I have previously introduced subscription shares, and explained how they can leverage your returns. Please read those two posts first, since they explain the basics of subscription shares, which I’ll assume you know below.

Today, I’m going to outline the pros and cons of subscription shares, and give you some ideas as to when and why someone might choose to buy them.

Warning: Subscription shares are very volatile and much more risky than ordinary shares, which are themselves far riskier than cash or bonds. They are only suitable for experienced investors, who have done their homework and understand the dangers as well as the potential gains.

The executive summary is you can make explosive gains through subscription shares if you’re right (or lucky). But you can easily lose your entire investment, too, so you must understand the risk and return profile.

To do this you’ll need to drill into the numbers, which we’ll do in the next post in this occasional series. For today, let’s consider the main Need To Knows.

Advantages of subscription shares

Gearing

You can hugely amplify your capital gains compared to buying the underlying investment trust. Leverage of 3x is typical, and even 10x gearing is not unusual, though obviously far riskier. I have a small position in a particular subscription share that is geared over 20x! I expect it to expire worthless, but the upside is considerable if it doesn’t, and I think the odds are reasonable.

Fixed downside risk

The most you can lose is 100% of your investment. Not a champagne moment, but better than a spreadbet that runs against you and so incurs losses beyond what you first put in, for example.

Tradeable

Subscription shares are quoted on the stock market, and can be bought and sold like any other share through most brokers. You don’t have to hold until they expire. You can trade in and out before then, to take advantage of short term enthusiasm in the market.

Transparent

You can see exactly what price the underlying trust needs to hit for your subscription shares to be in the money, and how much you might make if the price continues higher. You can also read the underlying investment trust’s updates to form a view on its holdings and prospects, and thus the outlook for the subscription shares.

Liquid (sort of)

The bid/offer spreads on some subscription shares are horrible, and the prices do jump around. But at least you can dispose of your holding if you have to, at some price, up until the excise date (even if you don’t like the price you’re offered!) Far better than with guaranteed equity bonds, say, which you must usually hold until a fixed date.

Tax efficient

You can hold subscription shares in an ISA, and so avoid capital gains tax when you sell. Given their gearing can produce big capital gains, this can be very beneficial. Also, as I understand it1, exercising your subscription shares to buy into the underlying trust’s shares does not generate capital gains at that point (though it does require you invest more money).

Some disadvantages of subscription shares

There are fewer entries in this section, but don’t be fooled – these are big enough downsides to rule out subscription share for most active investors.

They can expire worthless

And if they do you’ll lose 100% of what you put in. That’s very unattractive compared to buying the underlying trust, which you can hold for years to see if it comes good again if you want to. A company share can go bust, too, so many active investors won’t be daunted by this risk (but see ‘time sensitivity’ below).

Gearing

As well as those big gains, you can easily lose most of your money from relatively small downward moves in a trust’s share price.

Poor liquidity and large bid/offer spreads

Most subscription shares are issued in relatively small numbers and are rarely traded. If the price falls to penny share status, you could easily take a 20% or more initial hit on buying the shares, just from the bid/offer spread. The bigger and more liquid subscription shares are on much tighter spreads, but there’s no guarantee you’ll be able to buy and sell them whenever you want; you may have to call your broker to get them to work a deal, and if you really must sell that day you’ll need to take whatever price you’re given.

No income

The underlying investment trust may pay a dividend, but you get nothing as a subscription share owner. In fact, big dividend payments are undesirable since they mean less money for the trust to reinvest into growing net assets that could benefit the share price. (Conversely, share buybacks by the trust are beneficial).

Time sensitive

Every subscription share issue has an expiration date. It is always a huge disadvantage to buy any stock market linked investment that has to keep to a calendar, given the short-term volatility of share prices.

So why might you buy subscription shares?

Most private investors have no business trading individual company shares, let alone subscription shares. You should stick to index trackers and perhaps high-quality income investment trusts and the like.

For those of us who do actively manage some portion of our portfolio, however, subscription shares enable some interesting trades:

Value opportunities: Sometimes the subscription shares look very cheap for no good reason, especially if the market is panicking or if somebody has to dump their holding. A keen-eyed active investor might put on a trade for a big profit if they spot this happening.

Special situations: A subset of value opportunities, these typically come about because of a scary crisis. When the Japanese stock market plunged in early March, for example, I bought JP Morgan Smaller Companies Trust subscription shares, which I judged to be oversold given they had a few years to come good again, among other things. The spread was horrible, but the gearing on subscription shares can compensate; after my subs rose nearly 50% in a few days shortly afterwards that spread hardly mattered. There are subscription shares covering India, several Asian ones, at least one green technology one, and more, so plenty of themes to play.

