Victor Mendes. CMVM-Portuguese Securities Commission

Transcription

1 CEFAGE-UE Working Paper 2012/19 The investor in warrants Victor Mendes CMVM-Portuguese Securities Commission CEFAGE-UE, Universidade de Évora, Palácio do Vimioso, Lg. Marquês de Marialva, 8, Évora, Portugal Telf: cefage@uevora.pt - Web:

2 The investor in warrants Victor Mendes * CMVM-Portuguese Securities Commission and CEFAGE-UE victormendes@cmvm.pt This version: 26 July 2012 Abstract This paper investigates the profile of the individual investor in warrants. It is concluded that the average investor in warrants has a greater level of financial literacy and a greater appetite for risk. It is also concluded that higher experience in stock trading and the investment in foreign stocks facilitate the investment in warrants, which may be a result of learning by trading and of greater competence of investors. However, lower returns from the investment in stocks also favor the investment in warrants, which may mean that (at least some) warrant investors look to this market as an alternative to recover from their minor success with investments in stocks. Finally, overconfidence encourages the investment in warrants and this may lead to unsound decision-making. JEL Classification: D03; G11; G12 Keywords: Warrants; Individual investor; Behavioral finance * The opinions expressed in this document are those of the author, and not necessarily those of the CMVM. The author acknowledges the comments of Margarida Abreu, Carlos Alves, Fernando Silva and an anonymous referee in an earlier version of this text. Any errors and omissions are the author's sole responsibility. CEFAGE-UE is supported by FCT through POCTI of the QCAIII, which is financed by FEDER and Portuguese funds. 1

3 1. Introduction This study aims to contribute to characterizing the profile of individual (ie, noninstitutional) investors in warrants. Using data from the Portuguese market, this paper aims to answer the following questions: What are the main socio-demographic characteristics of warrant investors? What is the influence of some behavioral traits (financial literacy, investment in foreign stocks 1, investment in other types of derivatives, overconfidence, among others) in characterizing the investor in warrants? As far as I know, this is the first study to address these questions, thus filling a gap in the academic literature. There is no market for warrants in a significant number of countries, including the United States. According to data from the World Federation of Exchanges 2, the five largest global markets for warrants in terms of trading volume are Germany, Hong Kong, Italy, Switzerland and the Euronext markets (which include the Portuguese stock exchange). However, nothing is known about the profile of the individual investor in this financial instrument, in a way similar to what is understood about what happens in other instruments and markets. 3 The Portuguese market has been considered as one of those which had the largest growth in the early years of this millennium, and investors traded this financial instrument very actively. This contributes to making the Portuguese market a strong candidate to conduct a natural experiment on the characterization of investors in warrants. The study is structured as follows: The next section provides a brief description of the Portuguese market and describes the database used. The third section traces the sociodemographic profile of investors in warrants, making a comparison with equity investors and the general Portuguese population. In section 4 a probit model is estimated to help define 1 Foreign stocks are defined as direct investments in foreign securities listed outside Portugal. 2 Cited in Glaser and Schmitz (2007). 3 Two exceptions are SFC (2006) and Weber and Schmitz (2007). In the first case, the Securities and Futures Commission of Hong Kong produced a short report based on a survey of investors, which contains a brief description of the demographic characteristics of investors in the warrants market in Hong Kong. In the second case, the authors use information on actual transactions of warrants, made through a financial intermediary by 1,454 German investors. The socio-economic characteristics presented in the paper were age, gender, experience, income and risk profile. 2

