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! [↩]

Knowing how closely your tracker hugs its benchmark index should be at the top of every passive investor’s To Do list.

Your chosen fund may have a dirt cheap Total Expense Ratio (TER), but if it lags its index by 2% a year then you’re paying a lot more for it than you realise.

No tracker perfectly delivers its benchmark’s returns. Tracking error is the measure that’s commonly used to describe and compare this deviant behaviour.

Yet the investment gods are cruel, and currently you’ll be hard-pressed to find many fund providers or independent investment sites queuing up to offer you tracking error data that can be meaningfully compared across all funds.

Try tracking difference

So when you’re choosing between trackers, you’re better off using a simpler measure that’s easier to find and use. Some call it tracking deviation, some call it trailing returns, and yet others call it tracking difference.

What we do know is that it’s a simple comparison of:

Total fund return Vs. total benchmark index return

For example:

If the Global Llama Volatility ETF (LAME) returns = 1%

And, its benchmark Llama Vol index returns = 2%

Then tracking difference = 1%

Whatever the TER says, that tracking difference provides a far more accurate description of the cost of owning that fund.

Check the tracking difference over:

• 1 year (minimum)
• 3 years (better)
• 5 years+ (you’ll be lucky)
• A cumulative basis

Given the explosion of new trackers launched in this country over the past couple of years, it’s a struggle to find even three years of data to rub together for the average fund, so consider my wishlist as more of a forward-looking statement.

Look out!

There are plenty of pitfalls to trap the unwary investor seeking a simple tracking difference reading:

• Make sure you’re checking like with like. The comparison is only meaningful if you’re pitting the tracker’s performance versus the actual index it tracks. You’ll find that information on a fund’s factsheet.

• Data from Morningstar or Trustnet can be used but should be treated with caution as they regularly use the wrong index to benchmark a fund. Even a fund as straightforward as HSBC’s FTSE All-Share index fund is compared against the FTSE 100 by Morningstar.

• You can chart your tracker against one of the more common indexes on Google Finance, Trustnet, or Yahoo Finance, but if the benchmark index is more unusual then these sites won’t enable you to dial up the right data.

• Beware there can be a few different versions of the same index. Check whether your fund is meant to hug the Total Return version, or the Price Return incarnation.

So where do I turn?

The best source I’ve found to make tracking difference comparisons are the fund factsheets. They generally show the last 1-3 years performance against the correct index (assuming the fund’s been around that long), as well as cumulative performance.

Watch out for product providers who present this information before management fees. Comparing a tracker’s return against its index before subtracting a dirty great TER gives a misleading impression of how well the fund is doing and, more importantly, how well it will really do for you.

When comparing similar funds:

Choose the fund with the lowest tracking difference over as long a time period as possible.

The larger the performance gap between fund and index, the more flawed the product is. Even a tracker that’s trouncing its index is no cause for celebration. Trackers are designed to match the market, not beat it, so deviant performance simply shows the product isn’t to be relied upon over the long-term.

Chances are that the funds with the lowest TERs will also be the ones with the lowest tracking difference. But if you face a choice between a fund with a low TER and one that’s cheaper after tracking difference, then I’d plump for the latter.

Take it steady,

The Accumulator

Good reading around the web this weekend.

However many times you warn them about scams and tricksters, people don’t listen.

I’m not only talking about the likes of my mother, who is an old-fashioned sort who believes that if somebody has taken the time to knock on her front door or phone her up then she should speak to them – even if they’ve blatantly only come to check if she’s senile enough to be diddled out of her pension, or when they’re phoning from Nigeria.

Even less interested in scam stories, seemingly, are the likes of Consumer Direct, The Office of Fair Trading, the FSA, and the National Fraud Agency.

All these and more turned out to be completely uninterested when MSN Money journalist Neil Faulkner tried to shutdown a scam website promising guaranteed 100% gains over five years and 100% protection for your money (about as likely as me getting a gift-wrapped Keira Knightley for my birthday, and her having arranged the whole thing personally when she discovered my deep interest in nerdy financial matters).

The journalist discusses this official disinterest in my post of the week, from The Motley Fool:

You can’t go and say, look – I know that there could be people losing thousands here. There could be people losing millions altogether, so please can you investigate. They don’t do it. They only want to hear about it after you’ve lost the money. As you and I both know, when you lose money in these investment scams, you normally don’t get it back, so it doesn’t help anyone.

The complete interview, which recounts how a dozen scam-busting bodies and charities showed no interesting in busting a scam, is also available as a podcast.

It makes for enlightening – and depressing – reading. If these scammers were shoplifting or mugging grannies, they’d be nicked. On the Web, they rip-off their victims without a care.

It all proves again that only you can be responsible for your money:

• Delete anything that comes through email.
• Ignore junk mail and shred old documents.
• Hang up the phone at will.
• Go ex-directory where possible.
• Don’t buy any product or service you didn’t initiate the hunt for yourself.

When it comes to investing money, look out for FSA-registration and research widely. Most people should simply use common-as-muck tracker funds, anyway, so you’d better have a good reason to go off-piste.

Outlandish promises on a website do NOT qualify for ‘extremely good reason’ status. Trust me, I’d know if there was a safe way to get 100% gains over five years with no risk.

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