It was struggling markets that drove investors into funds of zeros in 2001, Investment Week's sister...
It was struggling markets that drove investors into funds of zeros in 2001, Investment Week's sister magazine Fund Strategies reported in July last year.
At that time, the zero universe was expanding rapidly and it was a widely repeated mantra that no zero had ever failed to pay out.
Richard Prvulovich, senior investment manager at Gartmore Investment Management, told Fund Strategies at the time: 'There is now more choice than ever and valuations are pretty decent. The equivalent five-year gilt is offering 5.4% against the average zero's 7% to 8%. The risk is not comparable, but the yield premium is attractive.' Prvulovich pointed out that at the time that the FTSE 100 first breached 6,000 in March 1998, so many investors had seen flat or negative returns for the preceding three years, while zeros produced steady returns.
Many investors were looking for equity exposure and equity-type returns, but were nervous about the stock market. Zeros, underpinned by equities but apparently offering lower risk, seemed to be the answer.
At the time the July 2001 article was written there were few indications of the troubles ahead in the split cap sector, but some industry figures took a cautious line.
Fund Strategies posed the question: Are several zeros going to deliver, or are they 2001's answer to technology? It turned out to be a prophetic statement. A number of issues were raised that indicated the troubles ahead.
Warren Perry, investment director at Whitechurch Securities, said: 'Recently the market has become two-tier, and the quality at the bottom end is not so good. Higher yields really do mean more risk. Investors must examine the hurdle rates, otherwise they could take on more risk than is comfortable.'
Perry also expressed a dislike for 'splits of splits' ' a large weighting of other split caps, usually income shares, in the underlying portfolio.
Prvulovich echoed Perry's caution and said the key to understanding risk was understanding the underlying portfolio including the asset classes they are exposed to and how diversified they are.
Prvulovich also flagged up technical issues with a bearing on the risk of zeros. He said: 'Splits are using more gearing and debt in their structures. This was the exception, but now this is the norm. You have to evaluate risk of bank gearing as it gets paid out before zeros when the trust winds up.'
In addition, because zeros are paid out of capital, Prvulovich said it was important to look at where charges were being taken from.
He said: 'There is a higher degree of charges to capital. Previously, management fees and bank debt were 100% charged to income, but now in most issues 50% or more of the costs are charged to capital.' It is true that except for a select few such as Investec's Alastair Mundy, who sought to protect capital value in his Investec Capital Accumulator fund by moving out of higher risk zeros, most did not see the true scale of the split capital trust sectors problems coming.
David Hambidge, fund manager at Premier Asset Management, said: 'There is a danger that everyone piles in for the 7% returns and the stock market suddenly goes up. But private investors will not get their fingers burned on zeros as they did with technology shares.'
There were other issues raised at the time as well. Perry said an annual fee of 1.5% was hard to justify on a fund of zeros. It is perhaps even harder to do so today.
Perry said: 'Zeros are much less volatile than equities. It is easy to run a concentrated portfolio ' it doesn't take a lot to manage, and costs can be cut to the bone. There is a big dent in the income if you take charges from yield.'
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