4 the profile of investors in warrants and evaluate the influence of other behavioral traits in this characterization. In the last section some final conclusions are drawn. 2. The database 2.1. The Portuguese market The stature of detachable warrants came into Portuguese legislation in 1988 with the publication of Decree-Law No. 229-B/88 of July 4. Under this regulation, bonds may have detachable warrants, and the bondholder has a warrant that confers on him the right to acquire shares at a price under predetermined conditions. This warrant is detached from the bond and can be freely traded on the stock market regardless of the bond it was detached from. The first issue of detachable warrants in Portugal was led by the Banco Comercial de Macau, in Subsequently, Decree-Law No. 172/99 of May 20 was approved, which was followed by Regulation No. 19/99 of the CMVM, dated November 10, both of which established the legal framework of covered warrants. The first issue was Net B@nco PSI-20, by Banco Santander in September Covered warrants are financial instruments that confer on the holder the right to a specific underlying asset. The warrant can confer the right to buy, sell or to subscribe to the underlying asset, or to receive a cash difference between the price of the underlying asset at the exercise date and the exercise price of the warrant. This right can be exercised on the maturity date or before that date, at specific exercise price, determined under the conditions of issue. The main features of covered warrants are the inherent right to buy or sell the underlying asset (which may be shares, bonds, stock indices, interest or exchange rates, among others), the exercise price (price at which one has the right to buy or sell the underlying asset), parity (number of warrants equal to one unit of the underlying asset), time of exercise (in the American type the holder can exercise this right at any time, from acquisition to maturity date; in the European type the owner can only exercise this right at maturity), the activation of the exercise (the exercise at maturity date can be automatic or not; if it is not automatic, the holder has to declare his intentions of exercising his right and if 3

5 he does not do so his rights expire without being exercised) and the type of settlement (physical, if the right holder receives, subscribes to or delivers the underlying asset by paying the exercise price; financial, if exercising the right gives rise to payment by the issuer of the warrant in the amount corresponding to the difference, if positive, between i) the market price of the underlying asset at the exercise date and the exercise price, multiplied by parity, in the case of call warrants; ii) the exercise price and the market price of the underlying asset at exercise date, multiplied by parity, in the case of put warrants). There are multiple factors influencing the value of a warrant. Among them is the price of the underlying asset and its volatility, the exercise price, parity, time to maturity, the interest rate for the period of maturity and dividends. It is not surprising, therefore, that covered warrants are a much more complex financial instrument than stocks and bonds, and it is to be expected that warrant investors would have a better knowledge of financial matters than other investors. Moreover, it is expected that the investor in this financial instrument will have a greater appetite for risk, given that uncertainty about the future trend of the price of the underlying asset and price volatility, together with substantial financial leverage, clearly condition the risks of this type of investment. The Portuguese market has witnessed a substantial growth in the early years of this millennium, and investors traded warrants very actively. Indeed, the growth of the Portuguese secondary market in warrants was very significant. According to the annual reports of the CMVM, between 2000 and 2009 the average annual value of transactions in warrants in the secondary market was around 1,210 million euros, representing 2.1% of the annual average value traded in the secondary market in the same period (excluding public debt negotiation) - see Table 1. Moreover, between 2005 and 2009, the share of orders received (by financial intermediaries registered with the CMVM for the business of taking orders on behalf of others) on warrants from resident non-institutional investors accounted for about 77% of total orders received on warrants, which means that the importance of individual investors in this market segment is very relevant. 4

6 Table 1 Value of warrants traded in the secondary market Millions of euros Regulated market (1) Non-Regulated market (2) Total warrants (3)=(1)+(2) Total Regulated Mkt(a) (4) Warrants in % of total (5)=(3)/(4) 0.2% 1.3% 2.1% 3.1% 2.4% 2.1% 3.1% 2.4% 2.9% 1.8% (a) Excluding public debt 2.2. The dataset The database used in this study is private and contains information from one of the top five national financial intermediaries. 4 The information relates to the accounts of individual investors that were active in late September 2006 and includes socio-demographic data (marital status, birth date, gender, education, occupation and residence) on the first account holder and on the existence (or nonexistence) of deposits, consumer loans and mortgages associated with the account holders. In addition, we obtained information on all transactions in financial instruments linked to these accounts for the period 02/01/1997 to 16/09/2006. This information included the date of the transaction, the transaction type (purchase or sale), the ISIN code of the financial instrument, the quantity traded and at what price. For a comparison with the corresponding characteristics in the Portuguese population data from the 2005 INE Statistical Yearbook and the 2001 Census were used. In the period of about ten years covered by the database, there were 3,620 investors who traded warrants. In the same period there were 491,540 who traded stocks. This means that for every 136 equity investors only one traded warrants, which is to say that the market of this derivative financial instrument is composed of a very small percentage of the Portuguese population. 5 This may reflect the programs of privatization carried out by successive governments (which was somehow associated with the term 'popular capitalism') that led many Portuguese families to invest in the stock of firms being privatized during this period, as 4 The author thanks the financial intermediary for providing this database. 5 The percentage of investors in warrants is far lower than reported in Hong Kong. According to SFC (2006), 12.6% of individual investors (those who are over 18 years old, and invest in at least one of the following assets: stocks, mutual funds, bonds, derivatives, structured products and others) had made transactions in warrants. 5

