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Zero worship

The highly volatile markets of the past year have highlighted the importance of risk management. While searching for a safe haven, many investors will probably look at gilts. But although gilts are relatively risk-free, they provide investors with little else.

In contrast, zero-dividend preference shares have similar risk characteristics to gilts but provide returns between 1.5 and 2 per cent above those of gilts. Over the longer term, they have outperformed gilts significantly. This is without taking into account the specific tax adva
ntages offered by zeros.

Zeros are a class of share associated with split-capital investment trusts. As the name suggests, they do not pay out any income so the investor is not liable to pay income tax on the investment. Rather, zeros have a predetermined redemption price at a set date in the future.

In other words, when you invest you are given an indication of the return you will receive as the final repayment value has already been calculated. For a higher-rate taxpayer using the current capital gains tax allowance of £7,200, a return of 8 per cent on a zero is equivalent to a gross redemption yield of 13.3 per cent.

Although zeros will never outperform traditional equities over the longer term, they do provide investors with a less volatile route to growing their assets. Over the past two years, the FTSE All Share index has returned over £1,168 on a £1,000 investment while the Micropal zero sector has produced a return of £1,111.

However, the volatility of the two investments is quite different (see graph below). The path of the FTSE All Share is more volatile while the zero sector is much flatter.

In addition to being more attractive than gilts and less volatile than many traditional equity investments, zeros have three key advantages over with-profits funds:

Capital gains crystallised within a with-profits fund are subject to tax within the fund. Any capital gains generated within the underlying port-folio of an investment trust,on the other hand, are not taxed within the fund. For an investor who does not utilise his or her annual capital gains tax exemption, therefore, investments in zeros present a tax advantage compared with a with-profits fund.

Investors who sell their zeros before the redemption date do not suffer any early encashment penalty above market valuation while with-profits funds typically incorporate penalties designed to provide profit to the life office involved.

As zeros have a set redemption value, investors have a good idea of the potential return. But the future return from a with-profits fund depends on future market conditions as well as the approach to investment and distribution of returns of the life company involved. Recent experience of bonus cuts suggests future returns on with-profits funds may be less predictable.

Due to these attractions, zeros are becoming an increasingly important investment tool. As zeros provide investors with an indication of the return they can expect, the shares are particularly popular in terms of financial planning, such as saving for education fees.

Because investment trust shares are listed on the London Stock Exchange, advisers also have the option of constructing a portfolio of zeros for a client. Traditionally, however, it has been very difficult for small investors or advisers to access the zero market due to the lack of widely published detailed information on the different zeros.

But investors can still benefit from zeros without constructing their own portfolios by holding one of a number of unit trusts or investment trusts which invest specifically in zeros. Aberdeen, Exeter and Investec all manage unit trusts invested in zeros while Aberdeen and BFS offer investment trusts.

Zeros may not provide the glamour associated with technology funds but, for a balanced portfolio, these returns have to be weighed against lower-risk investments.

With zeros offering returns above those provided by gilts, as well as being taxefficient and having a number of advantages over with-profits funds, they are a highly attractive way of managing a balanced portfolio.


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