Select Committee on Treasury Minutes of Evidence


Memorandum submitted by Aberdeen Asset Management PLC

INTRODUCTION TO SPLIT CAPITAL INVESTMENT TRUSTS AND THE CURRENT ISSUES AFFECTING ZERO HOLDERS

BACKGROUND TO ABERDEEN ASSET MANAGEMENT PLC

  Aberdeen Asset Management PLC is a leading independent fund management group, which manages over £27.2 billion of global assets for institutional investors and individuals, from 26 locations around the world. Aberdeen Asset Management manages three main asset classes: equities (£14.8 billion), fixed interest securities (£7 billion) and property (£5.4 billion).

  The Group manages 44 closed end funds/investment trusts (£6.2 billion) for financial institutions and retail investors in Australia, Canada, United States and United Kingdom. As UK investment trusts are listed on the London Stock Exchange, investment trusts managed by Aberdeen also have non-UK institutional investors.

  The funds have a wide range of investment remits investing in: specific geographic regions (eg USA, Europe), specific sectors (eg media, technology), specific securities (eg Asian bonds) or in a combination of these. The Company manages 25 conventional closed end funds/investment trusts and 19 split capital investment trusts.

EXECUTIVE SUMMARY: ABERDEEN ASSET MANAGEMENT'S BRIEFING DOCUMENT TO TREASURY SELECT COMMITTEE

  The main difference between investment trusts and eg, unit trusts is pricing: the value of the shares of an investment trust is determined by the market, influenced by the view of market makers, trading volumes, sentiment, etc. Therefore, investment trust shares can trade at a price which is higher or lower than the relative value of the assets of the company.

Market statistics

    —  there are currently 134 splits in existence;

    —  of these, there are 310 share classes in issue from three main types of share;

    —  total sector assets of £13.2 billion;

    —  37 fund management splits; and

    —  ZDP shares were introduced in 1987.

  Zeros were widely considered to be a low-risk investment until relatively recently. In April 2002, Gartmore Monthly announced it could not redeem its zeros in full on its redemption date.

Risk profile

  Splits cannot be assessed for risk as a class, but should be assessed upon consideration of various interrelated factors, such as the level of gearing, the nature and volatility of the underlying portfolio and the existence of cross-holdings. These factors are now being considered with the benefit of hindsight. Fund managers, investment bankers, lawyers, advisers and the listing authorities all worked to a common assumption that some form of equity market growth could be expected from equity markets in each succeeding year, as had been the case for the preceding decades.

Cover and hurdle rate

  The "cover" and "hurdle rate" calculations were the standardised tools used both by analysts and the AITC to analyse risk attaching to zeros; it was only when the prospect arose of zeros not paying out that the use of these calculations came to be considered in any detail. It was not until early 2002 that the AITC agreed a standard approach to the calculation and reporting of cover ratios. A 2001 study by Merrill Lynch found:

    —  cover and hurdle rate are, in isolation, wholly inappropriate measures of risk;

    —  bank debt and increasing portfolio volatility are major risks facing zeros;

    —  the application of derivative pricing in the sector is the only form of analysis that provides a rational assessment of risk and a rational assessment of relative value; and

    —  full disclosure (on structure and portfolio) is essential if the sector is to be fairly priced.

Barbells

  Barbell trusts hold two distinct portfolios of investments: a low-yielding growth portfolio (typically financed by debt) and a high-income portfolio (typically financed by equity). While a good number of barbells are splits, most splits are not barbells. It is the division of the assets side of the balance sheet into two separate portfolios, together with a high level of gearing, which makes a barbell.

  The HSBC analysis of March/April 2000 showed that, relative to the World Index, the splits sector was overweight in UK equities, thus concentrating portfolio risk. The aim of many barbells was to diversify this growth risk away from UK FTSE 350 shares into eg US equity, UK smaller companies, technology shares and Far Eastern shares (see chart on page 12).

  Disadvantages of barbells (although these could affect any split, whether or not it followed the barbell strategy) are:

    —  many barbells chose to increase gearing through bank borrowing—therefore they were open to the same risks as any other highly geared trust;

    —  many barbells were launched since 2000-01, at the beginning of market decline: as a class, therefore, barbells have reflected the recent decline in the markets generally, particularly since September 2001; and

    —  the nature of the recent market decline has been to affect both the equity and bond markets. Consequently, the perceived advantage of dividing the portfolio to protect against adverse market conditions has not been realised.

Cross-investment

  Cross-investment refers to the ownership by a trust of a portfolio of income shares in other splits to boost portfolio yield. It is possible for cross-investment to occur by trusts holding zeros in other trusts—however, this is less common. The "fund of funds" has long been a feature of splits, offering diversification, asset allocation and tax advantages over a single portfolio.

  In relation to cross-investment, as at 31 March 2002:

    —  only 15.43 per cent of the sector as a whole was invested in splits;

    —  73.59 per cent of the sector was invested in equities and bonds; and

    —  a further 7.25 per cent was invested in cash.

  The effect of market decline on the overall value of portfolios has been enhanced by applying across the portfolio, whether it is invested in equities, corporate bonds or other splits.

Allegations of collusion

  It makes good investment sense for a manager of a split to acquire high-yielding income shares, as these fall squarely within the trust's requirements. One source of such shares is splits issued by other managers.

  The market prices of shares in investment trusts are independently determined by market makers based upon supply and demand, following strict rules laid down by the London Stock Exchange. There are a number of brokerage houses which operate in the sector and up to seven competing market makers who set prices for shares in the secondary market. Primary prices, for new issues, are outlined in the issuing prospectus. These prices are in no way determined by other managers, so it is highly unlikely that cross-investment would directly affect the pricing of individual trusts or the sector overall.