7 well as the greater complexity of the warrants (in comparison with stocks) that discouraged the investment in this financial instrument. It is not surprising, therefore, that in the period covered by the database the total number of trades in stocks (3,813,845) is much greater than for trades in warrants (210,958) or that the average number of trades per investor is 58.3 trades in warrants 6 and only 7.8 in the case of trades in stocks. Indeed, many investors had their first contact with the stock market following the privatization of state-owned firms, but acquired the shares in a purely buy-andhold strategy or sold them later without having invested in new stocks. On the contrary, the greater complexity of warrants may have led some investors to specialize in this financial instrument and, consequently, to be much more active, buying and selling on market expectations that they have regarding the future prices of the underlying assets. The activity of Portuguese investors in warrants is illustrated in our sample by the size of the average trade (11,121 and 6,555 for trades in warrants and stocks respectively) 7 and the value of the average trade (3,884 euros and 1,860 euros respectively, for trades in warrants and stocks). The average number of warrants (vs. stocks) traded by investors is 9.4 (vs. 3.2) and the maximum is 258 (vs. 96), again confirming the higher activity of investors in warrants Socio-demographic characterisation of investors in warrants Unlike the demographics of the general Portuguese population and of most investors, more than half of the investors in warrants are younger than 45 (Table 2). Furthermore, albeit mostly married, investors in warrants are married in a smaller proportion than other investors 6 In the database used by Schmitz and Weber (2007) the average investor made 55 transactions in warrants. However, the time period covered is only 51 months, shorter than what is used in this study. 7 The fact that the warrants have a higher leverage than stocks also contributes to the higher average quantity per trade. 8 This may also result from the fact that warrants are more tailor-made financial instruments than stocks. 6

8 and the Portuguese population, and mostly live in Lisbon. Finally, warrant investors have more qualified occupations than most other investors and have a higher education level since, for all age groups, the proportion of individuals who have completed higher education is higher for investors in warrants. These socio-demographic characteristics of investors in warrants lead to the conclusion that the average investor seems to have a risk profile that fits the financial instrument that is traded. The literature considers that the more risk-tolerant behavior is associated with younger investors who do not have family responsibilities within marriage, whereas more qualified professions are generally associated with a higher income level and permit taking higher risks. 9 On the other hand, higher levels of education may be positively associated with greater financial literacy, a necessary (but not sufficient) condition to better understanding the characteristics of warrants. Among the sample there are some investors who traded warrants only sporadically and others who may be designated as heavy traders. In fact, 23.8% have only one warrant trade throughout the sample period, while 13% traded 10 times or more per year on average. 10 These two types of investors also have different demographic characteristics. Table 3 shows that, compared to occasional investors, the heavy traders are younger, are married to a lesser extent, mostly reside in Lisbon and Porto, and are more educated. However, there is no linearity in the structure of occupations in both groups (although there are significant differences in the case of blue collar workers). 9 Barber and Odean (2001) and Goetzmann and Kumar (2008) report evidence that married investors, women and older investors have less appetite for risk. 10 This is equivalent to more than 100 transactions throughout the sample period. About 50% of investors in warrants traded six times or less throughout the period. 7

