Sector defies volatility in technology market to spiral in value as number of trusts shoots from 70 to 137 in two years
The past two years have seen a resurgence in the split capital investment trust market with assets under management shooting up from £5bn to £12bn.
In June 1999, there were some 70 splits on the market but that has gone up to 137 today, and there are plenty of commentators who think this rise can continue. Paul Glover, investment trust analyst at Collins Stewart, believes total funds under management in splits could reach as much as £15bn by the end of the year.
The split cap market may well be bigger but the industry has seen ups as well as downs. Several high profile splits have run into difficulties in the falling market, most notably those in the tech sector.
At the beginning of April 2001, Framlington NetNet.Inc Plc sold off its income holdings and some tech stocks, taking it from effectively a £52m trust to an £8m one. Aberdeen has also had problems with its Tech & Income, Euro Tech & Income, and Media & Income trusts, all three of which have been close to breaching their banking covenants.
Even so, Nigel Sidebottom, director at BFS, which runs a number of splits, believes a key development of the past two years has been the diversification of underlying asset exposure in the sector.
He said: 'Three to four years ago, almost the entire sector invested in the FTSE 350 high yielding universe. There was the odd split in Europe but very few, so there was a very narrow universe to invest in. With asset classes the same, the only difference between the splits was their structure and management.
'In the last two years however, splits have invested in a much broader range of assets, including technology, bonds, US, Japan and the Far East. Funds now invest in almost all the different sectors.'
Glover estimates that only a third of splits are now dependent on the FTSE 350 high yield arena.
John Szymanowski, analyst at UBS Warburg, believes the long-term plan of splits is to mimic conventional trusts by getting a wider range of choice to invest in. He said: 'Splits tend to come in waves, which is a result of the underlying asset base the client wants at the time. You cannot just have one trust in a sector, there need to be several so people can choose.'
One development which has aided this diversity is the growing trend towards more than one manager running a split.
In the past, one manager would tend to run the portfolio, keeping a growth bias but with an eye on ensuring the income requirement was met.
Sidebottom and Andrew Watkins, head of investment trusts at Jupiter, both suggest a change has come about in the past 18 to 24 months.
Now it is far more common for one manager to concentrate purely on growth and another to concentrate on income generation.
Recent examples of splits using this approach are the Property Income & Growth trust by BC Asset Management, in which Richer Cross will be running the property portfolio, while David Bruce and Michael Yeo will run the income. Jupiter's new Financial Income trust will have its growth portfolio managed by Phillip Gibbs, and its income will be run Laurie Petar.
Watkins said this has meant that there is now a much wider range of splits to choose from than there was in the past, as income portfolios can be linked with almost any growth portfolio.
A second significant change in the split cap market over the past two years has been to do with capital structures and a move to using bank debt as a gearing instrument instead of just zeros.
Zeros work in much the same way as zero coupon bonds in that they can roll-up interest. However unlike the bonds, the price of zeros is affected by the underlying asset cover of the trust. As UK interest rates have come down it has made more sense for trusts to use bank debt to gear themselves up.
Sidebottom said: 'In the last two years we have seen trusts which have simply used bank debt to gear and in other cases trusts have used a combination of zeros and bank debt.
'Two to three years ago, there were no trusts with structural bank debt. They may have had a small bank draft but this was not part of their capital structure.'
Szymanowski said the tech collapse has taught a lot of fund managers about the use of gearing and they have learned their lessons. The problems some trusts have had with breaching banking covenants has meant zeros are coming back in favour as a means of gearing.
An example of a split launched recently that has a combination of zeros and bank debt is Aberdeen's £804m Real Estates Opportunities Trust which has 75 million zeros and up to £347m bank debt, equivalent to a gearing level of 42%.
The appetite within splits at the moment is for zeros as intermediaries and institutions realise what a good risk/reward instrument is on offer, according to Sidebottom.
With most zeros, even if underlying portfolio assets do not grow, investors will get back their fixed entitlement of around an 8%pa gross redemption yield and all gains are subject to CGT rather than income tax.
According to Paul Branigan, head of investment trusts at Framlington, there are 29 trusts using zeros that have gross redemption yields of 8% or more, 41 trusts with gross redemption yields of 7.5% or more, and 75 with yields of 6% or more on their offer price.
