Having devised a new form of zero coupon financing, Glasgow Investment Managers found a hedging strategy benefitting from the lows of the FTSE 100 brought added value to investors
In 2000, economic conditions and the UK equity market had changed considerably from 10 years earlier. Retail price inflation, 9.5% in 1990, was down to about 2%; clearing bank base rates were down from 15% to about 6% and the yield on the All-Share Index had fallen from 5% to below 2.5%.
The yields on the three high-yield trusts managed by Glasgow Investment Managers had also fallen ' Shires Income to 4.3%, Glasgow Income Trust to 4.6% and Shires Smaller Companies to 4.4%. These yields were high relative to the All-Share Index yield but they were not competitive with those on other investment trusts specifically designed for the purpose of distributing a high income.
The challenge at this juncture was to raise the attractions of the trusts to the private investor and so encourage their discounts to narrow. It was agreed that this could be achieved by raising the yields on the trusts while at the same time seeking to preserve their growth characteristics. While the boards of Glasgow Income Trust and Shires Smaller Companies decided upon a change in strategy, reinstating the high level of income the trusts had offered in the past, the board of Shires Income opted to pursue a strategy of income growth.
The new strategies sought to combine a target yield on net assets of 6% with achievement of a total return in line with that on the two trusts' respective benchmark indices ' the FTSE All-Share Index for Glasgow Income and the FTSE Small Cap Index for Shires Smaller. This was to be achieved by raising gearing.
A yield target of 6% was significantly lower than the yields on offer by a number of competing trusts, with complex capital structures designed specifically to provide a high yield. There were two good reasons for this. First, a higher yield would have required initial gearing in excess of 50% of net assets. Second, a target yield higher than 6% would have jeopardised the maintenance of the trusts' capital growth characteristics. It would have required either a significant reduction in holdings of ordinary shares or the inclusion in the portfolio of securities offering a high yield but at a possible risk to the preservation of capital value.
A new form of zero coupon financing was devised, raising funds from the derivatives market through the sale of 'in-the-money' index options and capping the liabilities by purchasing 'out-of-the-money' options on the same index, at a higher exercise price. This is cheaper than other funding options of the same term and, as the index options bought and sold are capital instruments, the cost of the finance is a charge to capital reserve.
The total cost of the finance is the difference between the net amount of funds received at inception and the total amount to be repaid at maturity. It is effectively amortised over the period of the strategy by marking the four option components to market. As the prices of the options move over time, the net impact is the cost of borrowing. From the viewpoint of the trust raising the finance, the outcome is certain, but each option component is dependent on the movement of the FTSE 100 Index.
The combination of a realistic yield objective, a sensible gearing policy and low-cost finance enabled the trusts to continue to invest 100% of shareholders' funds in ordinary shares, a major step towards the maintenance of their growth characteristics. One further measure was introduced to protect the net asset values of the trusts from the greater volatility that might result from the employment of higher levels of gearing. It is satisfying when gearing operates to provide leveraged growth of a trust's net assets in a rising equity market. But leverage works in both directions, upwards and downwards, and it is disconcerting to witness the rapidity with which high gearing can erode net assets in a declining market.
It was therefore decided to hedge the trusts' UK equity portfolios to provide some protection against key adverse movements of ordinary share prices. Hedging is not as simple as it sounds. For a UK equity portfolio, the marketable hedging instruments are options on the FTSE 100 Index. The portfolios requiring protection, however, were invested respectively in higher yielding ordinary shares and the ordinary shares of smaller UK companies. The probable behaviour of the two portfolios relative to the FTSE 100 had first to be assessed.
When that was completed, the objective characteristics of the hedge had to be established. To buy an 'at-the-money' index put option would have been simple but costly. While providing total downside protection, it would have cost about 10% of the value of the portfolio being protected. Moreover, if the index were to rise, rather than fall, its value would erode rapidly, adversely affecting investment returns.
So a hedging strategy was required and devised that would provide partial protection of the portfolio in the event of a major adverse movement in the UK equity market and yet not cost too much.
The value of hedging has been demonstrated twice in 2001, first when the FTSE 100 Index fell below 6,000 in February and again when it fell below 5,000 in September.
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