9 Table 2 Socio-demographic characterisation of investors (%) Warrants Investors Portugal 1.1. Age groups (a) > Total Marital status Married (b) (c) Other (c) 1.3. Area of residence Porto Lisbon Rest of the country Professional status Senior management (d) Specialists (e) White collar (f) Blue collar (g) Inactive (h) Education (i) > (a) Over 25 years of age (b) With and without civil registry (c ) In relation to the population over 15 (d) Upper levels of public administration, directors and business managers (e) Specialists in science, physics, mathematics, engineering, health, professors, etc. (f) Office workers and similar (g) Farmers, industrial workers, mechanics, and non-qualified workers (h) Retired, unemployed, students (i) Proportion of individuals within each age group who have completed higher education Investors: If invested in stocks, bonds, mutual funds, or derivatives. 8

10 Table 3 Occasional investors vs. heavy-traders (%) 1 trade More than 100 trades 1.1. Age group (a) > Marital status Married (b) Other Area of residence Porto Lisbon Rest of the country Professional status Senior management (d) Specialists (e) White collar (f) Blue collar (g) Inactive (h) Education Primary (i) Secondary (j) Higher (k) (a) Over 25 years of age (b) With or without civil registry (c ) In relation to the population over 15 (d) Upper levels of public administration, directors and business managers (e) Specialists in science, physics, mathematics, engineering, health, professors, etc. (f) Office workers and similar (g) Farm workers, tradespeople, industrial workers, mechanics, and non-qualified workers (h) Retired, unemployed, domestic workers, students (i) Four or less years of school (j) Between five and 12 years of school (k) Completed technical or higher education course 9

11 It should be noted that not all investors in warrants have these characteristics. Some investors have a low education, or less qualified occupations, or an older age, which means they may make investments which are not adjusted to their risk profile. In our sample 8.6% of investors have less qualified occupations (or are inactive) and are over 60 years of age, of which about 25% have not completed six years of school. 4. Multivariate analysis This section presents the results of a multivariate analysis. A probit model is used to allow distinguishing the characteristics of investors in warrants among the characteristics of other investors. For this purpose only investors who trade in stocks are selected from our database, residents abroad having been excluded. We end up with 134,951 investors in stocks, of which 1,786 also trade warrants during the period covered by the database. The base model has the following specification: Warrants = f (Married, Age, Male, Education, Occupation, Lisbon, Porto, Time deposit, Consumer loan, Mortgage) where 11 Warrants = 1, if the investor trades in warrants during the period; Married = Marital status of the investor. Equals 1 if married; Age = Age of investor. Defined as (2006 minus year of birth of the account holder); Male = Gender. Is equal to 1 if male; 11 The database does not include any variable directly linked to wealth or income of the investor, which prevents the consideration of this aspect in the analysis. 10

12 Education = level of education. Three categories are considered: Low = 1, if 4 or less years of education; Average = 1, if more than 4 but 12 or less years of education; High = 1, if a technical or higher course was completed; Occupation: Five categories are considered: Senior management = 1, if the investor is a business manager, director or is in the upper levels of public administration; Specialist = 1, if the investor is a specialist in science, physics, mathematics, engineering, health, professor, etc.; White collar = 1, if office work or similar; Blue collar = 1, if farmer, industrial worker, mechanic or non-qualified worker; Inactive = 1, if retired, unemployed or student; Lisbon = Residence. Equals 1 if residing in Lisbon; Porto = Residence. Equals 1 if residing in Porto; Time deposit = indicates holding a savings account. Equal to 1 if it is a time deposit; Consumer loan = indicator of loan. Equal to 1 if the investor has a consumer loan; Mortgage = indicator of mortgage. Equal to 1 if the investor has a mortgage. As stated earlier, the literature considers that higher risk appetite is associated with younger investors without family responsibilities within marriage, that more qualified professions (generally associated with higher income) permit taking higher risks, and that women have less appetite for risk (Barber and Odean 2001, Goetzmann and Kumar 2008). Investor behavior depends on age (DaSilva and Giannikos 2004), occupation (Christiansen et al. 2008) or the environment in which the investor lives (Goetzmann and Kumar 2008). On the other hand, seemingly irrational behavior diminishes substantially with investor wealth or with investor sophistication 12 (Calvet et al. 2009), and with investor trading experience (Nicolasi et al. 2009). In short, investor s characteristics may have an impact on investor behavior towards warrants. 12 Investor sophistication is proxied by education. 11

