What are warrants and should they be part of your investment strategy?

Market volatility, rising rates and geopolitical tensions continue to dominate our news headlines – and investors are feeling the impact on their portfolios, particularly in equity markets.

Investors are increasingly seeking ways to mitigate these growing risks and diversify their holdings to build long-term wealth. Warrants are one way to do this, incorporating leveraging as part of a well-executed investment strategy.

There are many types of warrants available to Australian investors, with one of the most common being instalment warrants.

These warrants offer investors an opportunity to borrow capital to invest in the share market, while still enjoying all the benefits of equities, including dividends, franking credits, and capital appreciation.

Think about it like this: Many Australians want to get into the property market, but few of us have the money in our bank account to purchase a home outright. So, we take our deposit to the bank to ask for a loan – giving us the benefits of home ownership while we make steady repayments on our loan.

Fundamentally, this is how an instalment warrant works, allowing investors to borrow part of the capital needed for their investment.

Who should consider warrants?

Instalment warrants are suited to longer-term investors who are wanting to invest over a 5-10 year horizon.

We often see these warrants used by younger investors who want to take advantage of market opportunities but may not have the capital to ensure a well-diversified portfolio. Self-managed super funds (SMSFs) also regularly incorporate instalment warrants as part of their strategy for retirement savings.

The key benefit of instalments is you are the beneficial owner of the underlying asset, and you can pay off the loan anytime. As the share price rises and falls this is reflected in the instalment price.

Most importantly, warrants are limited recourse loans. This means that if a stock loses its value, your investment value will similarly move up and down.

We saw this during the GFC (global financial crisis) when companies like ABC Learning and Babcock & Brown collapsed and banks and finance providers called on the loans, putting many stockholders in financial stress.

Warrants are a lower-risk loan and cannot be called on during the event of a market sell-off, meaning if the value of a stock is zero you do not need to repay the loan.

Being limited recourse, however, your initial investment will also be worth zero if the asset no longer has any value or is worth less than the loan amount. Investors can also trade the instalments at their leisure or pay off the warrant in full.

Warrants play an important role as part of a well-executed investment strategy, helping investors:

• Maximise the benefits of a rising market through franking credits
• Diversify holdings to better manage risks, including the ability to hold part of the warrant as cash
• Mitigating short term equity volatility by incorporating leveraging as part of the strategy

However, as a leveraged instrument, investors not only magnify their gains but also their potential losses.

How are investors using warrants?

In my work at Citi, I've seen investors leveraging warrants to diversify their holdings, either by buying a portfolio of instalments or through an instalment over an exchange-traded fund (ETF).

As demand for ETFs skyrocketed, attracting investors with diversified exposure and low fees, we saw this trend reflected in the warrants market. Many investors are now using instalment warrants over ETFs that are typically lower risk than holding a single stock, such as the ASX 200, or that are focused on paying high dividend yields.

Blue-chip stocks, such as banking, telcos and commodities, are also attractive to warrant holders. With increasing discussion of rising rates and inflation, investors are focusing on the longer term and employing conservative gearing of no more than 50% when investing in the market.

To further mitigate risk, many investors are choosing to use self funding instalments that use the dividends to pay down the loan and potentially own the stock outright.

What should investors be aware of?

As with all loans, instalment warrants do incur interest. These rates are based on the volatility of your stock selection and the level of leverage required. Investors need to ensure that capital appreciation on their stocks or ETFs as well as the dividend returns are greater than the interest incurred.

Investors should always remember the golden rule: Time in the markets, not timing the markets. With volatility sky high, many investors are leveraging warrants as part of their investment strategy, either deploying the capital in the market upfront, for example investing in a diversified ETF, or by investing steadily to minimise volatility and lower the dollar cost average.

Warrants can help investors get a foothold in the market, ensuring strong diversification and helping to manage risks. As with all investments, a solid understanding of the product and how it can be used in portfolios is a must.

Elizabeth Tian is Director of Equity Derivatives Solutions, Global Markets at Citi Australia. She has nearly 20 years experience working in financial markets and previous roles were at CBA, ABN AMRO, RBS and Macquarie Bank. She is also a regular speaker for the Australian Securities Exchange (ASX) Roadshow & Kaplan CPD Education Program and does regular TV Interviews with the ABC, SBS and Ausbiz.com.au.

Disclaimer: The views and opinions expressed in this article (which may be subject to change without notice) are solely those of the author and do not necessarily reflect those of Finder and its employees. The information contained in this article is not intended to be and does not constitute financial advice, investment advice, trading advice or any other advice or recommendation of any sort. Neither the author nor Finder has taken into account your personal circumstances. You should seek professional advice before making any further decisions based on this information.

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