If assets fell by 2.5% pa, there are four trusts in which investors with zeros would lose all their money. In all but 10 cases, final entitlement would be covered even if there were no growth in the portfolios' assets.
Institutions and private investors have always had an appetite for income, hence it has been relatively easy for trusts to make income shares look appealing, according to Szymanowski, although he believes it has been far more difficult to attract interest in capital shares.
Sidebottom said: 'Trusts with capital shares are the most difficult to place and are more difficult to price. For a long while people shied away from them, but over the last year, a number of new capital shares have come along.'
Daniel Godfrey, director general of the AITC, said the image of split caps in the industry is literally 'split.'
He said zeros, which are a low-risk way of getting a good return at a fixed date, receive very good publicity while highly geared income shares seem, wrongly, to get bad publicity.
Godfrey said: 'Splits offer something for everyone. People who need a high level of income will take risks and want exposure to a potentially high performing market. So for the right client, income shares are a very powerful tool.'
Watkins said he believes the image of split caps has been improving, with many more institutional players investing in them, principally for income, but also wanting the chance for capital growth.
What has tarnished the image of split caps in the past is the idea of the so-called 'Magic Circle' in which commentators argue the split-cap market is only maintained by the participants investing in each other, in other words fund managers using their client funds to invest in other split-cap trusts.
Watkins said he has two counters to this argument: first the so-called circle is widening, as there are now 20 or more institutional fund management groups which invest in splits, and second although they invest in each other, they are being sustained by a constant demand for income. Szymanowski said: 'The idea of the magic circle has been hugely exaggerated. People see splits as fund of funds, yet most generate their income through a variety of different portfolios, such as bonds, properties, reverse convertibles and corporate bonds.'
Watkins believes the development of splits going forward depends on dividends being maintained by the underlying investments and corporate bonds, which is where some of the yield comes in, continuing to do well.
He said: 'There are no signs of any defaults in corporate bonds, or any wholesale cuts in dividends paid by companies.'
Szymanowski believes the realistic level of income generated by splits over the past two years is around 8% pa, and a hurdle rate of between 2.5%-5%, meaning if assets did not rise by this amount investors would start to lose their original capital. 'If investors can get a 8%-9% yield to redemption on a 5% growth assumption they are doing well,' he said.
Watkins said that for intermediaries who can properly grasp splits, the sector can be a very good area for them to get into as the yield is almost double what they could get elsewhere. He said: 'As long as you understand the capital risks attached to splits and do not get panicked into selling at the wrong time, they are a great area for investment.'
Szymanowski believes going forward there are going to be very interesting opportunities in split caps for long-term income.
He said: 'Look at Dartmore. On no portfolio growth, you are still looking at a yield to redemption of 8%.
Also look at Edinburgh Pacific which still has nine years to run, on no growth the fund has a yield to redemption of 6%. Geared Income which runs until 2018, on no growth you are looking at 14% yield to redemption. So there are some wonderful opportunities at the moment.'
Zeros: Short for zero dividend preference shares, a class of share which pays no income. Zeros move to a predetermined redemption price at the end of their defined life. Generally deemed as suitable for risk-averse investors looking for predictable returns.
Income shares: Many different types of income share but most are entitled to receive all the income from the underlying investment of the company.
Traditional income shares: Also entitled to the surplus assets at wind-up after the zeros and the other entitlements have been paid.
Annuity income shares: Receive a nominal repayment at wind-up having effectively converted all capital invested into income during the course of the trust's life.
Ordinary income shares: Are entitled to all the income plus the surplus at wind up but without a pre-determined capital entitlement.
Capital shares: Offer the potential for high capital growth but at a higher risk. These shares are suitable for investors who do not require income and who are prepared to take more risk with their investment in return for the possibility of higher capital growth.
Hurdle rate: The rate per annum by which the company's assets would be required to rise (or fall) to ensure that there are sufficient assets available to repay zero holders in full on the redemption date.
Gross redemption yield: The assumed annualised growth rate of the gross assets of a trust to wind up.
Gearing: A measure of the risk and return or volatility of the NAV of the capital/ordinary share calculated as the total assets of the company divided by the net assets attributable to the ordinary shareholders.
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