Short-term trading: Some people believe they can regularly gamble with stocks over the short-term, irrespective of special situations or insights. If that’s you, then the leveraged returns from subscription shares can make them an option to add to the mix, though beware the huge costs of the spread. Personally I wouldn’t recommend this – frequent traders usually lose more money.

Long-term leverage: Very few people consider this as a reason to buy subscription shares, but I think it’s potentially the best reason. While you’ll find many subscription shares have only a year or two (or even less) to run, there are a few with several years to go before they expire. I own some with around seven years to go! Given how they gear up your investment, this is a way to greatly increase your exposure to a rising stock market without actually investing any more money. The downside is far higher volatility along the way, and the potential of losing everything (together with the other risks above), but you can mitigate some of this by top-splicing your holding if it shoots higher, and averaging down if it falls, to control your exposure.

I suppose one final reason to buy the subscription shares would be if you really admired an investment trust manager and wanted to increase your exposure to his or her stock picking. But most trusts don’t yet have associated subscription shares, so this isn’t generally applicable.

The final part of this mini-series on subscription shares will look at how you can try to value what a particular subscription share is offering, to judge whether you want to invest. Subscribe to ensure you see it.

1. The caveat is I have never actually exercised my subscription shares. I have always sold them before expiry in the market. [↩]

The old investors’ advice to “Never invest in something you don’t understand” strikes a powerful chord in the wake of warnings about the risks of Exchange Traded Funds (ETFs).

Often tagged as exotic in comparison to their physical ETF brethren, synthetic (aka swap-based) ETFs use financial engineering to achieve the same ends, but in ways that pose specific risks that every passive investor should know about.

What is a synthetic ETF?

A synthetic ETF is designed to deliver the return of a selected index (e.g. the FTSE 100) just like any other tracker.

But it’s the way the synthetic ETF comes by that return that reveals its exotic nature.

The most obvious way to track an index is to own all (or most) of its component securities in the same proportion as that index. This way, the ETF should spout the index return minus costs and a few other inefficiencies. That’s how a physical ETF does it.

But a synthetic ETF doesn’t bother with any of that old pony.

Why go to the trouble of actually owning the shares of an index when you can deliver its return using a total return swap?

A total return swap is a financial derivative. In the case of a synthetic ETF, it’s a contract struck with a financial partner (known as a counterparty) to pay the ETF the precise return of its chosen index (both capital gains and dividends) in exchange for a stream of cash.

With a total return swap in place, the synthetic ETF can imitate an index without owning a single one of the benchmark’s securities.

Short-circuiting ownership means synthetics can overcome many of the tracking error issues that dog physically buying an index.

Synthetic ETFs are not tracking error-free, though. Performance is still leeched due to the fund’s TER, and other operational costs like the fee for the swap itself.

Problems? What problems?

Synthetic ETFs are often used to forage in markets that would otherwise defy tracking because of:

• Illiquidity
• Inaccessibility
• The huge numbers of securities to physically track

Many small cap indices, for example, would require a physical ETF to own a massive constellation of equities that would be costly and time-consuming to trade, due to market illiquidity and yawning bid-offer spreads.

The effort involved would make physical replication too expensive, so synthetic ETFs step in like robots cleaning up a nuclear reactor. The explosion in synthetic ETF numbers over the last few years shows how successful they’ve been in opening up markets where physicals fear to tread. Few niches are off limits when you can just buy the return with a derivative.

Ah, those problems… counterparty risk

A synthetic ETF’s reliance on derivatives may well send a little shudder down your spine. Derivatives haven’t had a good press ever since credit default swaps triggered the worst financial crisis since the Great Depression.

You’re absolutely right to be wary. All this financial engineering doesn’t come for free. The reduction in tracking error comes at the price of heightened counterparty risk.

Counterparty risk is the chance that the total return swap provider – even a seemingly indestructible entity like a giant investment bank – goes belly up. Lehman Brothers is the example of a counterparty crash par excellence.

If the worst happens, then the ETF’s source of return is cut-off and it’s time to fall back on the collateral.

Collateral damage

Investor cash sunk into a synthetic ETF doesn’t just go towards buying a total return swap. It’s also meant to buy enough collateral (almost) to fend off disaster.

So if the fund’s counterparty blows up, the collateral is sold off and investors (hopefully) get the value of their shares back.

Collateral can be held in cash, bonds and the equities of OECD countries. What’s more, European regulations limit counterparty exposure to no more than 10% of a fund’s Net Asset Value (NAV). In other words, the ETF must be backed by collateral worth at least 90% of its market value.

In practice, more collateral is often posted than required (known as over-collateralisation), and the ETF may be backed by up to 120% of its value in collateral.

The collateral quality counts as much as the quantity. There is no requirement for collateral to be held in the same securities that the ETF tracks. That means the ETF’s collateral basket can be stuffed full of all kinds of whiffy securities – Japanese small caps, unrated bonds – that could be hard to shift in an emergency.

