Investec's Alistair Mundy has sold out of 28 stocks in his Capital Accumulator fund
Fund manager Alistair Mundy made a name for himself in February last year with a massive programme trade to reduce risk in his £59m Investec Capital Acummulator fund, which invests in zero dividend shares of split-capital investment trusts.
The trade, in which he sold out of 28 stocks, cost the fund 200 basis points in performance terms. Since then, the performance differential between Investec Capital Accumulator and its main competitor funds has been marked.
Mundy made the move in response to his belief that zeros with a cross-shareholding of more than 10% in other split-capital investment trusts were virtually impossible to effectively price and far riskier than the market had acknowledged.
Following that, Mundy upped the portfolio's weighting in artificial zeros and structured products, with around 10% in self-generated artificial zeros and 25% in listed structured products such as Merrill Lynch Defined Returns.
Capital Accumulator was down 4.13% in the six months to 1 November, compared to a loss of 17.58% for the Exeter Zero Preference fund. Aberdeen Progressive Growth was down 25.05% over the same period, Jupiter Preference was down 21.74%, while Premier Zero Preference was down 13.45%.
Is it sensible to talk about your investment philosophy or style?
This is not an area where you can have much in the way of a philosophy or style because we are pushed into stocks at the quality end of the spectrum.
Can you give an overview of the market's recent developments to put the zero universe into context?
The idea of a split was that the zero financed the gearing of the trust. It was looked upon as a very safe piece of paper. As long as the assets the trust invested in didn't go down significantly over the life of the split, you got your return on the zero.
There were initially two classes of shares: ordinary and zero. Even if the trust's assets fell by 50% you would still get some positive return on your zero. That was why it was seen as a low risk investment.
It worked for years. In a bull market, it looked fantastic. People happily paid their kids' school fees with them for years. Every zero paid in full ' a lovely marketing line but completely meaningless for the future.
In that world it was not always clear where a manager could add value. How has the zeros universe changed since those early days?
When people launch splits there aren't always private client stock brokers and intermediairies aren't always there to give you £50m. Zero debt was replaced by bank debt because it was easier to get at a good rate over five years. The great thing about zero debt is that the zero holders had no vote and no say in the way the trust was run. Managers could therefore work their way out of a bear market.
The arrival of bank debt changed the dynamics completely. Right at the bottom of the market, a very important moment, a trust's debt holder now had a very important voice.
The market then saw splits with both zero and bank debt. What was the importance of that?
Zeros started coming out with 8% to 9% gross redemption yields, and this on a vehicle that had never failed to repay in a low interest rate environment. They had hurdle rates of -4% or -5%. It sounded really good. But what no one explained was what would happen if the trust did not get those hurdle rates.
This is when we started to get worried. With bank debt, the loss of return on a zero was much steeper when assets started to fall. You only had to go from £50m to £40m for the value of your zero to go to nought. The risk profile for zero holders completely changed and this was not being priced into the markets.
When did you come to this conclusion?
We were happily investing in these splits until February 2001 and were getting good profits on new issues. Some had gone to 10% and 20% premiums. Then we started to think that everything sounded too good. Zero holders were getting this 9%, the fund managers were doing well, as were the brokers. The banks were happy with it, everyone was a winner. That sounded warning bells.
Apart from this alteration in the risk profile were there any other factors behind the decision?
Historically, these splits had always invested in high yielding equities and, therefore, generated dividend income from which management expenses were taken. That changed with the introduction of barbell structures. If you take charges from bonds, it generates less income and if you take it from the equities basket, it reduces capital growth portfolios. That was a big drag for the sector. We were worried about that as well.
What about the levels of cross shareholdings?
We were getting to the stage where lots of trusts being launched were heavily invested in other splits. In the middle of 2001, some were 80% invested in splits. They came along with their hurdle rates at -5% or -6% and no one articulated what having all those splits meant for the hurdle rate of the trust holding them.
I tried modelling it and all I could come up with was that it significantly worsened your hurdle rate. I couldn't model it because it was so complicated but I knew the real hurdle rates were a lot higher.
So what did you do about it?
I got to this situation in February and thought it was dynamite. I then trawled through the portfolio and said let's get out of anything with accounting which is very aggressive, taking charges from capital rather than income, has a large ratio of bank debt to zero debt, or cross shareholdings in other zeros of more than 10%.
What was the effect on the portfolio?
I sold out of around 30 zeros and we bought about 14 or 15. I knew what I wanted to sell so buying was almost a secondary thought. It cost the portfolio 200 basis points. That was a massive call. The gross redemption yield dropped some 75 basis points but that was a result given what it did to the risk profile of the fund.
What other movements have there been since then in the way you invest the portfolio?
We have freedom to hold similar securities in the portfolio such as listed structured products and synthetic zeros, options that behave like zeros but are cheap and transparent. We now have around 25% of the portfolio in Close and Merrill Lynch products such as Merrill Lynch Defined Returns. Theoretically, we can hold up to 100% in these. We also have 10% in synthetics created from within Investec.
What will rejuvenate the split market?
There are great difficulties to overcome to improve the worrying parts but I am not really interested in them them because I can't see them reaching an attractive level for a long time. It is sad because split-capital structures are good products and there are all sorts of investors out there that want high income or capital growth.
Mundy began his career at Commercial Union in 1988 on the fixed interest team.
He moved onto the equities desk in 1991 where he was responsible for value and equity income investing.
In 2000 he joined Investec after growth house Norwich Union took over Commercial Union because, as a value investor, Mundy felt he had no core role.
At Investec, he rejoined Chris Burvill, who he worked with at Commercial Union. In July 2000, he took over control of the Investec Capital Accumulator Fund.
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