13 The model is estimated by maximum likelihood. 13 These results are shown in Table 4. Model (1) only includes the basic variables related to socio-demographic characteristics of investors. The results indicate that, conditioned to equity investors, young men living in Lisbon who have more academic qualifications have a higher probability of being investors in warrants, which confirms the results of the univariate analysis presented above. However, marital status does not appear to influence the probability of being an investor in warrants. Regarding occupations, the results show the absence of a linear relationship between professional qualifications and investment in warrants. Table 4 - Determinants of investment in warrants 13 Regarding the educational level and occupation, the basic categories are, respectively, four (or fewer) years of education and senior management. 12

14 (1) (2) (3) (4) Constant *** *** *** *** Male *** *** *** *** Age *** *** *** *** Married Specialists *** *** *** *** White collar *** *** *** Blue collar *** *** *** *** Inactive *** ** ** *** Average education * * * Higher education *** *** *** *** Porto Lisbon ** *** ** *** Consumer loan Morgage *** *** *** Time deposit ** ** Literacy *** Derivatives *** Log-likelihood LR ratio Nº of observations Obs: (i) t statistics in italics; (ii) *, **, and *** denote statistical significance at 10%, 5% and 1%, respectively Model (2) differs from the previous one in that it includes control variables for the existence of savings accounts, consumer loans and mortgages, which certainly affect the level of wealth of investors. These controls allow us to conclude that investors with time deposits are more likely to invest in warrants, and that investors with mortgages exhibit a lower 13

15 probability of investing in warrants. These results are consistent with the idea that greater wealth will enable an average investor to invest in products with higher risk, just as having higher long-term responsibilities will diminish the appetite for such products. The results for the socio-demographic variables did not change. Finally, in Models (3) and (4) the hypothesis that financial literacy is a determinant of investment in warrants is tested, using two alternative proxies. Model (3) distinguishes those investors who may have greater knowledge of financial matters because of their education (economists) or occupation (business managers and bank staff). The variable "Literacy" is a binary variable equal to 1 if the account holder is an economist, or a business manager or a bank officer, and identifies those investors who are more likely to be financially educated because of their closer proximity with financial issues. Model (4) differentiates investors who at some point made transactions in derivative financial instruments other than warrants. These investors are more likely to have financial knowledge or to be more sophisticated. 14 The variable "Derivatives" is a binary variable equal to 1 if the account holder has traded other derivative financial instruments during the sample period. In both cases we conclude that more knowledgeable and sophisticated investors are more likely to invest in warrants (without relevant changes in the results of the other variables). Table 5 shows additional results for the estimation of the model. All models are estimated with the full set of explanatory variables used in Table 4, but the results for these variables are not reported (being essentially identical to the previous ones). Variables which may be relevant in understanding the determinants of investment in warrants are sequentially introduced into the model. Model (5) tests whether the number of trades in stocks (in logarithms) influences the investment in warrants. This may result from a learning effect, reported in the literature by Abreu, Mendes and Santos (2009), Seru, Shumway and Stoffman (2008) and Nicolosi, Peng and Zhu (2009). In Model (6) the importance of investment in foreign stocks is tested, supposedly carried out by more competent investors 14 Both literacy and derivatives are proxies because one cannot be completely sure that these investors in fact deal directly with more sophisticated issues in finance. On a similar vein, buying one option for fun is different from systematically trading on such instruments, and I do not distinguish investors by the number of different trades in derivatives. 14

