We all remember the ‘split-cap scandal’ of 2001-2003 that saw thousands of investors lose large amounts of money, but despite their chequered history, many experts believe split-capital investment trusts still have a place in investors’ portfolios.

Despite first being introduced in 1965, it wasn’t really until the 1990s that split-capital investment trusts became fashionable, promoted as the answer to every investor’s dream, offering the ability to concentrate on either capital growth or income, with the attraction of a predetermined return from zero-dividend preference shares as the icing on the cake.

Back to basics
The theory behind splits is a good one. They recognise that different investors want different things and offer each individual a tailored package – a pensioner may want a reliable income, whereas a younger investor will be more inclined to take risks to enhance returns.

Originally, the structure of split-capital investment trusts was simple. They had
a limited life with a fixed wind-up date and issued two classes of shares – income and capital. Investors who held income shares were entitled to all the income generated from the split during its life and the capital shareholders received the capital value of the investment company at wind-up.

Over the years, however, splits have evolved to offer a much wider range of structures and share types, each type of share with its own place in the order of entitlement at wind-up.

Annabel Brodie-Smith, communications director at the Association of Investment Companies (AIC), explains, ‘The advantages of splits are that they can provide for a range of investment needs, and if you want to invest for a fixed period, they can give
you a specific date for a potential capital payment. In addition, some share classes have no income associated with them, so there’s no income tax to pay.’

The batting order
At the top of the ‘food-chain’ there are zero-dividend preference shares – the first to be paid out when the company winds up. ‘Zeros’ are set up to deliver a capital return  predetermined at launch. So if the investment company performs well, these shareholders will receive no more than the value set at the launch. However, if the company performs poorly, they may receive less than anticipated  – or in some cases absolutely nothing.

Because the growth in the value of zeros is treated as a capital gain and not income, they are attractive to investors who want to avoid further income tax liabilities. Investors can, instead, utilise their capital gains tax limit – currently £9,600 for an individual each tax year.

Income shares are next in line; they provide shareholders with a regular return throughout the life of the split-capital trust in the form of dividends, which are generated from the underlying investments held within the company.

With this share class, there is also the option for some capital growth, as Brodie-Smith explains: ‘Over the course of the split’s life, investors receive an income, plus – if there is money left over after the previous ranks have been paid on wind-up – a proportion of the remaining capital.’

The final share class in the pecking order is capital shares. Investors who opt for these are entitled to all the surplus assets at wind-up after all previous ranks of shareholders and bank loans or other borrowings have been paid.

More suited to the riskier investor, capital shares have the potential to provide impressive capital returns. Furthermore, there is no predetermined return, as with zeros, so capital could grow to any amount. However, as the trust has to pay all its other liabilities off first, the capital shareholder could be left with little or nothing.

Light at the end of the tunnel
So what went so wrong with splits? ‘The problems in some split-capital trusts were caused by two changes in their structure which when combined with falling markets led to their downfall,’ clarifies Brodie-Smith. ‘The first change was that the splits invested in higher-yielding and more risky stocks – particularly the shares of other split-capital investment companies. The second change was the use of bank debt to gear the portfolio, which led to increased levels of gearing within the split structure.’

Subsequently, the Financial Services Authority (FSA) carried out an investigation into the debacle, securing a £195 million settlement fund to compensate investors burnt by the scandal.

But, as Daniel Godfrey, director general of the Association of Investment Companies, points out, ‘Many traditional split-capital companies emerged intact from the crisis, and many of these have been delivering particularly strong returns. The industry has demonstrated through changes to the Listing Rules and the introduction of the AIC’s Code of Corporate Governance that it has learned the lessons that needed to be learnt and, as a result, has in fact emerged stronger than before.’

A selection of those capital shares issued by splits that have performed particularly well over the last three years include Ecofin Water & Power Opportunities Capital trust, which has returned 273.41 per cent and Aberforth Geared Capital & Income (86.55 per cent) and the ordinary income shares of Royal London UK Equity & Income Securities (up 122.10 per cent).

Bad reputation
Richard Hughes, M&G’s head of investment trusts and manager of M&G High Income, enthuses, ‘Investors have steered clear of splits since the well-documented problems of a few years ago, but a number of conservatively run funds were unscathed and have prospered in the recent past and yet have received scant press coverage. This has created opportunities for investors to take advantage of some neglected opportunities in the sector. The variety of share classes provides opportunities for investors with different objectives, often in a tax-efficient way.’

Annabel Brodie-Smith adds, ‘The split-capital sector today has produced impressive long-term returns based on robust business models. The average zero-dividend preference share is up three per cent over one year, 20 per cent over three years and 71 per cent over five years.  Of course, the shares have been affected by the recent market downturn, but the longer-term performance has held up – so the average income and residual capital share is down 23 per cent over one year but up 45 per cent over three years and 167 per cent over five years.’

She concludes, ‘The split-capital investment company sector is in good health today, and although the size of the sector has shrunk over the last five years, a number of companies have rolled over into new companies. Changes to the listing rules have increased investor protection, so it’s impossible for a repeat of the crisis to take place as it is impossible for investment companies to cross-invest in each other. Split-capital investment companies offer a broad spectrum of risk and reward, and their diversity of objectives means that for investors prepared to do their research they are worth a closer look.’