Select Committee on Treasury Minutes of Evidence

Annex H




    "We remain nervous about some of the barbell portfolios underlying [split capital and highly geared] funds. The growth portfolio is often highly volatile, while the income portfolio has more capital risk than many investors think. Not only could the proportion invested in other splits fall sharply if the underlying hurdle rates are not met, but the high yielding bonds that are popular in some structures are quasi equity. The worst case scenario for investors is therefore a growth portfolio that does not grow and an income portfolio that suffers defaults and capital loss. In this instance high headline yields do little to mitigate the overall losses that will be suffered."

  Cazenove Investment Companies Annual Review, 10 January 2001.


  The sharp correction in markets has hit many investment trusts hard, but few more so than a number of the so called "barbell" trusts, whose highly geared capital structures have come under severe pressure. Barbell trusts are designed at issue to offer their shareholders the growth prospects of a popular sector (or market) together with a very high income.

  The 32 barbell trusts in our sample account for £4.6 billion or 50 per cent of the £9.2 billion of total assets raised by highly geared and split IPOs since the beginning of 1999. More significantly, during 2000 and 2001, of the £7.1 billion of total assets raised, barbells accounted for £4.2 billion, or 59 per cent.

  Despite this high level of issuance and their apparent popularity, there are serious structural issues with barbell trusts and perhaps most importantly the risk of a systemic collapse.

Systemic Risk

  A systemic collapse could result from the high degree of investment by these trusts in other geared funds. A sale of these assets by trusts breaching their banking convenants could cause a collapse in market prices, and as a result other funds investing in this area to breach their own covenants. If they then have to sell, it is easy to see how a downward spiral might develop, exacerbated by high gearing. Cross shareholdings which result in a trust effectively owning its own shares add to the gearing of a geared trust, but should not in themselves lead to a downward NAV spiral in the event of a fall in the underlying assets.

Structural issues

  Fees and financing costs as a percentage of shareholders' equity are magnified by the existence of high levels of debt, and this is exacerbated as gearing increases in a falling market. These vehicles were costly at issue and many have now become even more so.

  The high headline yields attract investors, but are achieved partly through an accounting sleight of hand, by charging most of their expenses and financing costs to the capital account, which transfers value from capital to income.

  There are a number of practical problems when a highly geared trust nears or breaks its banking covenant levels. The fund at this point is being controlled by the bank, not the shareholders, or the manager. Any forced rebalancing may be sub-optimal, and poorly timed—assets may have to be sold in a falling market, negating the benefits of the closed end structure. Furthermore, if the trusts degear after having fallen sharply, they are not so well placed to capture any upside. In addition there may be penalties to pay for early repayment of the loan, particularly if interest rates have changed since inception. New equity is expensive to raise if the managers are reluctant or unable to sell the existing portfolio and, if similar trusts are trading on discounts, it may be impossible. These problems do not exist where the gearing is provided by prior ranking share capital, although such finance is more expensive and is therefore less attractive to lower ranking shareholders.

  In flat markets with no dividend growth, the charges to capital (which enable a larger dividend to be paid) necessitate the sale of assets, and everything else being equal a fall in the level of income. So even if dividends generally are maintained, there is pressure on the revenue account. Underlying dividend cuts simply exacerbate this situation, and the market prices of many high yielding trusts would collapse if their yield prop was removed. Whenever ultra high yields are on offer it is always in return for high levels of risk.

  Hurdle rates can be difficult to interpret and can look deceptively easy to achieve. Investors should study carefully the basis on which they have been calculated and, just as importantly, whether in a low inflation environment they are achievable. The capital downside for many of these vehicles is greater than the upside for a given annual percentage change in total assets. An apparently low risk income portfolio invested in splits and bonds could decline substantially in capital value if the amount invested in other splits fails to meet its underlying hurdle, and/or where there are risky bonds that default.

  Providers of lower risk capital, such as zeros, should be wary about financing trusts backed by volatile assets they have limited upside but full downside.

  High profile losses in these funds for the smaller investor could ruin the good name of the whole investment trust sector. IPO documents, particularly those aimed at retail investors, should spell out more clearly the risks of these vehicles, and show a wider range of possible returns. Reporting by issued trusts is not always very informative, and too many funds operate as "black boxes".


  Despite their popularity, we have shown that there are some serious problems with the barbell structure. Our biggest concern is the risk of a systemic collapse. Even if this rather gloomy scenario does not materialise, many barbells have stretched capital charges to the limit in order to produce high headline yields and have invested in lower quality assets for income. This means that the growth and income portfolios will have to work hard to maintain the value of investors' initial capital. If current market conditions continue there will be further financial distress. Even if long term total returns from equities are in line with our expectations of about 8 per cent per annum, many funds will struggle to meet their hurdles.

  We are not against high gearing, or splits per se. We have shown in previous research that gearing has added value for trusts, while splits enable trusts to offer different types of securities to different types of investor, and can be used to increased demand for the underlying fund. The recent restructuring of Investors Capital is a good example of a sensibly structured fund. However, we believe that many of the more recent structures required unsustainable portfolio returns to avoid total capital loss.

  An over-dependence on easy and "cheap" bank finance has exposed the inflexibility of the barbell structure in more challenging market conditions. The underlying portfolio strategy should drive the structure rather than the structure drive the underlying portfolio strategy.

previous page contents next page

House of Commons home page Parliament home page House of Lords home page search page enquiries index

© Parliamentary copyright 2002
Prepared 17 October 2002