Memorandum submitted by Collins Stewart
To help the Committee this note:
Gives the background to Splits and
Examines the impact of changing market
conditions on Splits.
Discusses cross holdings and fees.
(a glossary of technical terms is at the end of this
Splits are Closed End listed investment trusts.
Investment trusts typically trade at a discount to NAV and Splits
are designed to reduce or eradicate this discount. Splits are
not new, they have been around since the 19th century. Over time,
the Splits have evolved to include new classes of shares such
as Zeros shares which carry no dividend or income but entitle
the holder to share in the assets of the fund on maturity. In
addition to the Zeros, many Splits took advantage of low interest
rates by borrowing to provide additional funds for investment
to enhance returns (see Annex 1).
With the changing market conditions in and after
2000, Splits faced the unforeseen circumstances of falling interest
rates and falling markets (a most unusual combination), declining
dividends, falling ratings and the cost of bank repayments. As
liquidity vanished and confidence was lost the prices of shares
in Splits moved from a premium to a discount (see Annex 2).
The changing market conditions had a greater
impact on Fund of Funds Splits as the cross holdings, which originated
from a desire to spread the assets in Splits, tended to intensify
the effect of the falls in equity markets discussed above (see
The fees and charges involved in launching and
annual management are not excessive in comparison with collective
investment schemes and new issues (see Annex 4).
25 October 2002
AnnexBackground to Splits
A split capital investment trust is a version
of an investment trust company issuing various classes of shares.
Splits are Closed Ended funds, which (subject
to re-structuring) have a fixed pool of assets at the outset represented
by a set number of shares in the trust. Shares in the trust should
rise or fall in line with their dividends and the NAV underlying
each share class. As shares in Splits cannot be redeemed they
are listed, allowing investors to realise their investment by
selling their shares.
Splits may have high levels of gearing (achieved
either through the relationship between the different share classes
or bank borrowing or a combination of the two).
The main types of share classes are as follows:
Income Shares, offering
the potential for high income through dividends, but little or
no capital growth;
Capital Shares, not paying
dividends but (normally) participating in the assets remaining
after repayment of any bank debt and other prior classes of shares,
for example Income Shares and Zeros;
Ordinary Shares, offering
the potential for high income (through dividends) and capital
growth, but ranking after the repayment of any bank debt and other
prior classes of shares (eg Zeros); and
Zeros do not pay dividends,
instead offer a fixed level of capital growth on redemption provided
the Split has enough net assets.
Splits, like other investment trusts, have an investment
remit governing their investment policy including investment in
other Splits and investment funds (a Fund of Funds)
Splits have been around for a long time. For
example, Foreign & Colonial launched a Split in 1868 which
had a fixed life and four share classes, the Hawaiian Investment
Company launched a Split in 1880 with £20,000 of share capital
and borrowings of £80,000, giving a gearing level of 5x.
These were typical structures.
In the late 1960s, Splits were used as tax effective
vehicles, for example income shares would often be suitable for
non tax paying investors and capital shares for tax payers whose
return was taxed as capital gains at a lower rate.
In the late 1980s tax treatment of income and
capital had come into line. Several large generalist trusts developed
the concept further splitting their ordinary shares into income
shares, capital shares, stepped preference shares and zero dividend
preference shares to reduce their discount to NAV. Their alternative
would have been to convert into an Open Ended collective investment
Zeros came about at this time to increase the
yield available on the income shares to make up for the lower
level of income from the equity market when compared to the 1960s.
The number of Splits started to grow in the
late 1980s/early 1990s with existing investment trusts re-organised
and many new trusts launched with structures including Zeros.
Splits based on Fund of Funds were created to
broaden the diversification of investments
Most Splits were invested in UK high
yield shares which suffered badly in the recession of the early
1990s, for example the NAV of the capital shares in Scottish National
(an investment trust with a split capital structure) fell from
300 pence at launch in September 1987 to nothing, but were finally
repaid at l04 pence in 1997. The general cut in dividends throughout
the market fed through to Splits and many in turn had to cut dividends.
Scottish National cut the dividend on their income shares twice.
