Split Capital Investment Trusts for beginners
Part 3 of the new 3-part series designed to provide trustees with a guide to the various types of collective investments they may come across and when and why they might wish to use them.
When you invest in a portfolio, you invest the money, and get your return by collecting the dividends and eventually selling the assets to get cash back at the end. Split Capital Investment Trusts use the company structure to slice and dice these returns using different classes of share with different entitlements in an Investment Trust with a fixed life. At the end of the term, the Investment Trust is wound up and the assets distributed to the various classes of shareholders in accordance with their entitlements.
Although, in practice, most Split Capital Investment Trusts have only two classes of share there are in principle three fundamental classes of share which are combined in various ways to create what is actually available. Most such Investment Trusts trust have a ten year life.
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The Zero Coupon Preference Shares
These shares are entitled to a fixed sum on wind up. In general that fixed sum is normally slightly more than the assets of the trust could provide at inception. This fixed sum is only paid in full if at the wind-up date the Investment Trust has sufficient assets to pay it. However, this class of share has first call on the assets of the trust after repayment of any loans that the Investment Trust has taken out. Generally, on the assumption of pretty conservative rates of capital growth the Zeros will be paid in full. In the normal course of events, for holders of the zero, risks are relatively low, but the returns are not great either. The great advantage is that these returns are subject to CGT not income tax. By definition these shares do not get any dividends.
Low risk does not mean no risk. If the assets of the Investment Trust fall to such a level that the Capital shares get nothing then the holders of the Zero Coupon Preference shares start losing money when asset values fall still further.
These are the risky ones. These shares are entitled to the whole capital of the trust at wind-up once the debts have been repaid and the Zeros have received their capital entitlement. These shares have a relatively small capital entitlement, which suffers the volatility on the whole portfolio of the Investment Trust. If the Investment Trust were wound up immediately after it was established these shares would get nothing unless (as is usual) the entitlement of the Zeros were scaled back. Their entitlement is really to all the capital growth in excess of that needed to pay the Zeros.
The capital growth potential of these types of share is phenomenal, but you can lose the lot in an afternoon. On the risk front their only positive feature is that the investor’s loss is limited to the initial investment. However, in the context of a larger investment portfolio a small investment in such shares may have a place, as long as a total loss on that particular investment is acceptable in the context of the whole portfolio.
An investor could for example hold a large portfolio of shares. If there was serious market crash his investments could lose three-quarters of their value. Alternatively he could get the same growth with cash balances and a holding in Capital Shares. In a similar market crash he would lose his whole investment in Capital Shares but still have his cash balances and be better off than an investor who had invested his whole portfolio in lower risk shares.
It should be noted that in that scenario the investors in the Zero Coupon Preference shares of the Investment Trust would be the ones that suffered the rest of the losses in the underlying portfolio.
These shares are entitled to all the dividends the Investment Trust receives after costs have been met and any loans have been serviced. They are generally entitled to a nominal capital sum at wind-up, something like a penny or something less. In the last year of the Investment Trust’s life these share could receive 12 pence of dividend but only one penny of capital repayment. These shares offer a guaranteed capital loss but the yield is fantastic. It is however useful if you want to create a Capital loss. The overall returns are good for a tax free fund or a basic rate taxpayer but most investors are averse to taking capital losses.
Unfortunately, in their pure form, these kinds of shares do not appear to be issued any more.
Winding up the Investment Trust
At wind up the Investment trust assets are realised and the money is then paid out in the following order.
- Any bank loans are repaid.
- Any income reserves are paid out to the annuity shares.
- The zeros are paid in full or as far as possible.
- The annuity shares receive their nominal capital entitlement.
- The Capital shares get the rest
Of course if at any stage the money runs out some of these share classes do not get much or anything. However the money to repay the Zeros is in principle pretty safe except in a serious bear market.
How it all went wrong for Zeros ten years ago
In the 2000-2002 crash there was a scandal because investors in Zeros did lose their money. The following describes how in the run up to this bear market the risk was engineered back into some zeros. The explanation needs to be seen in the context of the above list of who gets what and in what order.
First, many investment trusts were very highly borrowed so the funds under management were to a significant extent money that had been borrowed and when asset values halved the borrowing covenants were broken and the Investment Trust had to be wound up. Investors in the Zeros therefore made serious losses.
Second, there were some Investment Trusts which invested some, or even all, of their money in the Capital Shares of other Investment Trusts. When the stock market crashed the Capital Shares in the portfolio became virtually worthless very quickly. The underlying portfolios suffered volatility much, much greater than the stock market in general and so the assets available to the Investment Trusts own capital shares were wiped out leaving the Zeros suffering large losses
The financial services industry, in an effort to provide something wonderful for everyone, had taken what was a fundamentally low risk share class and engineered all risk back into it. Zeros became very risky indeed.
That does not seem to happen anymore, but it is wise to understand how things went wrong in the past because memories tend to be short and mistakes tend to get repeated.
Most split capital Investment Trusts now have two classes of share the Zeros and income shares which merge the entitlements of the Capital Shares and Annuity Shares. This gives holders of the Income Shares (sometimes called Ordinary Shares) a reasonably secure income, coupled with a high risk capital return.
There can be annuity shares where the capital repayment on wind up is not negligible shares but then technically they are no longer annuity shares.
Split Capital Investment Trusts can potentially offer real benefits to investors. They offer a financial toolkit. There are circumstances where the ability of Annuity shares to convert capital into income can be a real benefit to some investors. There are many investors for whom the fact that all the return on Zero Coupon Preference shares is in the form a capital gain is very attractive, particularly if that is coupled with relatively low risk. Even the high risk Capital shares can, as in the example above, form part of a risk control strategy.
Investment trusts are not unit funds. They have many advantages over normal unit funds but they also come with their own risks. Split Capital Investment Trusts are particularly useful. However to understand the risks and benefits provided by any particular Investment Trust it is best to read the Investment Trust’s accounts. For Split Capital Investments Trusts reading the accounts is essential to understanding the risks involved.
The zeros of an Investment Trust which has no borrowings and whose assets are sufficient to repay the zero’s three time over represents a very different risk proposition to another Split Capital Investment Trust with high borrowings and only just enough assets to repay the zeros.
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