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Acting on opportunity in uncertain times

With the fallout from Brexit, global historically low cash rates and the uncertain state of our own political landscape, it may be easy to overlook this time as a good investment opportunity. The reality is we are at a pivotal point for SMSF clients to consider good investment choices that will serve portfolios for years to come.

One investment product that has traditionally been misunderstood but has recently gained traction is investment warrants.

Why investment warrants? Why now?

There are three reasons to consider investment warrants:

1. Historically low interest rates are providing wealth-accumulating SMSF clients with the opportunity to make their money work harder.

For those investors with a bullish outlook over the medium to long term, leveraging into growth assets through an investment warrant without credit underwriting or risk of margin call is appealing, particularly in an environment where superannuation contribution caps are being reduced significantly and the need to grow wealth for retirement is increasing in equal measure.

By way of example, a $100,000 cash investment into an ASX top 200 exchange-traded fund (ETF) has the potential to provide about $185,000 in economic exposure to the ETF with a loan-to-value ratio around 50 per cent. This has ancillary benefits of nearly doubling the franking credits of an equivalent investment had they bought the same ETF outside of the warrant structure (which is useful for offsetting other income generated by the SMSF).

Furthermore, current pricing could even see the warrant being positively geared (allowing equity to be built through the automatic repayment of leverage), with historical dividends being 1.7 times greater than annualised costs.

2. Where there is uncertainty there is opportunity – time to get active.

Equity markets have been whipsawing like never before, with daily movements on the ASX of more than 1 per cent becoming commonplace. Many SMSFs are established in order to provide greater investment control and flexibility, so for the self-directed SMSF investor with a keen eye, short-term pricing anomalies can provide long-term investors with a great opportunity to pick up a bargain or can provide short-term investors with the chance to make a quick trading profit should the market move back in their favour.

Investment warrants are attractive to SMSF investors in this context as they are available over a range of stocks and ETFs and are traded on a T+2 basis through the ASX.

Moreover, they enable a range of high-conviction views to be expressed in a portfolio – for example, a leveraged position over a gold stock in anticipation of bad economic news and a flight to precious metals or a leveraged position over an infrastructure company or real estate investment trust in order to take advantage of speculation on interest rate movements.

3. Having your cake and eating it too – managing risk in volatile times.

Geopolitical rumblings and macroeconomic volatility can cause some SMSF investors to question whether they should continue being long equities or whether it is time to cut and run. But what if they get the timing wrong and how can capital be re-accumulated within the SMSF when contribution limits may have already been hit for the year?

Thinking back to the first scenario, what if the same investor with $185,000 in the ETF was concerned about short-term market fluctuations and wanted to reduce capital at risk without missing out on any potential rebound?

A common strategy here is for investors to sell down their $185,000 holding to cash and replicate the same position with a $100,000 investment – all while taking $85,000 off the table into a risk-free asset for future investment and/or general liquidity purposes.

Are there risks with any of this?

Yes, there are always risks, but they can be managed. Some of the main risks to be aware of include:

· leverage can magnify gains as well as losses and it is impossible to guarantee future returns on a warrant portfolio,

· key assumptions, such as dividend rates, interest rates and tax legislation, can all change and impact on the pay-off of a warrant portfolio,

· warrants don’t offer all of the benefits of stock ownership and may not offer the same flexibility in the way corporate actions are treated,

· all warrants have an expiry date, which may/may not be long enough for an investment thesis to play out in the market, and

· some warrants could see a position being sold out of the market early in the event of a sharp decline in the price of the underlying stock.

Conclusion

Where there is uncertainty there is opportunity and by breaking down some common misconceptions and thinking slightly outside the square there are some potentially attractive ways of adding value to SMSF portfolios, even in times of significant political and economic change.

However, as with all investment strategies it is critical the decision to purchase a warrant is considered within the broader goals and objectives of the client concerned and for that reason professional, independent financial advice is always recommended.

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