subject to reserves) as the money comes and is withdrawn by the fund’s investors.

Investment trusts are very popular in the UK – much more so than the U.S., with the notable exception of REITS – and until Exchange Traded Funds they were the main way to put money into collective funds via the market.

Investment trust basics

In most ways investment trusts are just like any other listed company: you buy and sell them for a quoted price via your broker, and some pay dividends.

However there are some extra terms you must be aware of:

• The Net Asset Value (NAV) of an investment trust is (in theory) the value of all its investments, and so gives an indication of what the trust would be worth if it were closed today and all its assets sold off.

• The premium or discount to the NAV expresses as a percentage how the share price compares to the NAV.

For instance, you might have the fictitious Monevator Investment Trust trading at 90p per share, with an estimated NAV of 100p. This trust is therefore trading at a discount to NAV of 10%.

Extreme discounts usually narrow over time. In the 1970′s bear market, discounts approached 50%, for example. Due to the fear in the market, the shares simply became illiquid. When normality returned the discount narrowed closer to what the assets were actually worth, enabling brave investors who bought at the bottom to pocket an effortless gain.

In late 2008 there were equity income investment trusts trading at unusual discounts, too.

However discounts may correctly anticipate reductions in NAVs that haven’t been worked into the official estimate yet.

As of mid-2009 there are many private equity and commercial property investment trusts trading at very steep discounts, for instance. In this case the discount may fairly reflect the fact that the assets are worth a lot less than the NAV indicates.

Even with big investment trusts like the £1 billion RIT Capital Partners that I hold, there’s an element of guesswork in official NAV estimates. That’s because the trust holds private companies, such as 50% stake in The Economist. You can never really tell what assets like that are worth until they’re sold.

In contrast, the portfolios of investment trusts that invest entirely in listed companies can be accurately modeled, both by the trust itself and by external companies who estimate NAVs between official updates.

Why would a trust ever trade at a premium to the NAV? It seems illogical to pay more than you know the trust is worth, after all, but it sometimes happens, especially in bull markets.

Usually premiums arise because investors rate the management very highly, and believe they can skillfully buy undervalued assets or sell over-priced ones for a profit that will reveal itself in the fullness of time.

Buying investment trusts at a premium to the NAV is risky, however. The premium is more likely to evaporate with a share price fall.

Other investment trust quirks

There are a few other things to be aware of with investment trusts.

• Warrants There may be warrants (a kind of share option) in issue, given the holder the right to buy shares in the trust at some pre-determined price. The NAV of the investment trust is given as ‘fully diluted’, to take into account the fact that outstanding warrants that are profitably ‘in the money’ will reduce the assets available to other shareholders. Normally this makes a very small difference to NAV, but it’s worth checking the details for any trust you buy.

• Debt Investment trusts can borrow money to invest. This debt will have a market value (what it would cost to repay today) and a par value (nominal) value. If an investment trust were to be wound up, any debt would have to be repaid at the market value. Investment trust updates to the market usually give NAVs with debt accounted for in both ways. Normally you don’t expect the trust to be wound up – it’s all about downside protection. And some trusts have no debt.

• Costs and expenses Again, if the trust was wound up, lawyers, brokers and accountants would all get a piece of the pie. This could devour 3-5% of the NAV, especially if the trust is small.

Investment trusts definitely give you some interesting ways to put your money to work, and the opportunity to bag a bargain if you spot a trust trading at an unwarranted discount.

If you’re new to the markets though, you’re best starting off with Exchange Traded Funds, which have far fewer of the extra complications (and risks) of investing in investment trusts.

Further reading:

1. Why do investment trusts trade at a discount or a premium?
2. Warning: Income investment trusts trading at a premium
3. Buying an investment trust on a discount versus a premium