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&#39Flawed and risky&#39 zeros are slated in Merrill report

The reputation of split-cap investment trusts as low-risk investments has been thrown into doubt this week following publication of a report by Merrill Lynch.

The report claims that zerodividend preference shares are massively mispriced and their risks are not understood.

It says the way zeros have traditionally been assessed is flawed and it is impossible to value zeros by looking at gross redemption yield and asset strength, arguing that they should be valued in the same way that City institutions value derivatives.

Portfolio managers of splitcapital investments cannot reconcile the conflicting risk profiles of different classes of shares in one single portfolio as zero shareholders will want risk-averse investments while income and growth shareholders may want more risky investments, the report adds.

Bank lending to meet ret-urns to other asset classes is also hitting zeros while splitcapital investments owning other splits further increases the risk.

Zeros have until recently been regarded as a risk-averse asset class compared with straight equities and had been popular with investors as they enable returns to be taken as capital, allowing inves-tors to take capital gains tax allowances. But zeros have come under pressure recently as fears grow that they will not be able to pay promised returns.

Merrill Lynch equity markets director David Curry says: “It is inev-itable that there is massive mispricing in the zero sector because of the lack of transparency at portfolio level. Some are safe but some are very risky. It is crucial that IFAs back a manager that understands the sector.”

Exeter Asset Management fund manager Nick Brind says: “The Merrill Lynch study is intellectually interesting but I disagree with their overall assessment. Pricing zeros using derivatives is very theoretical. At the end of the day, you have got to use common sense.”

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