Gearing

  Unlike unit trusts, investment trusts can borrow money and invest the proceeds. Gearing is an effective management tool to enhance gains in a rising market and, until recently, has served to set the investment trust sector apart from other forms of investments by providing competitive returns to investors. With a long-term view of rising markets, this remains the case.

  Gearing magnifies returns favourably or unfavourably in rising or falling markets. Over recent months, the markets have fallen at an unexpected rate and the effect of gearing has compounded losses in the short to medium term. This is because, while the percentage loss compared with the total portfolio remains the same, the costs of borrowing must still be met out of the remaining asset value.

1.  WHAT IS AN INVESTMENT TRUST?

  An investment trust is an investment company whose shares are listed on the London Stock Exchange.

  Generally, an investment trust works by issuing one or more classes of share that are fully listed on the London Stock Exchange. The investment company has no business as such but instead the assets of the company comprise a portfolio of investments that are actively managed under the direction of the Board of Directors with a view to providing a return to shareholders.

  Investment trust shares are regularly traded by market makers. Investors have a number of ways of investing directly or indirectly in an investment trust, of which the main ones are as follows:

    —  Buy a share as a new issue direct from the investment trust in accordance with the terms of the prospectus.

    —  Buy a share after the time of its issue, for example through a stockbroker.

    —  Buy a share as advised by an adviser or through the discretion exercised by a fund manager.

    —  Buy a product that itself invests in, or is based around, shares of an investment trust. Examples of this include Investment Trust Share and Savings Schemes, and certain unit trusts.

  One of the principal differences between investment trusts and other forms of investment, such as unit trusts, is the pricing. With a unit trust, the value of each unit is determined directly by reference to the total value of the underlying assets at the time and the number of units then in issue. By contrast, the value of the shares of an investment trust is determined by the available market in those shares, influenced by the view of market makers, trading volumes, sentiment and the state of the markets generally.

  Investment trust shares can therefore trade at a price that is higher or lower than the relative value of the assets of the company, having regard to the number of shares in issue. This is particularly significant for highly geared income shares whose price in part expresses the expected future dividend stream offered by the share, as well as its underlying asset value.

2.  WHAT IS A SPLIT-CAPITAL TRUST?

2.1  Introduction

  A split capital trust is an investment trust company with more than one class of share (hence "split capital"), each class having different rights to participate in income or capital returns. Split capital investment trusts were originally devised over 100 years ago and operate on the basis that shareholders look for either income or capital growth and are able to meet such requirements through choice of the different share classes. Split capital investment trusts have a fixed life span—on averge seven years—at the end of which they are wound up or rolled over into a new fund.

2.2  Substantial industry

  As at December 2000, a Financial Times Supplement reported that there were over 90 split capital or quasi split capital trusts in issue. Capitalised at over £12 billion and comprising some 15 per cent of the investment trust sector. This represented an increase from £5 billion over just 12 months, while conventional trusts had shrunk by about £3 billion over the same period and were dropping by 10 per cent a year.

  These figures have risen still further and there are currently 134 splits in existence (including umbrella funds and highly geared funds with only one share type), with 310 share classes in issue from three main types of share, with total sector assets of £13.2 billion. Each split has its own independent manager, and 37 fund management groups manage splits.

  Aberdeen is one of the largest managers of investment trusts in the UK and is the largest manager of splits. Aberdeen manages 19 splits, all of which have different mandates, structures, histories and investors. Each split has its own individual website and can be accessed through Aberdeen's Investment Trust directory at www.invtrusts.co.uk

2.3  Stock Market returns over 15 years


3.  WHAT IS A ZERO?

3.1  Introduction

  A zero dividend preference share or "zero" is a particular class of share within a split capital investment trust. Its principal characteristics are:

    —  No dividend is payable at any stage to the zeroholder. In effect, therefore, the interests of the zeroholder are principally in capital return rather than income from the trust.

    —  At the redemption date (the date specified on the establishment of the split for its winding-up), the zeroholder is entitled to receive a pre-established redemption price provided that there are sufficient assets in the trust.

    —  In determining whether there are sufficient assets to meet the payments due to zeroholders, the only prior call on the assets of the trust is in favour of any bank which has lent money to the trust (see section 7 on "Gearing" below).

  Zeros can be contrasted with the other two main share classes, income and capital shares. As the name suggests, income shareholders are entitled to a regular dividend payable from the assets of the trust during its lifetime. Capital shares do not pay dividends and do not have a predetermined value. Instead, capital shareholders are entitled to share in the remainder of the assets of the trust on winding-up once the prior interests of any lenders, zeroholders and income shareholders have been met. Consequently, the entitlements on winding-up to the assets of the trust are in the following order:

    (i)  Bank lending;

 (ii)  Zero holders;

(iii)  Income shareholders; and

(iv)  Capital shareholders.

  There are also hybrid types of shares such as Income & Residual capital shares. Individual trusts can have two or more classes of share in different combinations.

3.2  History

  The first split can be charted back as early as 1873, when a Scots lawyer, William Menzies, considered he had two types of clients: the risk-tolerant and the risk-averse. The Scottish American Investment Company Limited ("SAINTS") was created with two main share classes, ordinary shares and preference shares. For several years after 1873,the trust sector was made up of a mixture of legal trusts (like Foreign & Colonial—"F&C") and trust companies (like SAINTS). In 1879, F&C's certificates were converted into equal quantities of ordinary and preference shares and adopted a geared capital structure. Some might argue, therefore, that not only has F&C, the "grandfather of the industry" been a split capital investment trust for much of its life, but that the whole trust sector had a substantially split capital sector for most of its first 60 years.

