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Split opportunities

Criticism of split investment trusts has been hard to miss recently. The FSA is investigating the sector and the media is baying for blood.

As ever, one needs to get behind the hype to understand the situation. It is worth restating the attractions of splits for clients. The name arises from the fact that share capital is split into different share classes. They offer varying risk/reward profiles to investors. A typical structure would be:

•Zero-dividend preference shares. These offer a defined payback at maturity, typically equivalent to an annualised return of 7 to 9 per cent a year. They are useful for clients looking to accumulate a lump sum. Zeros usually have first call on the assets in a winding up – the zero shareholder will see full payment of their predefined return before any money is paid to the other shareholders.

•Ordinary shares. These offer high income, typically 6 to 9 per cent. This can be generated because all the income accrues to this single share class. In return for this, high-dividend investors forego a part of the capital growth on the portfolio.

It is possible to create a fund with a sensible, conservative, portfolio which offers a relatively low-risk, defined-capital growth option or a higher income option. The majority of funds are doing just this.

Unfortunately, a significant minority of funds are going wrong in a fairly spectacular way for a number of reasons. In isolation, each issue might be problematic but taken tog-ether the consequences have proved even more dire. The main issues include:

Quality of underlying portfolio

Many funds run split investment portfolios. This is not a bad thing but unfortunately the funds experiencing difficulties typically focused their portfolios in “high-growth” stocks and the high-yielding shares of other split funds. The aggressive nature of the equity portfolio combined with incestuous nature of the crossholdings in other splits creates a volatile and high-risk combination.

Capital structure and market conditions

Another characteristic has been high gearing through bank debt. In poor market conditions, gearing levels obviously magnify losses. Recent developments have shown a domino effect starting with steep falls in valuations of high-growth stocks. These falls have led funds to breach their banking covenants, which in turn has led to the partial liquidation of investment portfolios to fund repayment of bank debts.

Partial liquidation has been forced through at a time of depressed equity valuations and limits the ability of a fund to recoup its investment losses. Also, the sale of crossholdings creates further downward pressure on the pricing of split shares generally. A vicious circle is created impacting both the specific fund and other funds with crossholdings in higher-yielding split shares.

Investor understanding

In the past, too much emphasis has been placed on hurdle rates and cover statistics without due regard being given to how a fund has been invested. It is only by looking at the portfolio of investments that an investor can get a proper understanding of the risks. This is an easy thing to say in retrospect but given where we are, how do you best advise clients?

Obviously, specific circumstances will determine appropriate action but there are some generalisations that can be usefully made. It seems appropriate to examine the three basic categories of investor:

Investors holding &#39problem&#39 funds

Dependent on the extent of a fund&#39s problems, there will be very limited liquidity in the market. This absence of liquidity has compounded problems, creating an unfavourable environment in which to sell shares. Investors might have little option but to hang on.

Investors holding &#39quality&#39 funds

The current situation has seen all funds, to some extent, being tarred with the same brush. So funds with sensible portfolios and low levels of bank debt have seen their prices trend downwards irrespective of underlying asset performance. This will have alarmed some investors who need to be reassured that sentiment will eventually change and that discounts we are currently seeing will diminish over time. Ignoring market sentiment there is always a fund&#39s fixed wind-up date when market price and underling NAV will align with each other.

Potential investors

For those prepared to look behind the headlines, the current turmoil does throw up some genuine buying opportunities. For those prepared to do some due diligence, it could be well worth the effort.


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