High Risk Investment
John Claxton is a Chartered Management Accountant and Chartered Secretary with over 40 years' experience in management. He leads courses on personal finance and investment and has written a number of books on the subject.
COMMERCIAL FORESTRY HOLDINGS
The advantage of this investment is that it is free of income and capital gains taxes and, if held for at least two years, is excluded from your assets for inheritance tax purposes.
The disadvantage is extreme illiquidity and volatility in value.
INVESTING IN COMMODITIES
Anyone can buy a commodity, whether it be a metal, farm produce such as grain or coffee, or even wine. The objective is to hold the commodity in the expectation that it will increase in value. There is extra expense because of storage, insurance and perhaps shipping costs.
A more risky way of investing in commodities is to buy or sell futures or options (see below) in commodities.
A less risky way is to invest in companies or investment or unit trusts which deal in commodities or commodity companies.
BUYING CONVERTIBLES
These are bonds or shares issued by companies, earning fixed interest or dividends, which are subsequently convertible into equity, i.e. ordinary shares. They are usually redeemable before conversion.
Conversion can take place after a specified date in the future at a set price which is usually in excess of the ordinary share price when the convertible is issued. The conversion premium is the amount by which the equity share price must rise to make conversion worthwhile; it can be a negative amount.
Initially, market price is controlled by current interest rates. As the conversion date nears, the equity share price has increasing influence.
Convertibles can be very valuable if the share price goes up but meanwhile should be judged on the fixed return.
UNDERSTANDING EISs AND VCTs
EISs are enterprise investment schemes, where the investment is in one company. VCTs are venture capital trusts, which are pooled investments. In both cases, they are investments in new companies.
Investments for at least five years (three years for new issues after 6 April 2000) in new qualifying schemes receive tax relief at 20% at the time of investment. The annual limits are high – £100,000 in each case.
Capital gains are tax-free and, in the case of VCTs, so are dividends. Furthermore, CGT liability on any investment realised to make the investment can be deferred till the new investment is realised.
Losses on disposal of unquoted shares in an EIS investment can be set off against income. Also the allowances on EIS investments remain even if listing of the shares is sought within the initial period.
But these investments are risky because they are in new companies – very risky in the case of EISs, where all the money is put into one company, less so for VCTs where the risk is spread.
BACKING FILMS
This is very risky as few ventures succeed.
There is a tax advantage – production costs receive 100% relief from income tax provided they are less than £15 million and are at least 70% insured in the UK.
INVESTING IN FUTURES AND OPTIONS
Futures are a commitment to buy (a call) or sell (a put) at a set price (the strike price) on a future date An option is similar but is a right rather than an obligation. Both are known by the collective term derivatives, because they derive from something else, such as a share in an individual company.
Because the price is only a fraction of the underlying share price, they are in effect highly geared – and very risky.
If you think about trying futures or options (or any other form of risky investing), do some experimental dealing (paper trading) first, to see how successful you might be.
Universal stock futures (USFs) widen the availability of futures and options contracts to major US and European shares as well as UK shares.
Futures
In the case of futures, the cost of failure can be very high, unlimited in the case of a put (selling forward a share you do not have, which you will have to buy to deliver on the relevant date) because there is no limit to how high the share price can rise.
Investing in futures is not recommended unless you really know the market in that share.
Options
Options are less risky because there is no commitment and the most you can lose is the cost of the option.
Options can be of two kinds – traditional, where no further action can be taken until the relevant date, and traded, where the option can be bought or sold throughout its life. Dealings are in units of 1,000 shares.
In addition to individual large company shares, options are available for the FTSE 100 index. Then there are other areas, such as commodities (see above).
Options have an intrinsic value and a time value. The intrinsic value compares the option price with the current share price. The option is ‘in the money’ when the option price is the lower and ‘out of the money’ when it is higher than the share price.
The time value depends on the length of time the option has to run till the final exercise date.
Investing in options requires good knowledge of the market and a means of following the prices during the day, as urgent action may be needed.
Options can, however, be protective of your investments. If you think the market is going to fall, rather than sell all your shares you can sell options. If the market falls you make a profit on the options to set off against your share losses. If not then you let them lapse.
Similarly, if you expect to have money to invest at a later date, or you have to sell shares to raise some urgently needed cash and you think the market is going to rise, you can buy options.
These hedging techniques are protective of your investments, at a price. However, there are alternatives See Chapter 5 under CFD trading and below under spread betting.
Combination strategies such as straddles, where you both buy and sell options at the outset, and other more sophisticated techniques, are available.
BECOMING A LLOYD’S NAME
Lloyd’s of London is an insurance organisation. Members (called names) who put up capital as underwriting collateral get 100% relief from inheritance tax provided they have been members for at least two years.
However, you first need to have large sums to invest and your liability is unlimited so, although it can be very profitable, it is extremely risky.
USING OFFSHORE FUNDS
You can invest in investment trusts and unit trusts based outside mainland UK, in tax havens such as the Channel Islands.
If you are resident in the UK, both income and capital gains are taxable in the UK and there is no indexation or taper relief for gains, but income in certain funds is ‘rolled up’, i.e. left in, and is not subject to tax until disposal of the investment.
On disposal the total gain is treated as income but this might be advantageous to you if you are going abroad to live before then or if your income after retirement is such that you have a lower marginal tax rate. Not many people fall into either category.
Charges can be much higher than in the UK. Also investment protection is lower than in the UK and in some places is non-existent.