3.3  Risk profile

  Split capital investment trusts have become an increasingly popular investment trust sector; they offer higher yields in a low interest rate environment by having different share classes to offer basically predetermined growth, high capital growth or high income.

  Zeros are used as a quasi-fixed interest product and until recently, have been considered to be a low-risk investment. Research during the period supports such views. In Merrill Lynch's research in March 1999, "Risk Rating Investment Trusts", zeros were specifically excluded from their analysis. Their risk category system "loses the very low risk end of the spectrum. To be fair though, this is only populated only by quasi fixed interest stocks such as zero coupon preference shares."

  The traditional analytical measures of risks attached to an individual zero are covered in the next section.

  Zeros have been used by investors wishing to obtain a fixed capital gain at a pre-selected date in the future, for example, in school fees planning. For instance, the Bloomberg Money Guide of May 2001 included an article in which Barrie Golden, investment manager at Hargreaves Lansdown, commented on zeros:

    "They are the safest split capital investment as they are the first in line for a slice of the assets at the winding-up date . . . In terms of risk, they are almost on a par with building society accounts or UK Government Bonds."

  Bill Fowler, senior investment strategist at Hill Osborne & Co (stockbrokers) in his article of 29 June 1999 entitled "Zero Dividend Preference Shares" concluded:

    "No other investments offer the same combination of high returns, low risk and tax efficiency as zeros, which are strongly recommended for consideration."

  In May 2000, stockbrokers William De Broe published an independent report as a basis for discussion on the burgeoning split capital market. The report's author, John Newlands, who has also written a history of the investment trust industry, accentuates the unprecedented popularity of splits and the characteristics of zeros as a share class.

    "The zero dividend preference share, introduced in 1987, is a success story in itself. Zeros typically offer yields at a premium over gilts, building society and bank accounts, predetermined repayment terms, no liability to income tax and low risk."

  It has only been relatively recently that market commentators and analysts have called into question the accepted risk profile of zeros. This has come about largely as a reaction to the combination of low interest rates and falling markets, significantly since September 2001. In April 2002, Gartmore Monthly announced it could not redeem its zeros in full on its redemption date.

3.4  Risk profiling of investment trust shares

  Despite the endeavours of Merrill Lynch in March 1999, there has been no universal risk rating system of individual investment trust shares to date. Private investors need to use their own resources to investigate the profile of their investment (or rely on analytics produced by the AITC on a monthly basis).

  In the case of zero dividend preference shares, market analysts and commentators alike used similar formulae to determine the risk profile of individual zero shares, until recently. These ratios are covered in the next section, however it is worth alluding to the general market views of the risk profiles of splits at the time in question.

  In considering the risk profile of any product, there is a fundamental decision to take: is risk related to:

    —    the probability of an event happening or not happening ie if we consider it extremely unlikely that a zero will fail to pay out in full then it should be considered to be low risk; or

    —    the worst possible result if that event does happen ie if a product would return all capital in full but provide no return, then it would be viewed as low risk, compared with a product where the entire capital could be eroded.

  Kestrel Research, in its Bulletin entitled "Split Capital Trusts and Zero Funds" dated April 2002 presented its understanding of risk in this way:

    "Myth Number Five: "Low Risk" means "No Risk"

    Consider the world of insurance. Most sensible insurance companies only accept those risks which they are able to evaluate. Events which are deemed to have a low (but not zero) probability of occurring (an earthquake in Tokyo, annuity rates falling below 10 per cent, repeated mass flooding, the destruction of the World Trade Centre) are often under-provisioned for. The logic goes like this: If an event has a very low probability of occurring, or has never happened in the past, then, for all practical purposes, we can ignore it. Wrong.

    No one can ever fully quantify all the risks associated with any financial venture for all time. Changes in interest rates, taxation, inflation, currencies, oil prices, good health, the birth rate, economics and confidence can all affect the risks associated with financial assets. In attempting to assess risks, some people will look to see how often something has happened in the past. Others prefer to concentrate, not on the probability of an event occurring, but, on the maximum damage that an event could inflict, no matter how unlikely.

    . . . Zeros are commonly regarded as low risk investments because, well let's be frank here, up until recently they always have been. Zeros still remain low risk investments where the underlying portfolios are blue chip and, crucially, do not have additional layers of gearing. Our industry faces a fundamental recurring problem. Innovative structures attract money and success breeds success. This leads to a progressive adulteration or creep such that when market circumstances no longer make the products attractive, certain providers will nevertheless continue to issue increasingly inferior produce for as long as people are prepared to buy them."

  Many commentators have also come to realise that splits cannot be assessed for risk as a class. Instead, their risk assessment should be based on consideration of a number of inter-related factors, such as the level of gearing, the nature and volatility of the underlying portfolio and the existence of cross-holdings. Such measures are however being applied with the advantage of hindsight. Fund managers, investment bankers, lawyers, advisers and the listing authorities alike all worked to a common assumption that some form of equity market growth could be expected from equity markets in each succeeding year, as had been the case for the preceding decades.