The longer it takes to sell off the collateral, the more likely it is to plummet in value in comparison to the ETF. (And let’s face it, the chances are a counterparty will only fail during torrid market conditions.) If that happens then investors take a haircut.

i.e. They won’t receive the full market value of their ETF shares.

A number of ETF providers publish their collateral policy and the contents of each fund’s collateral basket on their website. I’d argue such knowledge is of limited use to retail investors, though.

Swap types to look out for

How ETF providers fund the total return swap has implications for the amount of collateral a synthetic ETF can call on in a crisis.

Two types of swap are commonly used:

1. Unfunded swap

• Investors’ cash is used to buy securities that make up the basket of collateral.
• The return on this basket is swapped with a counterparty for the return on the index.
• There is little, if any, over-collateralisation.
• The collateral is legally owned by the ETF provider.

2. Funded or pre-paid swap

• Investor cash is paid to the swap counterparty.
• The counterparty pays the ETF the index return.
• Collateral is pledged to the ETF’s account held with an independent custodian.
• The ETF is often over-collateralised up to 120% of NAV.
• The collateral is only available to the ETF if the counterparty goes bust.
• The ETF provider is not the beneficial owner of the collateral assets.

That last point is crucial. Because the collateral is pledged and not legally owned by the ETF, it can be frozen by a bankruptcy administrator stepping in to clean up the mess left by a failed counterparty.

In that scenario, the collateral isn’t released to the ETF provider as promised, but is caught up in the scramble to pick the best bits from the bank’s carcass. This happened during Lehman’s demise, and some investors (though not all) were left dangling for their cash.

Using synthetic ETFs

Synthetic ETFs are not constructs to be feared like killer ASIMO ‘bots from the future. But they do have features to be wary of (as do all investments) and they are certainly more complicated than physical ETFs.

So in general, I prefer to use physical ETFs, when I have the choice.

Bear in mind, too, that when you look at the securities listed in the index section of a synthetic ETF’s webpage, you aren’t seeing what the ETF owns. This list only reflects the composition of the index that the ETF artificially tracks via the total return swap. What the ETF physically owns, if anything, is found in the collateral basket section of the webpage.

There are other synthetic tracker vehicles out there: Certificates, ETNs and some ETCs. They work differently again from synthetic ETFs, but we’ll leave them for another day.

Take it steady,

The Accumulator

Thoughts from around the Web.

Run, don’t walk, to put some money into the new five-year index-linked certificates from National Savings & Investments.

NS&I is a wing of the UK government, and money you invest with it is 100% capital protected.

You may remember that NS&I’s index-linked certificates were withdrawn due to excess demand last year. Commercial banks have rushed to fill the gap with inflation-proofed bonds, but these are less attractive and based in some cases on derivatives. The Post Office also launched a bond, but it could not be held in an ISA, making the income taxable.

The new 5-year certificates from NS&I offer annual tax-free gains of RPI + 0.5%.

As the FT notes:

If RPI inflation remained at its March level of 5.3 per cent, the certificates would pay 5.8 per cent interest tax free. To achieve that return from a conventional, taxed savings account, a basic-rate taxpayer would need to earn a gross rate of 7.25 per cent, a higher-rate taxpayer would need to earn 9.67 per cent, and a 50 per cent taxpayer would need to earn 11.60 per cent.

It’s good news that NS& have continued to link to RPI, as I wrote when we first got wind these certificates would return.

The 0.5% rate above inflation is fair in these low interest rate times, though less than the old rate.

Of course, there’s every chance that inflation could fall and interest payable on ordinary savings accounts rise over the next five-years, which could make these certificates uncompetitive. But that is not the point.

Their value as part of your portfolio is diversification on unbeatable terms. No other inflation hedge can give you a guaranteed real return above inflation with zero risk to your capital. They’re a rare break for private investors, too. Banks and other institutions have to buy index-linked gilts, the price of which fluctuates, unlike the capital value of these certificates.

You can even withdraw your money early if the certificates get too uncompetitive, albeit with a reduction in the payment of interest due for the first year.

In short, even limited to £15,000 maximum investment per person, the limited issuance is likely to be snapped up very soon. Blogger Simple Living in Suffolk is beside himself with joy:

All in all, pretty awesome, a safe home for your cash. You aren’t going to get rich on it, but your cash is worth as much at the end of the five year term as it was at the beginning, there’ll just be more of it. I kind of like that in cash.

As I say, I see the certificates as a diversification play as much as about return. I am a chap who loves cash in a portfolio, anyway, but these certificates go an extra mile in usefulness.

Their appeal is an interesting sign of the times. It’s hard to remember the days when you could routinely get a real return (i.e. above inflation) from a savings account of 3% or so, yet that was the case for an account-hopping saver just a few years back.

Those days will return, and it may then be hard to remember why we got so excited about these new certificates.

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