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The Miles File

The debacle in the split-cap-ital investment trust market is a

headache that most IFAs could do without and our representatives in

the House of Commons only added to the pain last week by chipping in

with their ha&#39penny-worth on the scandal.

Advisers escaped the real heat of the MPs&#39 scorn, which is strange,

given that the honourable members are wont to sound off about almost

anything or anybody, regardless of whether or not they have any

knowledge of the subject.

But they did not let advi-sers completely off the hook. When they

came to make observations about zero-dividend preference shares, they

did wag the finger of blame at IFAs, albeit in a quiet way. Given the

general belief in the market that zeros were low risk, there was a

clear onus on advisers to make clear what the risks were, they said.

It is true that zeros were regarded almost universally as low risk

prior to 2001, when Cazenove, that most blue-blooded of City brokers,

raised the alarm in a report on the sector. The phrase “a zero has

never yet failed” was bandied around like an election slogan by

advisers, fund managers and the press. I hold up my hands here – we

in the media contributed to the sense that these were a safe type of

investment, largely because experienced advisers said so.

In mitigation, many firms have pleaded with good reason that it was

impossible to gauge the genuine level of risk attached to any

individual zero. The conventional measures of financialhealth, such

as cover and hurdle rates, proved woefully inadequate at capturing

the true risk to what in essence turned out to be derivative-like


Advisers rightly argue that they did not have the necessary

information on which to act. Some of the promotional material

distributed by fund managers, most notably Aberdeen Asset Management,

which was accused by MPs of being reckless, was not only misleading

but also served to reinforce the belief that zeros were low risk.

Even with the full data at their disposal, it is difficult to see how

even the most sophisticated and experienced research department of an

advisory firm could have worked out the corrosive force of the

network of cross-holdings that riddled the sector.

When the derivatives department at Merrill Lynch attempted to model

the risk of such relationships, its computers broke down, so complex

was the web.

If advisers are at fault -and let me make it plain that I am not

convinced they are – it is in their failure to realise the

significance of gearing. The new generation of split-capital trusts

came loaded with bank debt. Cheap borrowing in a rising market meant

that many managers could produce bumper returns for investors without

having really to try.

Eager to feed the appetite for splits, the manager of each fund

brought to market – no fewer than 86 were launched between 1998 and

2001 – had to crank up the yield and usually did so by increasing the

gearing. Bank of Scotland and Royal Bank of Scotland were two lenders

to the sector. They were careful to ensure they pulled their money

back when the market turned sour.

Gearing is splendid in a rising market but horrific when shares start

to fall. It is all too easy to slip into a vicious downward spiral.

Asset prices collapse, triggering a breach of the banking covenant.

The manager has to sell assets to pay down the loans. And so on,

until there is little left. Ironically, gearing is often cited as one

reason why so few advisers recommend shares in conventional

investment trusts.

Nor can the fund management groups be accused of hiding the fact that

the portfolios contained huge amounts of lending. In their report,

the MPs quote Piers Currie of Aberdeen Asset Management as saying an

investment in the enhanced zero trust was a “no brainer. It is a

banking decision, really. You are able to borrow cheap, invest high.”

This is all so easy to see with hindsight but advisers could help

protect themselves from similar accusations in the future by getting

their clients to answer the following question. If interest rates are

at 5 per cent, how come this product can pay 9 per cent and still be

safe? It can&#39t and, in the case of zeros, the extra return was all

down to risky borrowing.

Richard Miles is deputy personal finance editor at The Times


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