  More recently commentary from Merrill Lynch has been exploring the weaknesses of the split capital income share market. For example, Merrill Lynch's consideration of cross-ownership noted:

    "The market to date has apparently failed to interpret cross ownership correctly and as a consequence, the level of risk inherent in zero dividend shares extends from being low (some zeros are akin to high-grade bonds) to phenomenally high (akin to highly geared plays on equity markets). On creation, the perception was that all zero offerings were low risk investments (when compared with standard equity risk)."[1]

  In a second paper, Merrills summarised the position:

    ". . . Recent press comment has added to the uncertainty with sentiments ranging from "zeros are not risky because no zero has ever defaulted" to "zeros could become the next mis-selling case". Such extremes in pricing and opinion are undoubtedly a consequence of the diverse investment properties offered by different zero dividend shares. With this in mind we question the suitability of the current analysis used to value zeros and in particular the use of capital cover and hurdle rate as the main measurement of risk." [2]

3.5  Conclusions

  As the markets have continued to fall and the split capital investment trust sector suffer in particular as a consequence, the structure, management and marketing of split capital trusts has been challenged.

  The remaining sections of this paper consider in more detail some of the principal criticisms that have been levelled against split capital trusts, in terms of:

    —    The use of "cover" and "hurdle rate" as exclusive measures of risk (section 4);

—    The "barbell" strategy for management of the trust's assets (section 5);

—    The "magic circle" of managers and cross-investment (section 6); and

—    Gearing (section 7).

4.  COVER AND HURDLE RATE AS MEASURES OF RISK

4.1  Introduction

  In recent commentary, much has been written on the subject of "cover" and "hurdle rates" in connection with the split capital sector. These terms relate to calculations used to analyse risk attaching to zeros. The purpose of this section is to consider what these terms mean and how they have been used both historically and more recently in assessing the risk profile of this type of investment. The use of "cover" and "hurdle rate" have been the standardised tools used by analysts and the AITC alike until very recently.

4.2  Cover

  Cover, or the cover ratio, is a measure of how well the redemption price of a zero is covered—ie the probability that it will be paid out in full on the redemption date.

  Basically what we are trying to achieve is a ratio of total assets of the fund to the charge of the zeros to measure how well they are covered. This will normally come up with a ratio where one expresses that they are exactly covered, a number less than one that they are not fully covered and greater than one that they are covered with some degree of surplus.

  There are two measures of "cover" in use. One looks at the impact of cover including debt and all prior charges and relates to the specific share, the other reflects the inverse of the hurdle rate.

4.3  Hurdle Rate

  The hurdle rate, also known as fulcrum point, measures how much the fund's assets can drop each year, over the life of the fund and still pay out the redemption price of the zeros in full.

  It is obviously correlated with the cover ratio and if the cover ratio is greater than one the hurdle rate will be negative, showing that the fund's assets can drop a certain amount each year and still be large enough to pay out in full.

  Conversely, if the cover ratio is less than one the hurdle rate will be positive, indicating that the fund's assets will have to grow by at least that much each year to be able to pay out the redemption price in full.

4.4  Recent consideration of cover ratios and hurdle rates

  Since the failure by certain trusts to pay out in full to zeroholders on redemption, many analysts have criticised the use of cover ratios and hurdle rates as measures of risk. For example, it has been argued by Merrill Lynch that the detailed methodology used to calculate cover is crucial and without full disclosure of this to, for example, the investors or their IFAs, it is difficult to identify the level of risk associated with the product:

    "It is evident that mis-pricing in the sector is inevitable if asset cover and/or hurdle rate is seen as the sole representation of risk."[3]

  Merrill Lynch's conclusions were that:

    —  Cover and hurdle rate are, in isolation, wholly inappropriate measures of risk.

    —  Bank debt and increasing portfolio volatility are major risks facing zero investors.

    —  The application of derivative pricing in the sector is the only form of analysis that provides a rational assessment of risk and a rational assessment of relative value.

    —  Full disclosure (on structure and portfolio) is essential if the sector is to be fairly priced.

  Merrill Lynch also said:

    "The typical ways of looking at zero dividend shares ie, cover and hurdle rate as a measure of risk and GRY as a measure of return are hopeless in the face of sizeable cross ownership. This is more apparent where zeros have been issued on markets that have since fallen in value (and so the zeros have no capital cover)."[4]

  Merrills' new analytical model attempts to show the shortcoming of the traditional analytical tools in assessing the risk in zeros, particularly when uncovered.

  However, zeros have been around since 1987 and until April 2002 all of them paid out in full on the redemption date. Consequently, questions over cover and hurdle rate have not been relied upon heavily by investors or IFAs in selecting zeros above other forms of investment. For example, Bill Fowler, Senior Investment Strategist at Hill Osborne & Co (stockbrokers) wrote in June 1999:

    ". . . Most zeros are adequately or very well covered, rendering them relatively low risk. Advocates will proclaim the fact that, since zeros were invented 20 years ago, there has not been any issue that has not repaid its full price on redemption. This is an enviable track record . . ."

  With such impressive past performance and clear evidence of high yields in the sector, cover and hurdle rates were considerably less important to the investor than currently. This is demonstrated by the fact that until recently, there was no standard method of calculating the cover ratio or hurdle rate. Over the last 30 years, various methods have been formulated and used by City stockbrokers and the AITC and they all aimed to provide the same simple measurement in slightly different ways.

  By way of example, when splits were first introduced, interest on loans was always paid out of the income account, but in recent years funds have taken to apportioning part of this cost to the capital account. This means that the fund's total assets at redemption will be reduced and hence this effect has to be taken into account when calculating the cover ratio. The different approaches for calculating cover and hurdle rates and the detailed analysis that underlie those calculations meant that it was extremely difficult for third parties to evaluate these figures to determine relative risk between different trusts.

