Split capital investment trusts will be forever linked with the notorious City scandal that cost 25,000 investors in 40 trusts more than £650 million, and wiped out some poor souls’ retirement savings. Most private investors still run in fright when they hear the dreaded word “Splits”, and who can blame them? But some analysts claim this means bargains are to be had. Is it really time to forgive and forget?
Splits, introduced in 1965, were so called because they offer two or more classes of share, originally income shares and capital shares. This allowed investors to concentrate on either capital growth or income, and receive a potentially greater return from the larger pooled amount. In time, other share classes were added, notably zero dividend preference shares.
In the 1990s, zeros, in particular, were marketed to investors as a low-risk investment product offering secure growth. As their name suggests, zeros don’t pay any income, but instead offer a pre-determined return on a fixed date, when the trust is wound up. They have priority over other types of share class within the trust, hence their apparent safety.
Many investors used them to plan for specific future costs such as school fees, or bought a series of zeros with different wind-up dates to boost their retirement income, enjoying tax-free returns inside their annual capital gains tax allowance (the return from zeros being regarded as a capital gain).
The proud boast was that no zero had ever failed to meet its payout – the investment with more safety features than a Volvo, according to one vainglorious marketing department – but then the vehicle crashed. Troubled stock markets and the rash actions of a group of trust managers (known by their critics as the Magic Circle) left the sector a total wreck.
The Magic Circle was accused of artificially-inflating prices by gobbling up each other’s shares, so when one split ran into trouble, the others swiftly followed in a domino effect.
Worse, many zeros with cross-holdings were both heavily geared and over-exposed to tumbling technology stocks, which accelerated the speed of collapse.
This sparked the biggest investigation in the Financial Services Authority’s history, putting some asset management companies under severe pressure and requiring a radical restructuring of many trusts, while some of the brokers and fund managers at the heart of the disaster were barred from working in the City for up to seven years. The unholy mess has taken three and a half years to clear up, and still isn’t fully resolved.
In April, Fund Distribution Ltd (FDL), a company set up to share out the £143 million compensation fund raised from 18 of the companies involved in the shambles, announced it would pay investors just 40p in the pound for their losses. A further 9p payout should follow later this year. The news dashed hopes that investors could get up to 80p in the pound, and will do little to appease investors who are now rubbing along on a diminished retirement income. Investors in trusts run by the now defunct BFS Investments have so far received nothing, because the company pulled out of the compensation deal hammered out with the FSA, and are now seeking compensation from the Financial Services Ombudsman.
The splits fiasco was bloody and brutal, so why on earth would we suggest you return to the scene of the crime?
Peter Hewitt, manager of F&C Progressive Growth Fund, an OEIC that invests in zeros and other instruments, claims that reports of their death have been exaggerated. Since the end of 2002, the zero universe has contracted from around £2.75 billion to little more than £2 billion, but he claims successful rollovers of splits and the emergence of new types of zeros that aren’t linked to investment trusts have shown the sector can survive and even flourish.
“The debacle surrounding highly geared splits with crossholdings have knocked zeros off investors radars for some years, yet high quality zeros have continued to offer attractive yields compared to gilts and corporate bonds,” he says. Hewitt points towards the success of his own fund, which ballooned from £6.9 million at the start of 2003 to £35 million today, as evidence that profits can be made even as the sector continues to contract. I target high quality zeros linked to trusts with little or no gearing, without significant cross-holdings and where the assets of the underlying trust are already more than sufficient to pay the zero holders.”
This latter measure is known as “cover” – a zero with a high level of asset cover offers protection in troubled times, which means investors get paid in full providing markets don’t do something drastic. Hewitt claims zeros offer comparable long-term returns to ordinary equities, but with less volatility. “The long-term annualised return on equities is around 7 per cent, while low-risk gilts return between 4-5 per cent. That makes my fund’s current gross redemption yield of 8.4 per cent competitive, particularly when volatility is taken into account.”
He also points to the successful number of recent rollovers and new launches as another sign of the rehabilitation of zeros. These include Jupiter Second Split and Jupiter Second Enhanced in November 2004, Edinburgh Income in May 2005, swiftly followed by Aberdeen Development Capital and the launch of Bear Stearns Private Equity. Last November, Invesco Recovery 2005 rolled over into Invesco Perpetual Recovery 2011, and December Jupiter Dividend & Growth rolled over in December.
New funds have also been launched on the back of expiring split-caps, notably Henderson High Income, a conventional investment trust reconstructed from a split of the same name, and Investec Capital Accumulator Trust, managed by Alistair Mundy, an OEIC that raised part of its assets from the City of Oxford Geared Income Trust rollover.
There has even been the occasional new launch, notably a £26 million worth of zeros issued by Economic Lifestyle last September, with the money being used to invest in a portfolio of retirement properties being purchased by their tenants at a discount to net asset value.
Richard Pavry, head of investment trusts at Jupiter, one fund house which escaped the splits debacle and now has three successful rollovers to its name, says it has underlined its faith in the sector by calling in big-name fund managers to run these funds. Jupiter Second Split is managed by Philip Gibbs of Jupiter Financial Opportunities, while Jupiter Dividend & Growth and Second Enhanced trust are helmed by Jupiter Income manager Anthony Nutt.
Pavry says these rollover splits allows investors to select their levels of gearing. “Many investors have been hurt by gearing, and we want to encourage them to make a conscious decision about how much exposure they want. The structure of our trusts allows that,” he says.
