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Split and polish

Over the last two years the most dynamic sector of the investment trust market has been the split-capital trusts. These trusts are well established but there has been a revival of demand.

This year, over 30 new funds will be launched, including a number of existing trusts which have been restructured. In 1999, 38 split-cap trusts were launched or reconstructed, raising over £3bn in new money. This is a sector with a huge level of demand and an increasing demand for more diversified and innovative trusts.

A key factor in the popularity of splits has been the range of investment opportunities offered by the split-cap structure as well as inv-estors&#39 appetite for income which, despite the recent rises in interest rates, remains strong. As their name suggests these trusts “split” the returns available between different classes of capital, allowing investors to choose the type of return most appropriate to their circumstances, income or capital.

Split-capital trusts have always been able to offer a wide range of investments based on the flexibility and variety of their structures but in the last year there has been a significant increasein the range of underlying asset classes offered in a split-capital form.

Innovative structuring of new trusts continues to provide investors with an increasing number of options but now the range of asset classes offered in the split-capital structure provides another level of diversity.

Each split will have a unique structure but there are two broad classes of split-cap inv-estment trust shares – ordinary shares and zero dividendpreference shares or zeros.

The ordinary shares provide a high level of income and the opportunity for capital appreciation while zeros receive no income but havea fixed capital return per annum over the life of the trust and rank ahead of the ordinary shares in respectof capital.

Most splits also have gearing through bank debt which enhances the returns which are available to the other classes of capital.

Ordinary shares

The ordinary shares have the right to all the income of the fund and therefore offer a high yield, usually in excess of 8 per cent a year at launch.

The ordinary shares also have the potential for capital growth but they rank behind bank debt, any capitalised expenses and the zeros in terms of repayment of capital. If the underlying assets perform well, then the ordinary shareholder receives a high level of income as well asa capital uplift.

Zeros

The zeros carry no entitle-ment to income but have a fixed capital return. As they rank ahead of the ordinary shares but behind the bank debt, their capital entitlement is less at risk than with the ordinary shares. However, they do not share in the capital upside that the ordinary shares can receive as their returns are fixed.

No review of an investment product is complete without surveying the risks. Split-cap trusts are more complicated products than orthodox trusts or open-ended vehicles and investors need to become comfortable with the nature of each company.

These funds are often more highly geared than orthodox trusts by bank debt and or other forms of capital such as zeros. In addition, most split-cap trusts, as well as many non-split-cap trusts, charge a significant part of their finance costs and management fees to capital which will erode shareholders&#39 funds unless the underlying assets grow in excess of these charges.

In some cases, split-cap trusts also invest in other split-cap trusts. While this provides a high level of yield for the investing fund, it can reduce the capital performance of the investing company if the underlying trusts do not grow at a sufficient rate to cover the charges to capital.

One of the criticisms of splits has been that to capture the high-yielding securities to meet the dividend requirements of the company, managers of splits have focused their underlying portfolio investments on a narrow range of high-yielding UK sectors such as chemicals, engineers, food producers and banks.

This has meant that investors may not have received the full benefit of holdinga diversified portfolio of securities. This criticism has been addressed both by new splits being launched to invest outside the UK and by refining the structure of split-capital investment trusts.

Over the last two years, the large number of new trusts launched has included funds investing in Europe, Japan, Asia and, most recently, the US, alongside the more traditional UK-focused funds. Even within UK-focused funds there is a broad range of options available. Certain trusts focus on UK smaller companies while others invest in larger equities. There are also a number of more specialist funds providing investors with the opportunity to diversify into technology (both global and pan-European variants), media, biotechnology and healthcareand private equity funds.

In each asset category, there are usually a number of different managers offering dedicated trusts. For example, there are currently three specialised Asian split-capital trusts as well as one trust that invests in the Japanese equity market. For investors looking for exposure to European markets, there are a number of existing funds and more in the pipeline.

The current range of split-cap trusts allows investors to have both a high level of income and the opportunity for capital growth from portfolios invested in most global equity markets or in specialised sub sectors such as technology. This provides better diversification of risk and flexibility.

The number of fund management houses offering split-cap products has also grown as the sector has expanded, with a large number of fund management houses now offering split-cap trusts, investors also have greater choice in which fund manager is managing their investments.

In addition to the fund manager, splits as investments trusts have a separate board to oversee the company and its investments (unlike a unit trust or an open-ended investment company).

The boards, especially in the more specialised markets such as biotechnology or media, add further expertise and knowledge on behalf of shareholders.

A recent trend in the structuring of the investment portfolios of new split trusts, mirrors the dual returns on offer to investors. Many newer trusts employ a “barbell” approach to construction of the underlying assets on which the trust is based with two separate portfolios – one to deliver capital growth and the other to provide a high level of income.

Often, different specialist managers will be employed to manage each portfolio within the company.

This allows the portfolios to be totally focused on delivering specific targets while the structure of the fund combines these two elements, growth and yield, in the way that individual investors demand. Split-cap trusts should, therefore, continue to grow in importanceas an asset class.

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