  In her article "Devil in the detail" published in the Bloomberg Money Guide in May 2001, Clare Gascoigne quotes David Crouchen, sales director for Exeter Funds Managers:

    "Where can the ordinary member of the public get access to the kind of detailed research you need to compare, say, hurdle rates? It's very difficult—a lot is only made available to institutions or specialist independent financial advisers. The average, general purpose independent financial adviser won't be receiving research showing the level of gearing. But you can't make a decision without it."

  Moreover, the exclusion of gearing from many cover and hurdle rate calculations meant that potential investors could assess the true risk of a particular trust only with the help of additional information on gearing ratios. Clare Gascoigne goes on to explain:

    ``Finding out what level of gearing an individual investment trust has, however, is difficult for the ordinary investor. Although the [AITC] publishes gearing levels of ordinary investment trusts in its monthly statistics pack . . . it does not include a figure for splits. It does offer that information on its website . . . but even then only for the last ranking class of share on wind-up.

    Instead, investors must make a judgement based on a number of variable factors: the asset cover (the higher the better); the hurdle rate (the lower the better); the number of years until wind-up (the longer a trust has to go, the more risks it can take); and the underlying investments of the trust (the riskier the sector in which it invests, the more dangerous it is)."

  It was only once the prospect of zeros not paying out in full became real that commentators started to analyse the use of cover and hurdle rates in any detail; it was only earlier this year that the AITC agreed a standard approach to the calculation and reporting of cover ratios.

4.5  Conclusion

  Much has been written recently criticising the use of cover and hurdle rate as measures of risk for zeros. However, this analysis has the benefit of hindsight in the context of falling markets and the failure of some zeros to pay out in full on the redemption date. Prior to last year, where the markets were strong and no trust had ever failed to pay out on zeros in full, considerably less importance was placed by market analysts and financial advisers on cover and hurdle rate. Instead, many considered that the existence of high yields and the track record of the sector were sufficient indication of zeros' low-risk status.

5.  THE BARBELL STRATEGY

5.1  Introduction

  Most investment trusts, including splits, hold a single focused ("bullet") portfolio of equity investments. By contrast, "barbell" trusts hold two distinct portfolios of investments—a low yielding growth portfolio and a high income portfolio. The income portfolio is typically financed by debt, while the growth portfolio is financed by equity, and this structure is designed at issue to provide the underlying growth from the equity portfolio in addition to a high yield.

  Several barbell trusts have more than one class of share capital and are therefore splits but it is technically incorrect to describe all barbells as splits. Gearing levels in these funds are typically over 100 per cent, which should be contrasted with most conventional trusts, where gearing is more commonly in the region of 10-15 per cent.

  A good summary of what makes a barbell trust can be found in Dr Andy Adams' and Robin Angus' article about barbell trusts in April 2001 Professional Investor Magazine:

    "While a good number of barbells are splits, most splits are not barbells. It is the division of the assets side of the balance sheet into two separate portfolios, together with a high level of gearing, which makes a barbell."

  The article went on to say:

    "In our view the "barbell" concept is fatally flawed. But the split capital concept has proved its worth over many years. The FSA must not confuse barbells with splits. If additional regulation is required, it should be applied uniformly across the entire UK closed end fund industry."

  In its publication entitled "Barbells unbalanced" of July 2001, Cazenove reported that £9.2 billion of total assets had been 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.

5.2  Advantages of the barbell strategy

  There is an element to which the barbell strategy is a natural development from the structure of splits. As an investment trust, splits require a regular income in order to satisfy the income shareholders, while also maintaining good capital growth in order to meet the entitlements of zero holders and the expectations of the capital shareholders. To this extent, therefore, it is necessary for any manager of a split's portfolio to balance the portfolio between income producing investments and those that will generate capital growth. Given that the directors of the trust must adopt an investment strategy that is to the benefit of its shareholders generally, having express regard to the dual nature of the split's profile is clearly appropriate.


  Much commentary on "barbells" has recently centred on fall in the income portfolios, many comprising corporate bonds and split capital income shares. It is important not to underestimate the expectations of the underlying equity asset base that was expected to offer the growth component from the portfolio.

  The chart above, produced by HSBC in March/April 2000, demonstrates the weighting of the split capital sector relative to other equity sectors worldwide. Relative to the World Index, the splits sector was overweight in the UK equities, thus concentrating portfolio risk. The aim of many barbells was to diversify this growth risk away from UK FTSE 350 shares into different equity asset classes, such as US equity, UK smaller companies, technology shares and Far Eastern shares for example.

  The majority of fund managers and investment banks during the 1999 and 2000 period were confident of continuing returns from equity markets.

  Whether the manager chooses to manage a single portfolio balanced between income and capital growth or expressly divides the portfolio into two notional asset pools, the overall investment strategy would be similar. The expectation would be to invest the portfolio prudently to achieve both income and capital growth with the added security that if one part of the portfolio suffers a fall in markets, the other part may hold up the trust overall.

5.3  Disadvantages of the barbell strategy

  The disadvantages of barbells are generally related to a number of factors that could affect any split, whether or not it followed the so-called barbell strategy.

  First, many barbell trusts requiring restructuring have chosen to increase gearing through bank borrowing. As highly geared trusts, therefore, barbell trusts are open to the same risks as any other highly-geared trust. This is discuss further at section 7 below. Moreover, if barbells hold cross-holdings in similarly highly-geared trusts, the risk of enhanced losses is greater. The effect of cross-holdings is considered at section 6.