Demand for zeros in the rollovers was particularly strong. “We had to scale back demand, because it was too strong relative to the demand for income shares. Investors who had got their fingers burned in highly geared investments were viewing income shares more cautiously.” But he argues that income shares should still appeal to aggressive investors, who want high income levels without exposing themselves to more complex financial instruments such as hedge funds or contracts for difference. “It is a good way of making both your own asset allocation and gearing decisions.”
Splits may slowly revive, but interest from direct investors is expected to remain slack. “This will increasingly be an intermediary-only market. Commission-based advisers may not sell them, because they don’t pay initial or renewal fees, but fee-based advisers should find they fill an interesting role in asset allocation,” Pavry says.
Peter Walls, investment manager at Unicorn’s MasterTrust Fund, a fund of funds targeting investment trusts, says splittin
g different share classes to appeal to different types of investor is still valid. “The problem is that managers stretched to the concept to extremes, with high levels of gearing and cross-ownership, but if you understand splits’ characteristics and carefully examine the underlying investment, they can be very useful portfolio planning tools.”
Walls has used splits to shield his fund from volatility. In March, suspecting markets were over-priced, he invested in the zeros of Premier Trust, managed by Martin Currie, a well-covered trust that winds up in December. “Its hurdle rate is -53 per cent, even after the recent troubles, which means its gross underlying assets would have to fall that much before it lost any value. It effectively works as a proxy for cash, helping to protect my fund against any downturn.”
Timing is everything. Walls admires other splits, but now isn’t the moment to buy. “Aberforth Geared Capital & Income Trust has a solid team and has averaged around 16 per cent compound growth since launch in 1991, which is quite remarkable. But it targets smaller companies, and now probably isn’t the ideal time to invest in them. Smaller companies are also more volatile, and when you throw in gearing, the downside is also volatile.” He also rates another specialist smaller companies trust with a strong long-term track record, Chelverton Growth Trust, and Jupiter’s range of splits. But he currently shies away from any capital shares. “I don’t think markets are going anywhere in the near term, so this isn’t the time to look for geared capital growth.”
Despite his guarded enthusiasm, he questions whether the sector has a long-term future. “A lot of trusts have recently come to the end of their natural lives, and another dozen will reach their final redemption date within the next year. Many will disappear rather than rollover. To make matters worse, there hasn’t been a good deal of new issuance. I hope people’s memories fade, and the sector turns around.”
Nick Greenwood, chief investment officer at iimia Investment Group, says a number of financial products now do the same job as splits, and in many cases do it rather better. “Splits were arguably the first structured product. They were stress-tested to survive a 25 per cent market fall, but couldn’t handle the 50 per cent drop we experienced. New structured products have come along with more bells and whistles, and I tend to prefer them.”
He cites Japan Accelerated Performance Fund as an example. “This is effectively a structured product with a high degree of capital protection, it will return 100 per cent provided the Nikkei 225 is above 12111 by December 2009. The index is currently at 15500, which gives the fund all the characteristics of a well-covered zero.”
Greenwood did recently invest in Jupiter Second Split, managed by Philip Gibbs. “We recently bought ordinary shares, because they are leveraged and fell quite heavily during the recent market correction. Splits are hardly flavour of the month these days, but this means there are plenty of opportunities for mis-pricing.”
Splits enjoyed their heyday during the bull run of the 1990s, and they remain a bull market product. “They were popular because people wanted risk. The gearing went very, very high, and that is why they exploded and remain tainted today. Splits are a difficult sell, but I would expect existing splits, such as the Jupiter offerings, to carry on,” he says.
Greenwood does recommend another split that is worth a look, although you might not like the sound of this one – the trust formerly known as BFS US Special Opportunities.
BFS was one of the villains of the splits debacle. While chief executive Tony Reid pocketed a tidy £7.5 million between 2000 and 2003, investors in his company’s splits were losing millions.
In May, the trust was renamed US Special Opportunities Trust, and is in the hands of an experienced team of managers, Nigel Sidebottom and Philip Davies at Premier Fund Managers, and Russell Cleveland of RENN Capital, manager of one of the most sucessful trusts investing in North America, Renaissence US Growth. “We invest in the income shares. We bought them at 81p, which looked reasonable value given that they are due to pay 103p when the trust winds up in May 2008, provided it doesn’t lose any money. This trust had been overlooked because BFS on the label tends to scare investors away,” Greenwood says.
Paul Craig, investment trust fund manager at New Star, continues to invest in splits, recently buying the ordinary shares in Jupiter Second Enhanced. “The fund is well managed by Anthony Nutt. It was trading at a discount to net asset value, which widened during the recent turbulence, and I would expect that to close in time, which means it offers good value.” He has also put money into Framlington Income & Capital Trust. “This is a geared play on the UK blue-chip market and I bought it at a discount.”
There are three key factors to consider when investing in a split: the quality of the underlying portfolio, the level of gearing, and the hurdle rate or asset cover. Craig says you should also decide how much time and effort you are willing to devote to this investment. “With a conventional trust, the manager will take the gearing decision for you. With a split, gearing is structural, and you have to be positive on the market for the duration that you intend to hold onto the trust. But if you get it right, there are good returns to be had.”
Many IFAs recoil from the entire sector, fearful that such a controversial investment could send their professional indemnity premiums through the roof. Mark Dampier, head of research at Hargreaves Lansdown, says rigorous compliance and FSA rules means that “we wouldn’t touch them with a bargepole. There is some excellent value out there. The good splits fell alongside the bad splits. Some have picked up really well, but we simply don’t go near them.
Many investors still carry the scars of investing in splits, and nothing will tempt them to take a second chance. Highly-geared trusts are only for the speculators, but more level-headed investors might find something of interest, provided they do their homework very carefully.

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