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Cutting through the split cap spin By Rob Griffin
Do you remember the split capital investment trust scandal? This was when 50,000 people who thought their money was tied up in relatively secure investments lost their savings when the stockmarket crashed at the start of the millennium. Thousands of these private investors were sold trusts on the premise that they were extremely low-risk products which would enable them to plan for specific future costs such as school fees as they could offer a pre-determined return on a fixed date. But the reality was rather different. Instead of being safe investments, many of them were actually running huge risks and their fragile positions were horribly exposed in the three-year bear market up to March 2003, and a string of them went bust. The combination of fund managers over-reaching themselves and holding shares in each other's trusts, high borrowings and plunging stockmarkets in the wake of both the dotcom bubble bursting and the 11 September attacks proved too much. The subsequent investigation by the Financial Services Authority led to compensation being offered to thousands of investors directly affected by the scandal and this will be paid out of a £144 million pot raised from the 18 companies involved. However, despite this chequered history, the marketing teams of the leading investment companies still in the sector are desperately trying to attract new investors. Investor's portfolio Split cap investment trusts, they say, should still have a place in an investor's portfolio. So are the bad days of 2001-2003 really behind them or are they still fraught with risks? Can they provide decent returns for investors or should they be avoided at all costs? To answer these questions we need to take a fresh look at what split capital investment trusts are and why they would be attractive to investors in the first place. Split caps are companies with a portfolio of investments - just like all investment companies - but which issue two or more different types of share in order to meet the needs of different investors. The idea behind these innovative products, which first started coming to prominence back in the 1960s, was to give people the option of accessing income or growth, or a combination of the two. The lowest risk class of share is the zero dividend preference share (known as zeros). They aim to deliver a pre-determined capital return, known as the redemption value, to investors when the wind-up date is reached. This target value is to be paid as long as the split has enough money which means it's only paid if stockmarket performance has been good enough. As their name suggests, no dividends are paid to holders of zeros, although they are the first shares to be paid when the trust winds up. It is only holders of these shares that were entitled to apply for compensation. As the name suggests, income shares do pay dividends. The holders of these shares will share all the distributable income received by the trust - less any interest on borrowings - but these shares don't have any target level of return at redemption. This means that the rate at which dividends are paid depends on investment performance. Capital shares Capital shares on the other hand don't pay an income and don't have a target redemption value. This means that their value will depend on how much money remains in the company after the zeros and income shares have been redeemed and any borrowings repaid. Clearly the fear is that if there is insufficient money to pay the target redemption value to holders of zeros, for example, holders of capital shares will receive nothing. As a result they are the riskiest type of share. It's fair to say that investment management companies that are still involved with splits have been on a real promotional push in recent months, with their marketing teams working flat out to change the public's perception. At the back end of last year this culminated in a number of rival firms coming together as part of a mission, spearheaded by the Association of Investment Companies (AIC), to extol the virtues of this style of investing. The companies pointed out that many split capital companies with traditional structures have not only survived the crisis, but have been performing very well over the last three years. Daniel Godfrey, director general of the AIC, said that the industry has learned its lesson and that changes to the listing rules mean the split cap debacle could now never be repeated. This is because cross-holding between trusts - which was the one the main reasons why the sector collapsed - are no longer permitted. David Barron, head of investment trusts at JPMorgan, agrees these products can still serve a useful purpose. Being transparent, he says, means the risk and return profiles of the different share classes can be clearly identified and understood by investors. "We believe that a well-structured, well-managed split capital trust continues to hold appeal," he adds. "The split structure provides effective solutions to investors with differing needs and tax positions." Just before Christmas the investment house launched the JPMorgan Income & Growth investment trust, following a successful fund raising and restructuring of its predecessor company, the JPMF Income & Growth investment trust. The product, which has a fixed-life of 10 years and will end on 30 November 2016, is offering two classes of share - capital and income - to investors which can also be held together as a unit. It is anticipated that JPMF Income & Growth will offer shareholders an initial net dividend yield of 6% on income shares and 4.1% on the units in the company's first full financial year to 31 January 2008, as well as potentially significant growth on the capital shares. Richard Hughes, head of investment trusts and manager of the M&G High Income fund, also believes the current economic backdrop means that splits could be the perfect solution for many people. "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 - yet have received scant press coverage," he says. "This has created opportunities for investors to take advantage of some neglected opportunities in the sector." What do advisers think? Adrian Johnston, proprietor of Johnston Financial Services, says that you can't totally dismiss split capital investment trusts as they are now over the worst of their problems. "What was actually quite a good idea was spoilt by mis-management," he says. "A traditional split capital investment trust that has zero dividend preference shares on one side were really good investment vehicles for the right set of circumstances, provided the underlying investment vehicle was being properly run." But Warren Perry, head of research at Churchill Investments, hasn't been impressed with the return of split caps. "Where were these marketing people back in 2003 when a lot of split capital investment trusts blew up? The only reason they are coming out of their little PR holes now is because a lot of these trusts have had an exceptionally good run over the last three years on the back of strong markets." The point is a lot of these trusts are geared vehicles, he adds, which benefit from strong and rising markets - and this recent performance uplift is why the marketing departments can start singing their praises again. "I am a contrarian investor and my view is that if you've got people banging the drum about a fantastic investment opportunity it generally means that a lot of the performance has already happened," he explains. "This year could be another good year for the markets which means geared plays could perform well, but I'd rather have invested in them when they were completely bombed out and unfashionable." Nick Greenwood, chief investment officer at the iimia Investment Group (IIG), meanwhile adds that the world has moved on a lot since split capital investment trusts were at the height of their popularity during the bull run of the 1990s. A number of alternative structured products have already been introduced in the intervening period, he points out, and many of them do an even better job of delivering such returns for clients. "There is now a vast array of products to choose from and we have quite a few of them in our portfolios," he says. "Two we've bought recently are the CQS Rig Finance fund (RIG), which basically finances oil rigs, and the Prospect J-REIT Value (PEJR) fund as we think Japanese property is due a good run." Greenwood says both these trusts are attractive because of the sectors in which they are focused. Regardless of the structure of the trust itself, he points out, you still need to pay close attention to the areas in which it operates. On the CQS Rig Finance fund, in particular, he says: "One of our key investment themes is energy shortages and there aren't many shipyards involved in the building of oil rigs any more," he says. "A number of entrepreneurs have recognised this fact and have bought up all the slots in these yards so they can effectively hold the world to ransom." So where does this leave investors? No single asset class can be the answer to every investor's prayers, says Patrick Connolly, research and investment manager at JS&P Towry Law, so it's vital to seek advice to ensure the products are suitable for their specific needs. Cautious income-orientated investors, for example, are likely to have a higher exposure to asset classes such as fixed interest. "We concentrate on building client portfolios which will have a mix of asset classes attached to them," he says. "A person's investment goals can always be achieved by having a variety of different asset classes in their portfolio and the actual mix will depend on their requirements and the level of risk they are willing to take."
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