  Secondly, barbells have increased in number dramatically since 2000-01, as noted above. Consequently, they have suffered the unfortunate timing of having been launched at the beginning of market decline, a decline which has been more marked than, possibly, could have been expected, particularly since September 2001. Barbells have as a class, therefore, merely evidenced the recent decline in the markets that has affected all forms of market investment.

  Thirdly, in some cases barbells have suffered from the market decline to a greater extent than other investments. For example, where a barbell trust invests in the technology sector, it might be an appropriate management strategy to invest in direct equities to provide capital growth, while also investing in bonds to provide income. However, the nature of the recent market decline has been to affect both the equity and bond markets. Consequently, the perceived advantage of dividing the portfolio so that one part might support the other in adverse market conditions has not materialised.

5.4  Conclusions

  The barbell strategy has become increasingly popular for the management of split capital trusts over the last few years and should be viewed as an appropriate strategy to match the requirement of the split capital trust to balance both capital growth and income.

  However, the timing of this increased interest in barbells has coincided with a general decline in all major equity and bond markets. Consequently, it would be too easy to align the current market losses with the barbell strategy itself. In reality, the losses suffered by barbell trusts are, as with any split capital trust, caused by the inter-relationship of various factors such as gearing on falling asset classes and to a lesser extent portfolios in geared investment themselves: split capital income shares or "cross investment".

6.  THE MAGIC CIRCLE AND CROSS INVESTMENT

6.1  Origin of the expression, the "magic circle"

  The phrase "magic circle" is generally taken to refer to split managers that invest in other investment companies. 10 years ago, there were far fewer fund managers managing splits and "fund of fund" splits predominated. However, during the low yield environment of the late 1990s, the split capital sub-sector grew quickly from being a small constituent part of the investment trust market with relatively few participants, to a large part of the investment trust sector (see section 2.2 above).

6.2  Cross-investment

  Cross-investment is used in this paper to refer to the ownership by a trust of a portfolio of income shares in other splits to boost portfolio yield. It is possible for cross-investment to occur by trusts holding zeros in other trusts. However, this is less common.

  While the term may suggest that trust cross-investment only occurs where, for example, trust A owns shares in trust B and trust B owns shares in trust A, this is a much narrower definition that may confuse certain of the issues for co-investment generally.

  Of course, in practice, it may be the case that the narrower form of cross-investment does occur. For instance, it is quite possible for the following scenario to come about:


  In this example, it could be said that Trust A, in effect, owns its own shares. However, the number of intermediate owners means that:

    —  The manager of Trust A is highly unlikely to know that there is this form of cross-investment;

    —  It would be extremely difficult to "engineer" this form of cross-investment deliberately to affect the split capital sector; and

    —  The possible disadvantage of Trust A's portfolio of owning its own shares is significantly diluted by the potential benefits of exposure to the performance of the underlying investments in Trust B (in which Trust A's manager has knowingly invested) and, indirectly, those of Trusts C and D.

  "Cross ownership" and investment trust companies investing in income shares or other investment trusts have become incorrectly intertwined in the recent debate. "Fund of funds" has long been a feature of the split capital market, offering diversification, asset allocation and tax advantages over a single portfolio.

  Nigel Sidebottom of BFS in the Crédit Lyonnais Investment Trust Yearbook explains some of the problems:

    "Press reporting on the split sector has implied that an investment in another investment company is in itself a cross holding. This is of course nonsense. If Fund A invests in Fund B, then it has made an investment in another investment company. That investment only becomes a cross holding if Fund B then invests back into Fund A, either directly, or through a series of other investments, eg Fund B invests in Fund C, which invests in Fund D, which invest in Fund A. A trust with high exposure to other trusts may have no cross holdings."

  The impact of cross-holdings to recent falls and the potential for a spiral has to be qualified and this is in fact noted in the original July 2001 Cazenove report. Sidebottom explains:

    "This impact, in many cases, will not be as severe as many might think. To examine the potential effect, let us assume Trust A and Trust B are both conventional trusts with no gearing and their shares trading at NAV. They each have a 10 per cent cross holding in the other. Trust A's share price falls 10 per cent. This will cause the NAV of trust B to fall 1 per cent. Assuming Trust B's share price follows its NAV the resulting 1 per cent decline in share price will cause a further 0.1 per cent fall in A's NAV (in addition to the 10 per cent decline that triggered it). Assuming Trust B's share price follows its NAV the resulting 1 per cent decline in share price will cause a further 0.1 per cent fall in A's NAV (in addition to the 10 per cent decline that triggered it.) We can conduct a second iteration, which will reduce A's NAV by another 0.001 per cent. By the third iteration the impact is de minimis."

6.3  Advantages of investment in the split capital sector

  As discussed above, the nature of a split trust means that a manager has to adopt a strategy that produces both capital growth and income. Against this background, the income shares of other splits offer an appropriate risk profile to achieve income for the trust as part of its overall portfolio. In fact, there are relatively few investments that are able to offer the manager the same or an equivalent combination of income and risk as offered by the split capital sector. One possible alternative is a corporate bond, which already forms a part of many split portfolios. However, while offering equivalent yields to the split income shares, coporate bonds do not offer capital growth in the secondary market and lay open the portfolio to their own default risk.

  Recognising the split capital sector as an investment type in its own right therefore has served trusts well over the years. For example, in the mid 1990s, split capital funds of funds were a highly successful investment and supported dividend payouts.