In the second half of the 1990s,
the number of Fund of Funds Splits grew and the sector performed
well. Mindful of the problems of the early 1990s managers sought
to diversify their portfolios both in terms of asset exposure
and in terms of manager risk. This led to the creation of a number
of Splits investing in asset classes outside the UK high yield
shares for example technology, European shares, US equities and
Asset classes (other than UK high yield) tended
to be characterised by low yields. In order to maintain an attractive
yield on the highly geared ordinary shares the balanced portfolio
Splits, also known as Barbells, were created. These separated
their portfolios into growth stock and high yielding securities,
which were either corporate bonds, other Splits or a combination
By the late 1990s, the cost of bank borrowing
became relatively cheap compared with the cost of Zeros, leading
to a decline in the proportion of Zeros in split capital structures
and an increasing proportion of bank borrowing. Some Splits moved
away from Zeros completely.
The theory was that the income from corporate
bonds would cover the cost of bank borrowings and the capital
growth on the ordinary shares would meet the redemption costs.
This worked well as equity markets continued to rise. For example,
the ordinary shares of The Technology & Income Trust Limited,
launched in July 1999 at 100p, rose to an NAV of 365 pence and
a price of 307 pence respectively on 10 March 2000 (they have
since fallen to zero as the technology markets in which the trust
The introduction of bank debt into Splits changed
the nature of the risks involved in the structures. In the late
1980s and early 1990s, simple structures with up to 50 per cent
ordinary shares and 50 per cent Zeros were not unusual. These
Zeros tended to have low cover ratios (that is their final entitlement
was often greater than the current gross assets of the trust).
Also the assets in front of them were only lx their current entitlement
(ie they have £50 million of ordinary shares in front of
their £50 million current zero entitlement).
As equity markets grew progressively over the
next 10 years, Zeros were increasingly becoming better covered
typically with a positive cover ratio of around 1.2x (for example,
the final value of the Zero had to be covered 1.2x by the current
assets of the trust increasing the likelihood of the investor
being paid in full). This was achieved by a combination of reducing
the life of the Zeros and reducing the proportion of Zeros in
Zeros in newer Splits have therefore been better
covered at launch than 10 years ago. A typical Split in the late
1990s could have a 40/20/40 structure, where the ordinary shares
represent 40 per cent, the Zeros 20 per cent and the bank borrowings
the remaining 40 per cent. The Zeros would have a higher positive
cover ratio than the older Zeros. They were better covered under
normal market conditions and under conditions of assumed market
Looking at the two previous examples with the
Zeros compounding at 9 per cent for five years, their final values
would have grown by 54 per cent. For the old style Split with
50 per cent in Zeros their original £50 million would grow
to £77 million. Therefore the gross assets of the trust could
fall by 23 per cent over the life and the Zeros would still receive
their final value. It would require the assets of the trust to
fall to nothing before the Zeros received no return at all.
For the newer structures including bank debt,
the Zeros would rise from £20 million to £31 million.
Therefore the assets of the trust could fall by 29 per cent before
the Zeros did not receive their full final value.
However, the crucial difference in our example
between the older Zero and the newer Zero is that if the assets
fell by 60 per cent the newer Zeros would receive nothing. It
is therefore fair to say that in normal market conditions, or
in conditions where markets fell by around 25 per cent-30 per
cent over the life of the trust, the newer Zeros were less risky.
It is also fair to say that in extremely adverse market conditions,
such as we have recently experienced, the newer Zeros were more
risky than the older Zeros.
Annex 2Changing Market Conditions
The continued decline in the value of the shares
of leading British companies which represented the bulk of the
investments made by Splits assets in the split sector triggered
repayment obligations under banking covenants given by the trusts.
The technology markets collapsed (Nasdaq fell77 per cent
from peak to trough) and markets generally declined (FTSE 100
fell46 per cent and the S&P fell48 per cent
peak to trough). This impacted sharply on asset values, which
fed through to the Fund of Funds Splits.
Newer Splits were designed to withstand market
falls of 25 per cent-30 per cent but even they suffered.
