I have previously introduced subscription shares [1], and explained how they can leverage your returns [2]. 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 [3]. 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 [4] 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 [5]. 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 [6], 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 [7] when you sell. Given their gearing can produce big capital gains, this can be very beneficial. Also, as I understand it1 [8], 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 [9]. The bigger and more liquid [10] 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 [11] and perhaps high-quality income investment trusts [12] 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 [13]. 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 [14] to ensure you see it.
- The caveat is I have never actually exercised my subscription shares. I have always sold them before expiry in the market. [↩ [19]]