Investment trusts torn apart by the split capital crisis

Aberdeen Asset Management share price plummets anew as fears grow for future of dozens of split cap trusts
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Split capital investment trusts, for decades an obscure niche sector in the multi-million pound financial services industry, have in the last few months become one of its most controversial investments. The cause of the notoriety is an appalling set of investment performances, leading many investors to face their investments being entirely wiped out and triggering an investigation for potential mis-selling by the Financial Services Authority.

The shadows hanging over the sector have also decimated the share price of fund managers involved in the sector. Aberdeen Asset Management, the most exposed investment company to split caps, yesterday became one of the biggest fallers in the stock market, closing down 6 per cent to 264p. This followed a 16 per cent drop on Wednesday in Exeter Investment's shares after the company issued a profits warning.

It is a long way away from the heyday of split caps in the late 1990s, when fund managers were pocketing massive fees as they launched a raft of funds, which promised ever more dramatic returns to investors.

Now funds that are doing well among the total of 119 split caps are considered to be those that will struggle through to an upturn in the stock market without being drowned in debt.

At the other end of the spectrum, analysts are talking about the "meltdown" that is approaching for around a quarter of all split caps whose debts outstrip assets and have breached their banking covenants.

There were indications this week that the process has begun. Quilter Global Enhanced Income became the first trust to suspend its shares amidst speculation that it has become insolvent. Other splits are expected to follow and plenty have not been able to afford dividend payments recently.

Split capital trusts, so called because they have different classes of shares, have been around for more than 100 years, but they have thrived when markets have boomed because their geared structure has meant they could take advantage of market upturns.

Splits provide growth for investors who take no income for a number of years with a view to receiving a return of something like double their money in the long run. These shares are called zero dividend preference shares. They also offer something for investors who want a regular income, who buy ordinary shares and – when things are going well – receive an annual dividend.

Some splits have done so badly recently that in some cases no class of shareholder will receive even their initial investment back. Daniel Godfrey, director general of the Association of Investment Trusts, says: "Shareholders in a smallish number of trusts stand to loose virtually all of their capital".

The reason why some splits have become so dramatically unstuck in the recent economic downturn lies in the decisions fund managers took in the context of the frenzy of accelerating stock markets and the boom.

The first decision, which looks very misguided with hindsight, is the timing of the launch of many splits. The most obvious example was Aberdeen Asset Management's decision, two days before the burst of the bubble in March 2000, to launch its technology and income fund. According to past performance, the fund should have produced mind-boggling returns but it actually crashed and had to be merged with another fund this January.

Fund managers can be excused for the timing to an extent because investment vehicles are often launched at the top of the market because this is when private investors are at their most bullish about buying shares. But the extra competition for investors' business drove fund companies in the late 1990s to distort the split capital structure in order to offer increasingly ambitious yields.

To meet the higher yields, fund managers started to deduct the costs of running the fund from their capital account rather than from revenue, which was used to pay the yield. John Newlands, an analyst at Williams de Broe, says: "In the absence of growth in the stock market, this strategy meant they were eroding the assets of the trust."

Some trusts also adopted an extreme investment strategy known as a bar-bell. On the one hand, they invested in potentially hi-tech shares which promised very high growth and on the other they poured money into corporate bonds of new economy companies. The bonds were meant to be the safe part of the portfolio but in many cases have been relegated to junk status.

Another tactic, which took hold in the 1990s, was to dramatically gear up split caps. Until 10 years ago, splits' only gearing was the capital they were, in effect, borrowing from their zero shareholders. This changed so that they took on increasing amounts of bank debt – to the point that loans from banks now make up £4bn of the £12.8bn of total assets held by split caps.

Some critics are cynical about the reasons for the heavy gearing. "It is all about greed. Board directors and managers of splits are incentivised to borrow more and more because it earns them more fees, which are based on gross rather than net assets," says Mike Neumann, investment officer at the stockbrokers Bestinvest.

The final charge managers of splits face is that they have invested heavily in each other, led by a "magic circle" of fund managers who were attracted to cross investments as a way to boost the yield of their own fund. The obvious domino-effect dangers of this type of investment has already been seen in the number of splits blaming the suspension of their dividend on the fact that returns on funds they are invested in have done the same and now the FSA is investigation whether there has been "collusion" between fund managers to prop up each others' share prices.

Apologists for the split cap industry emphasise that only about £2bn of the £12.8bn in the industry are tied up in cross holdings. But that, which permeates through the industry, is expected to create considerable damage. Mike Neumann, investment officer at the stockbrokers Bestinvest says: "There has been a polarisation between some good quality funds and bad ones and the bad ones are going to get wiped out."