Shaun Harris
TAKING STOCK
Small investors’ nerves are getting frayed, it seems, as we approach the end of the year. That was the clear message to come out of the last unit trust quarterly results, which showed a strong move out of equity funds into low-risk money market funds, or out of the unit trust industry altogether.
Reasons for this fear of equities are unclear.
Professionals like Brian McMillan, head of warrant sales at Standard Bank, points out that rising interest rates in the United States and the Dow nearing its all- time high is justifiably making investors nervous.
Ralph Cope, who heads warrant marketing at Deutsche Bank, says sentiment towards marginal stocks on the Johannesburg Stock Exchange (JSE) has turned negative following some recent spectacular collapses – Macmed, FBC Fidelity, NRB Holdings.
A number of fund managers argue that large parts of the local stock market are offering value and now is the time to be buying shares. They could well be right, but it will take a lot of convincing to swing small investors away from the underlying negative perception towards equities. Cash is safe, and this is where investors are taking refuge.
But what about those individuals who don’t want to commit to direct equity investments, but also want better returns and more excitement than money market funds? The rapidly growing local warrant market is an option.
Established just more than two years ago when Deutsche Bank launched the first warrant, the market has really taken off this year and is currently growing at about 30% a month. There are presently 105 warrants listed on the JSE with more than 25-million warrants trading every week. The value of this trade has increased dramatically – in October 1998 the monthly value of trades was R86-million, last month it was R279-million.
Simply put, a warrant is an option on an underlying share, typically the blue chips, to buy or sell that share at a predetermined price within a specified time range.
The value of the warrant will behave more or less like the share on which it is based, with two important differences – because warrants are geared, movements up or down will be greater in percentage terms than the actual price of the share, and the investment has a limited life.
Two of the chief attractions of warrants are that they are far cheaper than buying the actual share, typically costing between 10% to 20% of the price of the underlying share. And the market is very liquid – the issuers of warrants are market makers, undertaking to sell and buy back the investment vehicles.
Warrants can be tremendous in a bull run for the investor who chooses the right share. The gearing effect means share price gains are magnified for the holder of the warrant.
Figures from Societe Generale, one of the issuers and market makers, show some spectacular performers. For example, a warrant was launched on Datatec on October 1 at an issue price of 59c. The current price is 182c, an increase of 208%. A Dimension Data warrant issued on August 13 has increased in value by 109%.
But there are also at least two ways smaller investors can score with warrants if they believe equity prices are due to decline.
One way is to hedge an existing portfolio of shares, either through buying put warrants on individual shares (the right to sell the underlying share at a predetermined price), or a put option on index warrants, based on indices like the all share or industrial index.
With a put warrant the value of the instrument increases as the price of the underlying share decreases. So the private investor with a small portfolio of shares who believes equity prices are going to decline, but does not want to sell the shares, can buy put warrants to cover the expected loss. If losses on the underlying shares are accurately predicted, the investor can make a profit on the warrants, and still have the share portfolio for future recovery.
An index warrant will work in the same way, though its application is more general – the trick here is to find the index that most closely represents the shares in the portfolio.
More speculative investors can target a share they believe is going to decline in price and buy a put warrant on that share. If correct, they will make money as the price of the underlying share goes down.
McMillan warns against investors putting all their capital into warrants. Like actual shares, there is risk in warrants. His advice to a bearish private investor nervous of the equity market is to hold about 80% in cash and put the remainder into warrants, combining safety with the possibility of still benefiting from equities.
Creatively used, warrants can also provide a hedge against interest rate movements. Last month Deutsche Bank launched South Africa’s first bond warrants, based on the benchmark R150 bond. Apart from allowing small investors access to high-priced bond investments (R10 000 in bond warrants offers exposure of about R1-million to the R150), Cope says it can also be used to offset the effect of interest rate increases.
Bond yields are directly correlated to movements in interest rates. If you have a large mortgage bond on your house and believe interest rates are due to go up, an investment in bond warrants can offset the increase.