Subscription shares

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! [↩]