Despite recent criticism and the prospect of an FSA investigation, split cap ITs can still be an important tool in an investor's financial planning
Criticism of split investment trusts goes on, but to be calling their demise looks somewhat premature.
The fact remains that many split funds are still an attractive proposition for investors and can be a key tool in financial planning. Indeed, there was never a problem with the structure of splits as such. The roots of the problems today have been created by weak equity markets, excessive levels of debt and extensive cross-holdings.
The problems facing splits have finally led to action by the FSA. Speaking at the recent conference held by the Association of Investment Trust Companies (AITC) for investment trust directors, FSA managing director John Tiner said there would be an investigation. In particular, it will examine allegations in the press as well as in the industry itself that a core of managers actually colluded to buy shares in each other, ultimately to prop up prices.
To understand how the sector came to reach this point, it is worth recalling how the simple split capital investment trust developed. Though basically more than 130 years old, its origins as we know it today go back to the 1960s, when capital gains tax was comparatively low and, by contrast, income taxes were punitively high.
The structure was simple: capital shares and income shares. High net worth individuals bought the former because they wanted their returns to be taxed as capital. The income shares were in demand from organisations such as charities or indeed any other non-income taxpayers.
This straightforward vehicle went through a series of changes as managers adapted to market conditions and demands for performance from shareholders. Different structures and types of investment were introduced, ultimately leading to the product we know today. Many splits have evolved into a structure with two share classes: ordinary and zero dividend shares.
Holders of ordinary shares receive dividends and enjoy capital growth once the zero shareholders ' who were promised a set capital repayment at a predetermined date ' were paid off.
This is an attractive proposition for investors with different needs. Returns could be good and, if planned correctly, favourably taxed. The predictability of knowing exactly how much money would be paid back and when meant they could be useful in meeting future obligations, such as school fees for example.
However, as many managers sought to improve returns, some adopted strategies that were risky and would eventually lead to difficulties. Some portfolios became dominated by high-growth, but obviously riskier, stocks. And corporate bonds were favoured to generate income, particularly the lower-rated, higher yielding issues. This was fine when markets were on the up but performance suffered when the inevitable downturn came. Unlike most general investment trusts, the split had specific obligations to meet.
Given that markets have recent- ly been through their worst bear period for 25 years, weaker absolute returns are not perhaps a surprise. But those that had invested in the heaviest hit areas such as information technology and telecoms suffered more than most. And the poor returns were not confined to equities. Numerous corporate bonds came under pressure and some issues in high-growth sectors still show few signs of recovery as investors doubt issuers' ability to repay.
The most vulnerable splits ' and those that come in for most criticism ' are those that bought shares in other splits, attracted to the apparent high returns. As some splits saw their net assets decline, they began breaching their banking covenants and, of course, the managers began to lose control to the banks.
While the banks were co-operative, they demanded that certain assets were sold and directed how future investments should be made. Even after this action was taken, some splits were forced to shore up their balance sheets by issuing new shares to raise funds.
Share prices in these splits fell dramatically and, of course, the knock-on effect was felt by those that had invested in fellow splits ' for their net assets were now also heavily down and they too were facing bank and solvency pressure.
What compounded the problem was that in such circumstances, market liquidity had dried up and they could not raise cash to satisfy their creditors. A chain had begun and many split investment trusts were pulled down by it.
The FSA's investigation will centre on the extent to which managers of these splits colluded to buy shares in each other's trusts in order to support share prices. Whether or not they did collude, those splits that invested in each other have in numerous cases been seriously damaged.
Putting aside the splits that took the course of building cross-holdings, it can still be said that they remain good investment vehicles, but with the obvious caveat that they must be sensibly structured.
The emergence of the split trust was based on the fact that no two investors are alike.
The variety of investor needs and expectations from investment is enormous. A split trust literally splits the returns from its assets and makes them accessible to different investors as required. These attributes are as valuable now as they ever were.
The heavy press criticism of them might, ironically, have added to the woes in the sector, and at the very least has certainly obscured the simple benefits they can offer.
Maybe it was always the case that the majority of private invest- ors who bought them understood little of how they operated and concentrated on the potential returns instead.
But this in itself should not have presented a problem if splits had not gone down the route of excessive borrowings and cross-holdings. But one thing recent events have highlighted is that current or potential split fund investors must be able to distinguish between whether a split can achieve its aims or not ' or financial advisers must certainly be able to.
The fact is that split investment trusts can still be an important tool in financial planning, but advice and understanding are crucial.
The advent of the internet makes it much easier to compare split trusts against each other. One recommended site is www.splitsonline.com, which readily offers comparable data on various share classes. For instance, the site shows how the cover levels of different zero dividend shares compare.
The higher the level of cover, the closer it is to fulfilling its capital repayment objectives. A look at this site, which sets out clearly what the relevant indicators mean, will help investors and advisers take an informed view of risk.
Also to be welcomed are initiatives by the AITC encouraging greater disclosure from splits. By declaring the extent of their cross-holdings, the industry gives a further tool that can be used to judge safety. In all, more and better data can only help investors and advisers use split trusts responsibly.
A number of managers have developed conservative and sensibly structured splits that should serve their purpose. Certainly these splits do not intend to invest in other splits and have relatively modest levels of gearing. Whether it is to provide a means of generating tax-free returns or funding set future school fee repayments, for example, they should serve investors well.
In many ways, it is a shame that the misfortunes of one group of splits have allowed attention to be diverted so powerfully away from what remain ongoing attractions. Now, for a return of confidence in the sector as a whole, more managers need to follow the path of those mentioned. Reducing levels of debt and the extent to which they hold shares in each other must certainly happen.
There is a need for managers and advisers of trusts to work harder to get the message of what they are trying to achieve. These moves, coupled perhaps with better market conditions, should all go some way to help remove the near vitriolic comments from some newspapers and industry watchers, allowing investors to again take a considered and balanced approach.
The rationale for the split capital investment trust remains, and should continue to do so. Undoubtedly, though, there are some very badly damaged ones for which there is no clear future.
But the split is not about to disappear. Many will survive through this period and the sensibly structured ones will go on for many years to help investors achieve their aims.
The roots of the current problems with the split cap market lie in weak equity markets, excessive debt levels and extensive cross-holdings.
The most vulnerable splits are those that bought shares in other splits, attracted by apparent high returns.
Reducing the level of debt and the extent to which splits hold shares in each other must certainly happen.
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