Money: Warranting closer attention

Nic Cicutti on how higher risks can pay

Equity investment is, at its most basic, a sophisticated gamble. It offers the potential to make vast amounts of money, as long as the investor is prepared to accept the possibility of losing it all.

Few investments carry more of a risk warning than warrants, which are available on the shares of trading companies and of investment trusts. More than pounds 600m is invested in a range of more than 150 warrants on offer from investment trusts alone.

A "warrant" is the option to buy a share at a future price, fixed at the outset and called the "exercise price".

The option may be taken up either on a particular date or a set of dates. This can take place each year up to a final date, after which the option lapses.

An investor makes a profit if the exercise price of the share at the relevant date, plus the cost of the warrant itself at the time it was first bought, jointly add up to less than the current market value of the share.

If the exercise price is higher than the existing market price of the share, the warrant does not have to be bought. However, if every exercise date is passed on without the exercise price being paid, the warrant lapses, leaving the investor out of pocket.

The aim is to choose a warrant that is cheap when it is first bought, with a low exercise price. Warrants are traded on the Stock Exchange and because they are bought as investments in their own right, they can vary in price over time.

Prices of warrants are lower than those of the shares they are linked with, but they do reflect the underlying share price. In effect, investors can achieve the same exposure to a share, and its potential upside, for a fraction of the price.

If, say, a share is priced at 200p and rises to 250p, investors are sitting on a 25 per cent gain. If the warrant was priced at 50p, that same rise in the share's value might translate into a 100 per cent gain. Equally, there is far more of a risk element. The same fall in the value of a share will impact far more on a warrant.

Investment experts call this phenomenon "gearing", which is measured as the share price divided by the warrant price. Therefore, high gearing means high risk.

Warrant prices are also affected by extra considerations. These include the lifespan of the investment itself up to the final exercise date. The longer the remaining lifespan of a warrant, the more it will cost to buy because there will probably be several exercise dates - with the potential to generate a profit for the investor - before it lapses.

Another factor affecting potential profits is the "premium" at which a warrant is sold - this is the difference between the exercise price plus the cost of the warrant itself, compared to the current price of the underlying share. The higher the premium, the higher the element of risk may be.

One major area of choice for would-be warrant investors lies in investment trusts, where they have generated an average return of 21.55 per cent, against a 9.58 per cent average rise in investment trust share prices and gains of 9.46 per cent from the FTSE All Share index and 13.94 per cent from the MSCI World index.

However, warrant prices remain depressed, partly due to continuing worries over the outlook for the market.

Williams de Broe, the stockbroking firm, points out that for investors worried about the potential of a downswing in UK stocks many investment trusts show a strong bias towards international markets and smaller company sectors, with emerging markets taking up pounds 160m of the pounds 600m market and European sector warrants a further pounds 102m.

Many investment trusts now carry no premium, in some cases even a discount to their underlying share price, making it unprofitable to exercise the right to buy. Equally, investors can buy "geared" exposure at less than the value of the underlying investment trust's assets.

Clearly, there are opportunities for canny speculators, although any choices need to be carefully made. For most savers, this will not be an area in which they will want to risk their shirt.

However, for those with the majority of their assets in unit and investment trusts, who have also invested in far safer Tessas and similar funds, a small warrant punt is an option.

As in all such cases talking to a good investment adviser is critical. The wrong decision could mean losing a lot more than with traditional investments. Getting things right, on the other hand, could leave you quids in.