HOW SPLIT FUNDS WORK
These are investment trusts with a fixed life, where the shares are divided into more than one category. The simplest form is a split between capital shares and income shares, where the income shares receive all the income and the capital shares all the capital growth.
Capital shares are more risky because at the end of the investment period the income shares are paid back at, usually, the original investment amount and the capital shares receive the balance. They may be of particular interest to higher-rate taxpayers as there is no income tax to pay, only capital gains tax at the end.
Income shares are less risky and may be of more interest to those needing income, such as pensioners.
There are other variations:
- Zero-dividend preference shares (zeros), which receive no income during the investment period. Instead they are repaid at a fixed amount on redemption, which is taxed as a capital gain rather than as income, so the yield is known at the outset. They have first claim on the assets at redemption. There is a slight risk with zeros, as there could be insufficient assets to meet the final commitment and for this reason the yield tends to be over 7%, but in fact there has never been a failure so far. Comparative risk is measured by the ‘hurdle rate’, which is the annual amount by which the asset value can fall before the redemption value is cut back. It is expressed as a negative percentage of the asset value. Zeros could be good for investing for school fees, for example.
- Highly geared shares, which receive income plus growth, there being no capital shares, the other part of the split usually being zeros.
- Participating income shares, which receive some of the capital growth as well as all the income.
- Stepped preference shares, which receive dividends increasing in steps over the period of investment.
BETTING ON FINANCIAL SPREADS
Spread betting is really gambling rather than investing and is very risky. You bet on increases or decreases in the price of an individual share (or an index, interest rates, currency movements, commodities, futures and options or property values).
You are quoted the spread (buying and selling price) of a share three and six months ahead and you buy (an up bet) or sell (a down bet) at the appropriate price, depending on whether you are gambling on a rising or falling market. Your bet will be at so much a point, usually a minimum of £5 (these amounts are called units).
If you get it right, you collect the movement times the price per point but if you get it wrong you pay it. For example, if the spread on the FTSE 100 index is 6,000 to 6,100, you bet on an increase at £10 a point and the spread goes up 100 points to 6,100 to 6,200, you gain 100 x £10 = £1,000. However, if it goes down to 5,900 to 6,000, you lose the same amount.
So profits and losses are unlimited, but you can close out at any time (even outside normal stock exchange trading hours, as it is a 24-hour market) in order to lock in your profits or limit your losses.
As it is gambling, no tax is payable on any gain you make but of course any losses cannot be set against any other taxable gains. Betting tax is included in the spreads, which are wider than on the underlying shares.
Flotations
One important area for spread betting is flotations (such as where a new company comes to the market) because usually only institutions can subscribe; private investors must wait till the first day of trading, when the big price increases frequently associated with flotations have already taken place.
In this case, spread betting offers the opportunity to participate, because spread betting companies operate a ‘grey’ market based on what they expect will be the first day’s closing spread.
Selling short
Selling the spread is a suitable substitute for ‘selling short’ – selling shares you do not have because you expect the price to fall, so that you make a profit when you buy back at the lower price – a process which is difficult in the UK stock market itself.
You can also hedge your investments – protect them against a fall in prices without selling the shares. Instead you sell the spread, for an individual share or for your whole portfolio (by choosing the most appropriate index). This way you avoid brokerage fees and stamp duty as well as capital gains tax.
Similarly, you can buy spreads to lock in an expected future rise in prices of shares you have had to sell or have not yet got the cash to buy.
It is therefore an alternative to hedging via CFD trading (See Chapter 5) and options (see above), which are taxable and for which you do have to put up cash to buy them.
BUYING WARRANTS
A warrant is a right (but not an obligation) to subscribe for shares, or another form of security, at a set price on or during a set future period. They are usually issued as part of an issue of new shares, particularly by new investment trusts, but once issued they have their own market value.
Warrants are only different from call options (see above) in that they are issued by the company itself, most often by new investment trusts. They have all the same qualities as options – high gearing and therefore high volatility and a risk of losing all the investment if the underlying share never reaches the option price.
They are freely traded on the Stock Exchange.
Unit trusts specialising in warrants are available because they invest in a number of warrants, the risk is spread and so reduced.
CASE SCENARIOS
Amanda goes for a VCT
With her high marginal tax position, Amanda can invest in a VCT and save 20% tax on the investment, thus reducing the cost to 80%, which means in effect a 25% gain to start with and the prospect of further tax-free gains over the three-year minimum period.
She prefers a VCT to an EIS as it should be less risky, the investment being spread over a number of companies instead of in just one.
Alistair considers options
As Jean now has options on shares in her employer, Alistair has become interested in the concept and considers whether to buy stock market options. Reading up about it, he thinks it would be best to go for traded options, as the investment can be realised during the option period. He also favours those based on the FTSE 100 index, as they are less risky.
However, the experts point out the need to be in continual touch with the stock market, as it may be necessary to sell quickly during the day. This would not be convenient, so he gives up the idea, for the time being!
Gwen and Hugh favour income shares
Gwen hears about income shares in split capital investment trusts on the Money Programme on the radio. She tells Hugh about them, because they sound like a good idea for providing income during retirement.
They decide to find out more and put them on the list for the pension lump sum.
POINTS TO CONSIDER FURTHER
- 1.Would you consider investing in convertibles? In what circumstances would an initial fixed-interest return followed by an equity investment be attractive? What is the conversion premium?
- 2.What are the relative advantages and disadvantages of zeros in a split capital investment trust?
- 3.Why is a VCT less risky than an EIS? What additional tax benefit does a VCT have?