16 (Graham, Harvey and Huang 2005). The Foreign stocks" variable is a dummy variable equal to 1 if the investor traded stocks of foreign companies in foreign markets. Model (7) tests the hypothesis that the performance achieved by investors in the stock market influences the investment in warrants. The underlying idea is that the performance obtained can help identify the ability of the investor in making informed investment decisions and therefore lead these investors to 'test' their skills with other types of financial instruments. Alternatively, it can be argued that investors with the worst performances more easily invest in warrants, which are more leveraged than stocks, in order to recover losses suffered. Thus, dummy variables are defined (one for each quartile of performance) that cover the spectrum of distribution of performance of equity investments. Lacking information on the composition of the investment portfolio of each investor, the methodology of Seru, Shumway and Stoffman (2008) is followed and I measure the performance of investors by the 30-day average return of stocks purchased. Accordingly, the variables "Low return", "Average / low return" and "Average / high return" are binary variables equal to 1 if the investor had a return on the investment in stocks which is in the lowest, the second and third quartile returns, respectively. 15 Finally, Model (8) tests the hypothesis that the investment in warrants may be influenced by a feature of investors currently identified in the literature: overconfidence. Overconfidence can lead investors to trade financial instruments in which they are not accurately familiar with the characteristics. I follow the approach of Goetzmann and Kumar (2008) and Bailey, Kumar and Ng (2008), and define an investor as overconfident if his trading activity is in the top quartile of the distribution on investors trading activity and his performance is in the bottom quartile of the distribution on investors performance. The underlying idea is that overconfident investors trade too much and consequently get lower returns for their investments (Odean 1999 and Barber and Odean 2000). The results obtained from the estimation of these additional models show that the factors referred to do in fact influence the likelihood of investing in warrants. Thus, it can be 15 The base category is the quartile of higher returns. 15

17 concluded that increasing the number of trades in stocks increases the probability of the investor trading in warrants, just as investors with foreign stocks are also more likely to invest in warrants. On the other hand, lower returns from the investment in stocks are associated with higher odds of investing in warrants, which suggests that the investment in warrants may be very speculative in nature or even a second-best solution in an attempt to obtain better returns on investment in financial markets. Finally, overconfident investors are more likely to invest in warrants. Table 5 Additional Results (5) (6) (7) (8) Constant *** *** *** *** Log Trades *** *** *** *** Foreign stocks *** *** *** Low return *** *** Average/low return ** ** Average/high return Overconfidence *** 3.99 Log-likelihood LR ratio Nº observations Obs: (i) t statistics in italics; (ii) *, **, and *** denote statistical significance at 10%, 5% and 1%, respectively 5. Conclusions The main objective of this study is to characterize the profile of warrant investors. The results of the study help us to better understand the characteristics of these investors and what differentiates them from other investors in financial instruments, particularly those who trade stocks. As far as we know, this is the first study to address the profile of the warrant 16

18 investor, thus filling a gap in academic literature. Also, for the first time, the influences of some behavioral traits on this profile are studied. It is concluded that the average investor in warrants has a greater level of financial literacy and a greater appetite for risk. In fact, compared to other investors and with the Portuguese population, warrant investors are more financially knowledgeable, have a higher level of schooling and are mostly younger males who live in the Lisbon metropolitan area. Nevertheless, it is also found that there are some investors for whom investment in warrants does not seem the most appropriate given their socio-demographic characteristics. The sample reveals a significant number of investors with low educational levels, less qualified occupations or older ages, which means that the investment in this financial instrument might not be the most appropriate in relation to their knowledge and risk profile. On the other hand, it is found that higher experience in stock trading and the investment in foreign stocks facilitate the investment in warrants, which may be a result of learning by trading and of greater competence of investors. However, lower returns from the investment in stocks also favor the investment in warrants, which may mean that (at least some) warrant investors look to this market as an alternative to recover from their minor success with investments in stocks. Finally, it is concluded that overconfidence encourages the investment in warrants and this may lead to unsound decision-making. In this context, financial intermediaries have a fundamental role to ascertain (for all potential investors in warrants and not just for the average investor) whether this financial instrument is indeed appropriate to their knowledge and risk profile. Furthermore, the Markets in Financial Instruments Directive (MiFID) requires it. 17

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20 Odean, T. (1999). Do Investors Trade Too Much? American Economic Review 89, Schmitz, P. and M. Weber (2007). Buying and Selling Behavior of Individual Investors in Option-like Securities, Working Paper. Seru, A., T. Shumway and N. Stoffman, (2008). Learning by Trading, availaboe at SFC (2006). Warrant Investor Survey, Securities and Futures Commission, Hong Kong. Available at 19