6.4  Why has cross-investment been criticised?

  Brewin Dolphin Securities wrote as recently as 19 March 2002, "Cross-holdings, by which we mean trust shares held by other trusts, existed in July 2001, but had been there for years. No law or fundamental economic reason restricts the holding of such portfolios." (Brewin Dolphin, among others, analysed the effect of cross-holdings in June 1997 and again in November 2000.)

  In reality, as at 31 March 2002 only 15.43 per cent of the sector as a whole was invested in split capital investment trusts. 73.59 per cent of the sector was invested in equities and bonds, and a further 7.25 per cent was invested in cash.

  With the decline in markets generally and the more frequent default of split trusts as a consequence, split portfolios invested in other splits have suffered alongside other investors. Consequently, the effect of market decline on the overall value of the portfolio has been enhanced by applying across the portfolio, whether it is invested in equities, corporate bonds or other splits. As Merrill Lynch has explained:

    "Cross ownership imposed through traditional split capital structures gives rise to acute gearing and increases the embedded fund expenses at the outset. Zeros issued on such portfolios are unlikely to be low risk investments. Split capital structures with high levels of cross ownership can only repay zero dividend holders when stock markets rise dramatically, despite the fact that the zeros may be covered at the outset."[5]

  In addition, it is suggested by commentators that cross-investment concentrates market weaknesses in the splits sector such that splits invested in other splits are affected to a greater extent by issues such as portfolio diversification and liquidity and dividend cuts. Considering these in more detail:

    —  Increases in cross ownership tend to increase the level of correlation between the different constituent investments of the split's portfolio. Increasing correlation increases the risk in a portfolio (by reducing diversification), as all the constituents tend more to move in the same direction, exaggerating any market moves.

        It is thus argued that cross-ownership increases both the volatility and the correlation of the underlying portfolio. Consequently, the market decline experienced more recently has had a more marked effect on splits where high levels of cross-invesment are present.

    —  With high levels of gearing in a falling market, any income achieved by a trust will most likely be used in paying borrowing costs, reducing the amount available to income shareholders. If, as a result, the investee split elects to make a dividend cut, this can have a marked effect on the value of the investing trust. When faced with a dividend cut (either through the core portfolio or cross-owned income shares) the portfolio manager can do one of two things:

      (i)  Reflect the cut through their own income shares (thus reducing the yield).

      (ii)  Attempt to maintain the dividend and fund the cut by increasing the portfolio yield.

  The course of action taken by a fund manager is fundamental to the security of a zero dividend share. In summary, in (i) there will be little effect on zeros, provided that any effect on the net asset value is not so marked as to affect cover levels. In (ii), it will almost certainly have a negative impact on the security of the zero shares. The portfolio will need to be restructured to increase the portfolio yield which may involve converting capital into income.

  In both of these examples, it is not the fact of cross-investment that leads to decline in values of the investing split. Instead, it is the manager of the portfolio who has to determine, in line with the strategy set by the directors of the trust, the appropriate action to take. In the first case, a portfolio with high levels of correlation and poor diversification will suffer just as badly (or worse) in a falling market than a split that has a moderate level of cross-investment balanced with a diverse portfolio with low correlation. Similarly, in the second case, the manager of the split may elect to follow option (i) by implementing its own dividend cut, with minimal effect on the levels of capital available to meet the claims by zero holders.

  One further criticism of cross-investment has been the allegation that managers have colluded deliberately to influence market prices in the splits sector.

6.5  Allegations of collusion

  As explained above, it makes good investment sense for a manager of a split to acquire high yielding income shares, as these fall squarely within the trust's requirements. One source of such shares is splits issued by other managers. The relatively modest historical scale of the sector inevitably meant that there were relatively few managers involved ten years ago, and so the range of splits available for investment was more limited than it is today. However, to categorise this as something collusive or improper is quite wrong.

  Moreover, the market prices of shares in investment trusts are independently determined by market makers in the light of supply and demand and following strict rules laid down by the London Stock Exchange. There are a number of brokerage houses that operate in the sector and up to seven competing market-makers that set prices for shares in the secondary market. Primary prices, for new issues, are outlined in the issuing prospectus. These prices are in no way determined by other managers and, therefore, it is highly unlikely that cross-investment would directly affect the pricing of individual trusts or the sector overall.

6.6  Conclusions

  Cross-investment by split managers can have a tangible benefit to the strength of the portfolio and income shares should be viewed as an investment category in their own right, forming part of a balanced portfolio requiring both income and capital growth. The historical success of funds of funds in the splits sector demonstrates that appropriately managed cross-investment in strong market conditions can benefit the investor.

  However, the potential side-effects of cross-investment in terms of enhancing the effect of gearing, increased correlation and loss of portfolio liquidity have been experienced more recently in worsening market conditions. Again, therefore, it is not necessarily appropriate to criticise cross-investment per se, but rather to recognise the interrelation of various factors that have affected the sector in recent months.


7.  GEARING

7.1  Introduction

  Unlike unit trusts, investment trusts can borrow money and invest the proceeds. This is known as financial gearing. Typically the level of gearing of a particular trust is described as a ratio—gearing factor of 120 means that a trust with equity of £100 million has £20 million debt (bank borrowings). Launches over the past couple of years typically had heavy gearing, for example £100 borrowing for every £100 raised. But while this is high, most homeowners aged 26 have a 5 per cent equity component and 95 per cent debt—the mortgage—in their house so it is not automatically appropriate to equate gearing with risk or as a contraindication to retail investors.

