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Investment view

The way in which shares built on earlier gains last week was amazing. All the ground lost following the terrorist attacks of September 11 was recovered and, if anything, there was a scramble not to be left out of a recovering market. There were those who considered investors to be just a little too keen to jump aboard the bandwagon but at least it demonstrated how much money awaited investment. But indifferent news started to take over sentiment by the weekend.

There was plenty of opportunity to test the nerve of investors last week. Visiting the AITC forum in Coventry and IFA Events exhibition in Bristol, I was able to talk to private investors and IFAs alike. I was encouraged by how much optimism exists. But there was one topic that came up time and time again – problems in the split-capital investment trust market.

Splits were certainly in the news last week with the very public dismissal of a Govett Investments fund manager. His crime, apparently, had been to talk to the press about the split market. This, of course, prompted much comment on the suitability or otherwise of these investments.

One thing should be clear from the start. The problems in the split market were unlikely to have arisen had we not experienced a bear market of major proportions. Splits are clever and innovative structures. They provide a way of segmenting investment return according to the needs of different classes of investor. They also provided an opportunity for the investment trust movement, which had been shrinking, to launch new trusts.

The truth is that splits introduce additional gearing into the returns that investors can expect. Even in a simple trust with no bank borrowing, the need to repay zero-dividend preference shares at a predetermined price will mean that trusts&#39 assets must grow if the capital shares are to have any real value. So when markets decline, problems can arise very quickly. Gearing is a wonderful thing in rising markets but in falling markets it destroys value.

Add to the gearing effect the incestuous nature of some split-capital trusts&#39 portfolio construction and it is no wonder there is concern and uncertainty around. But it would be wrong to tar the whole industry with the same brush. True, there have been some high-profile implosions in value – and more than one trust is involved in a capital reconstruction which may involve the introduction of new money- but we are still in the fortunate position of no zero shares having failed to be paid out at the pre-determined redemption price.

Sensible investors will be paying particular attention to both asset cover and hurdle rates on zeros. Inevitably, these will have been damaged across the board because of the decline in markets but it is still possible to find plenty of zeros with a sound financial base on which expectations of full repayment can be built. Yields will undoubtedly reflect the uncertainties applicable to individual issues and, of course, trusts with a longer life might reasonably expect the market to bail them out. Long may the rally in share prices continue.

Investment managers tend to be optimistic. Their success depends on rising share prices. When markets turn against them, it can be difficult to react in time to ensure they are not damaged by events. Sometimes these events give little or no warning, such as September 11. If, as a result of additional gearing through bank borrowing, the negative effect on asset values is accentuated, that should be something assessable through the research that covers these funds. In the end, it is up to those who recommend or buy these shares to ensure they have done their due diligence. To write off an entire asset class because falling markets and gearing have accelerated declines is a very short-term judgement indeed.


J O Hambro Capital Management – JOHCM UK Growth Fund

Thursday, 18 October 2001.Type: Oeic.Aim: Growth by investing in UK equities.Minimum investment: £2,500.Place of registration: Dublin.Investment split: 100 per cent UK equities.Isa link: Yes.Charges: Initial 5 per cent, annual 1.25 per cent.Commission: Initial up to 3 per cent.Tel: 020 7747 5646. 

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