split caps, investment trusts

Split caps: profit from this fallen asset class

05.10.2007

by Tim Bennett

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US investor Warren Buffett once urged investors to be “greedy when others are fearful”. Ever since the collapse of a large number of split-cap investment trusts after the stockmarket turmoil at the start of the decade, many investors have been wary, adding them to a list of tarnished investments that includes Northern Rock savings accounts, Equitable Life with-profits annuities and Eurolife precipice bonds. But Matthew Vincent in the FT reckons that the fear factor has created some great buying opportunities – provided you choose carefully.

Why the concern about split caps?

A ‘split’ is a variation on a standard investment trust company, which itself is just a listed firm that buys shares in other companies and enjoys corporation tax concessions for doing so. Splits hail from what Investors Chronicle calls “the slightly exotic world of hybrid investments”. They issue different types of share – income shares pay out any income generated by the underlying investments held by the fund and offer low, or even no, capital appreciation. Zeros, on the other hand – short for “zero dividend” – are usually preference shares. These pay no income and can be cashed in when the fund matures for a predetermined price, provided the underlying investments achieve a minimum return. During the tech-fuelled bull run at the end of the last decade many buyers were persuaded that zeros were a low-risk way to build up a pot of cash to pay future school fees or fund a big purchase. What most were not told was that a significant number of these funds had borrowed heavily to enhance the returns on offer to shareholders and had also invested capital in their fellow highly-geared split caps.

The risks were similar to those faced by property owners who take on big mortgages just before a downturn – if you fund a £100,000 asset (be it shares, bonds or property) with 50% debt finance and 50% equity and the asset then halves in value, you only have £50,000 left to repay your borrowings. In short, your equity has been wiped out. So once the stockmarket turned bearish over the 2000 to 2002 period, losses on falling equities held by the split caps were magnified by high borrowing, meaning that many zeros couldn’t be redeemed in full, or, in some cases, at all. Worse still, as individual split caps collapsed, they pulled others down too, due to the cross investing that had taken place. All in all, it was a huge mess and it took until May this year for the Financial Services Authority to agree that £194m of compensation should be awarded to around 25,000 investors who bought shares in these trusts back in the 1990s.

So what should you buy now?

Matthew Vincent argues that while the collective brand “may be damaged”, the right split caps now offer “low levels of borrowing and attractive yields”. One route in is to hunt down individual trusts. Investors Chronicle likes the look of the Ecofin Investment Trust (ECW), which is a “hugely successful player in the utilities space and has made investors a stack of money in recent years”. They recommend the fund’s income shares, which, before tax, should offer a gross yield of around 9% between now and when the firm is wound up in March 2009.

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Or you could go for “a slightly riskier bet” in the form of Merrill Lynch 9% High Yield shares (phone your broker for more information on these), which pay out a tempting 9p per £1 share, semi-annually, provided the Dow Jones Eurostoxx 50 does not fall below 2,600 points – which hasn’t happened since December 2003. For a more diversified play, the FT tips F&C’s Progressive Growth Fund, which yields around 9.4% and includes 30 or so zeroes. Most of these trade at discounts – their market capitalisations are below the value of the investments they carry – raising the prospect of further gains for the fund as their share prices rise towards the expected redemption values when the trusts close. All in all, a “good reason to reach out to a fallen asset class”.

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