Secrets of Success: No one to blame for split trust disaster?

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The Independent Online

In the long and illustrious annals of "things they wish they had never said", I wonder whether David "Dotty" Thomas, of the stockbrokers Brewin Dolphin, regrets his now notorious evidence to the Treasury Select Committee hearing on the split capital trusts saga.

In the long and illustrious annals of "things they wish they had never said", I wonder whether David "Dotty" Thomas, of the stockbrokers Brewin Dolphin, regrets his now notorious evidence to the Treasury Select Committee hearing on the split capital trusts saga. "It is nonsense to think that the designers of this kind of trust were wilfully dangerous," he told MPs. "You would not have designed a product like this if you could have foreseen what was going to happen."

It is difficult even now to think of a crasser or more insensitive remark. Given the dramatic way in which many of the new breed of split capital trusts that appeared between 1998 and 2001 had cratered, leaving thousands of investors nursing heavy losses, the idea that even the inventors of the offending trusts had no clue they could be so damaging to your wealth invited incredulity, as well as adding insult to injury.

Yet we have to allow for the possibility that this remarkable thought might even be true. In his contribution to a new study - The Split Capital Investment Trust Crisis, edited by Andrew Adams (John Wiley) - John McFall, the combative chairman of the select committee, who rarely misses a chance to castigate the financial services business, seems willing to allow that the "manufacturers" of the worst offending trusts genuinely did not believe that investors might, in extreme circumstances, lose all their money.

"It is almost certainly the case that the impression of invulnerability was given in good faith, given the prevalent bull-market mentality," he says.

Other more impartial observers concede the same thing. Andrew Adams, the Scottish academic who was one of the first to raise concerns about the implicit risks in the way the new breed of trusts was being run, as far back as 2001, says: "It cannot be out of the question that a number of management companies and broker/advisers may have overlooked or miscalculated the risks involved."

With hindsight, we can see how the split capital trust debacle developed. The relentless fall in yields on all types of investment security towards the latter end of the bull market created a huge demand from private client advisers and investors generally for investments that offered high levels of yield. The new breed of split capital trusts that emerged in the period 1998-2001 was a direct response to this.

It is impossible not to give some credit to the ingenuity of those who pushed back the frontiers of product design so assiduously in a sector of the fund business not traditionally associated with openness to new ideas. (Regular readers might, however, recall my rule of thumb that any investment provider or adviser who offers "product" rather than a "service" is typically best avoided).

The innovations that contributed most to bringing several new split capital trusts to their knees were the use of bank debt in the capital structure and the practice of encouraging trusts with high yields to invest in other trusts of a similar nature. There were other wrinkles, such as the creative allocation of costs to capital to improve the yield on trusts.

The use of bank debt carried all the risks typically associated with high levels of gearing, while exposing holders of the various types of share capital (including, in particular, the zero preference shares) to increased risk of loss should the assets of the trust start to fall.

The cross-holdings were even more toxic: once the bear market started in earnest, and splits began to run into trouble, the problems spread to every other trust. It is no accident, as the chart shows, that it was the highly geared new split capital trusts that suffered most when the market started to collapse in 2001-2002.

The combination of all these new elements made the scale of the downside risk in the split capital trusts hard to predict. Even financial academics have struggled to come up with models that capture accurately the risk characteristics of some of the more complex split capital trust structures that emerged in 1998-2001. While historically it had been possible to describe zero preference shares as relatively low-risk, this was not true for many of the new capital structures in this period.

The unforeseen double gearing hidden within some of the new structures might be more convincing as a defence for the debacle that followed, were it not for the fact that the providers of the worst offending new trusts often seemed not to show as much regard for the risks as you might have expected. A number of split capital trusts listed risk factors, but in their projections often showed only the impact that rises in the market would have.

More telling of systemic failings in the business was the fact that many boards for the new trusts were not appointed until after the design of the capital structure had been completed and marketed. They had no chance to probe the risks, even had they the mind to do so. And fees paid to the promoters and managers of the funds were based on the total assets of the trust, including its debt, rather than on the net assets in the portfolio.

Both things gave every incentive to those who created the trusts to increase the gearing and turn a blind eye to the time bomb ticking away. There is nothing wrong with investment trusts, even split capital ones. But nobody can doubt that the whole split capital debacle has done the cause of investment trusts and the financial services business enormous harm.

jd@intelligent-investor.co.uk

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