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Split decisions

In times such as these, it is understandably difficult for some clients to

get excited about investing in the stockmarket. But falling interest rates

and ongoing negative comment on with-profits products mean that some of the

traditional alternatives to equity investment are not looking enormously

attractive either.

I would like to give a brief introduction to the attractions of another

product structure which to date has had fairly limited take-up in the

mainstream retail market – the split-capital investment trust. The

benefits of split funds are that they offer a variety of distinct

risk-return profiles.

Split funds are listed and their shares traded on the London Stock

Exchange. Their name arises from the fact that their share capital is split

into a number of share classes. As a public company, information on the

structure and the rights accruing to different share classes is set down in

the prospectus at launch. Post-launch information about individual funds is

not only available from the relevant fund management company but also from

the Association of Investment Trust Companies and specialist information


Split funds normally have fixed lives of five to eight years. An example

of a typical structure would be as follows:

Zero-dividend preference shares

These offer a defined payback at maturity, typically equivalent to an

annualised return of 8 to 9 per cent. They are useful for clients looking

to accumulate a lump sum at a point in the future, for example, to pay a

child&#39s university costs.

Zeros usually have first call on the assets when a fund is wound up. The

zero shareholder will see full payment of their predefined return before

any money is paid to other shareholders, making them the safest of all

share classes.

Income shares

These offer high income, typically between 7 to 9 per cent. Such an income

can be generated because all or substantially all income accrues to this

single share class. In return for this high dividend stream, investors

forgo most, if not all, capital growth. They also accept a measure of risk

since, if there is a shortfall in assets at maturity which cannot be

covered by the capital shares, then the capital returned to income

shareholders will be reduced.

Capital shares

These shares offer geared capital growth. They have no right to income but

will receive all the residual capital growth on the portfolio after the

predefined returns to the zero and income shareholders.

Capital shares are therefore the riskiest shares available within a split

fund but can generate significant growth if the underlying portfolio does

well. They may therefore be an attractive home for a small portion of a

client&#39s portfolio if there is a belief that the underlying portfolio

offers good growth prospects.

That said, when deciding to invest in these shares, it should always be

remembered that any shortfall in assets at the maturity of a fund falls on

the capital shares, so caution is required.

It should be noted that by no means all split funds have the above share

class structure. A popular alternative has just two share classes – zeros

and ordinary shares, with the latter effectively being the amalgam of the

income and capital shares described above.

As well as the share capital of a fund being split, quite often the

investment portfolio is also split. Where this is the case, there will be a

core growth portfolio investing in equities and a smaller income portfolio

investing in bonds or the income shares of other split funds. This income

portfolio helps generate a higher yield than would be possible if the fund

restricted itself purely to equities.

The risk profiles of the individual share classes obviously vary but, when

selecting a particular fund, the risk of the fund in its entirety needs to

be assessed. There are two main areas to consider.

If the equity portfolio is invested in a high-risk area, this increases

the risk across all share classes, albeit to varying degrees. Within the

income portfolio, the holding of the income shares of other split funds

(rather than corporate bonds) also introduces risk.

Many split funds gear up their exposure to the underlying assets through

use of bank debt. While this is not necessarily a bad thing, if the debt

exposure is high, it can introduce too much risk, particularly when a high

debt level is coupled with a volatile underlying investment portfolio.

Split funds are not the simplest of products but they do offer some unique

features for investors looking to diversify the risk within their

portfolio. I believe it is worth the effort to get to understand and use

these products.


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