Splits faced the unforeseen circumstances of
falling interest rates and falling markets. Historically, in a
falling interest rate environment, equity markets rise. However,
in recent times as interest rates have fallen, markets have also
fallen (a most unusual combination). As interest rates fell, the
cost of repaying fixed rate debt increased. Splits were faced
with the dilemma of repaying bank borrowings and eroding the assets
or waiting for markets to recover. As debt is repaid it typically
reduces the dividends and the future prospects of the ordinary
shares, but may help to underpin the Zeros. As liquidity vanished
and confidence was lost, many Split trust prices moved from a
premium to a discount. Splits were therefore impacted by falling
asset values, declining dividends, falling ratings and the cost
of repaying debt.
Annex 3Cross holdings
The level of cross holdings in Splits varies
enormously between different trust companies. Some have no exposure
whilst Fund of Funds Splits clearly have 100 per cent exposure.
The Fund of Funds concept is designed to provide
additional diversification. In the early 1990s, the Fund of Funds
Splits were able to maintain their dividend payments despite the
dividend cuts by quoted companies. At the time, confidence in
Splits was high and their share price volatility low. The expansion
of Splits in the late 1990s enabled the Fund of Funds Splits to
broaden their diversification through the growth of the sector
as new issues began to move away from the traditional UK high-yield
index (the FTSE 350 high yield index) and focus on sector themes
and geographical diversification (eg technology, property, and
US, Far East and European equities). The entry of other fund management
groups into the Splits market also served to reduce the exposure
to any one fund management group and provide a further means of
We show below three charts which illustrate
the impact of this.
The first shows the 10 year performance of the
Datastream highly geared ordinary share total return index, compared
with the total return of the FTSE All Share index. This shows
that the sector returns have been remarkably similar to the equity
market until the second half of 2001.
The second chart shows the relative performance
between those two indices. This chart shows the Datastream index
outperforming the main market strongly in 1992-93, with the UK
equity market catching up in 1996 and the indices performing in
line until 2001. The third chart shows the total return on Dartmoor
Investment Trust relative to the total return on the FTSE All
Share index. Dartmoor is generally used as an example of a Fund
of Funds Split, it was one of the earliest and largest. Again
the chart shows dramatically that for much of the period shown
the trust outperformed the equity market, again until 2001.
In other words, for all but the most extreme
adverse market conditions, Splits performed well.
Fund of Funds Splits were impacted by falls
in equity markets, the additional gearing they had taken on, but
also by a significant de-rating in the split shares in which they
were investing as discussed in Annex 2).
Annex 4Fees and Charges
It is important to separate fees and charges
into launch costs and annual costs.
Launch costs vary on the size of the trust.
Typically larger trusts bear a smaller amount of costs as the
fixed costs are spread over a larger trust and, in general launch
costs could be between 1.5 per cent-2.5 per cent of the gross
Any commissions paid to IFAs and brokers would
be additional to the launch cost. Commissions, payable to authorised
intermediaries, are not that frequent but if paid are in the range
of 1 per cent-3 per cent. The bulk of the regulated institutional
investors would not take the commission but would subscribe net
of it for the benefit of their clients. Some management groups
also underwrote the launch costs at around 2 per cent, such that
if the issue was not as successful as hoped the management company
and not the trust would pick up the difference. Conversely, if
the issue was very successful the management company would receive
the benefit of the difference between the actual costs and the
2 per cent charged to the trust. This underwriting provided greater
certainty to investors as to their starting net asset values.
These costs are low compared to the launch costs for collective
investment schemes, which can and are often substantially more
and when compared to the fees charged for new issues in the equity
market, which can be 5 per cent or more.
Annual charges would include fees for the fund
managers and also all of the other associated costs attributable
to the trust, eg fees for directors, auditors, administrators
and custodians. In line with the normal market practice, the management
fees are charged on the assets managed, and would vary between
0.75 per cent-1.25 per cent of funds under management. The other
costs would normally be less than 0.5 per cent which would be
paid by the trust company. This would add up to a total expense
ratio of around 1.5 per cent per annum of the gross assets managed.
Barbells a balanced portfolio fund developed
to maintain an attractive yield on the highly geared ordinary
shares by separating their portfolios into growth stocks and high
Closed End a fund with a fixed initial capital,
unlike unit trusts or OEICs
Fund of Funds a collective investment scheme
whose investment policy is to invest in the shares and units of
other collective investment schemes
NAV Net Asset Value
Zero Zero Dividend Preference Shares