  Gearing is also a term used to describe the structure of a split capital trust. In a simple trust, typically each class of share is entitled to either all the income from the underlying portfolio or all the capital growth. If each class of share were issued in a 50:50 proportion, then the income share could be said to have double gearing. This use of the term gearing is generally referred to as structural gearing.

7.2  How gearing works in investors' interest

  The ability to gear can be beneficial when markets are rising as gearing can be used to enhance gains. This is because a manager can borrow funds from the bank at, say, 4 per cent and use the proceeds to purchase stock that will yield say 6 per cent. This is clearly beneficial to investors as it increases their exposure to equities and hence the potential return. This is also a tactic that has served investment trusts well up to nine or so months ago. As a share class, while zero holders are only entitled to a fixed return and would not, therefore, benefit directly from any gains enhanced through gearing, the overall return on the portfolio is equally important to zero holders. This is because by maximising returns, the manager also increases the cover ratio or hurdle rate for the zeros, which will directly affect the price of zeros traded in the secondary market. This has been widely recognised and endorsed:

    "Daniel Godfrey, the director general at the AITC, said the ability to gear the fund improved performance. `If the markets are going up over time, which they tend to do, gearing will add value. A recent report by Cazenove estimated that gearing added 1 per cent a year on average to the value of investment trusts,' he said."[6]

  While an academic financial commentator remarked:

    "The first purpose of this paper is to use split capital funds in order to examine if the `financial engineering' of a company's liabilities increases their value relative to the market value of their assets. We find that 11 per cent of extra value is generated. Perhaps this is not altogether surprising, as otherwise there would be no reason to develop such complicated structures in the first place. The second purpose of the paper is to pinpoint more precisely from where the extra value comes: is the result of having debt, separate shares for the dividend stream or a date on which the company will be wound up. It transpires that the prime/score split into dividend shares and capital shares increases fund value significantly, but only by an average of 1.3 per cent. A much larger gain in value of 5.6 per cent comes from levering the fund's returns wih debt: zero dividend preference shares do this in a tax advantaged way and so are found to be particularly good at adding value."[7]

  However as we have experienced recently, gearing can also enhance losses when a sector is falling. As Kestrel Research reported in a Research Bulletin of April 2000:

    "while cross share holdings (where trusts effectively own a portion of their own equity) do add to the effective gearing of a geared trust, they should not in themselves lead to a downward spiral in net asset value in the event of a fall in the underlying assets. It is the gearing upon gearing seen in barbell trusts in their income portfolios rather than the cross share holding risk per se which is linked to concerns about a systemic collapse."

7.3  Why has the impact of gearing become apparent only recently?

  Gearing is an effective management tool to enhance gains in a rising market and, until recently, has served to set the investment trust sector apart from other forms of investments by providing competitive returns to investors. With a long term view of rising markets, this remains the case. As Rolly Crawford stated in February 2002:

    "And gearing has the obvious answer to enhancing returns in rising markets . . . An example of that, going back to the history of Second Alliance between 1950 and 1965, the NAV rose eight times, which was twice as fast as the rise in gross assets. And in times of falling markets, clearly gearing can be very damaging and in the aftermath of the crash in 1929-32, the NAV of Second Alliance fell by around 80 per cent . . . High-yielding stocks suffered very badly during the recession of the early 90s and split NAVs fell as well. The NAV of Scottish National capital shares was negative at the time for many months, though they were actually finally repaid at over 104p a few years later . . . Gearing is the greatest single factor contributing to the loss of value in the sector. Geared funds fall rapidly in falling markets, whether it is today or [the crash of] 1987 or 1980." [8]

  Over recent months, particularly since September 2001, the markets have fallen at an unexpected rate and the effect of gearing has compounded losses in the short to medium term. This is because, while the percentage loss compared with the total portfolio remains the same, the cost of borrowing must still be met out of the remaining asset value. In effect, therefore, the cost of borrowing accounts for a higher proportion of the remaining asset value, thus reducing the amount available to shareholders.

  An additional factor that has brought the existence of gearing to the fore is in the accounting treatment of the cost of borrowing. It is the responsibility of the directors of each trust to determine the trust's policy on the allocation of expenses either against the capital or revenue account. In simple terms, deducting the cost of borrowing exclusively from the revenue account benefits zero holders and capital shareholders, while deduction from capital account benefits income shareholders.

  International accounting standards have changed such that investment trust boards have to reconsider the allocation of borrowing costs. Whereas the cost of borrowing had previously been deducted from income account in the majority of trusts, there has developed an increasing practice to deduct from capital. Each Board has to make this decision based on a number of assumptions, including the future prospects of the markets, where is was anticipated the trust would obtain its returns. In practice, the effect of this decision has been to reduce the level of cover for zero holders.

7.4  Conclusions

  Gearing magnifies returns favourably or unfavourably in rising or falling markets. All split capital closed end funds are geared: either structurally or financially. The adverse impact of gearing on certain share classes in falling markets is not a new phenomenon. However the nature of gearing, and particularly now how flexible bank borrowings proved to be in adverse markets, is a topic of renewed interest.


8.  PRESS COMMENTARY

  8.1  The press coverage of splits has historically been positive and enthusiastic in relation to investments in zero dividend preference shares, and began to turn sour only in mid-2001. A historical survey of the financial pages presents the following:

    28 October 1995:

    "Only if your chosen trust puts in a truly disastrous performance will the zero holders' return be at risk." Guardian

    14 March 1998:

    "Zero dividend preference shares in a split capital investment trust are another safe option. These are shares which pay no dividends, have a finite life and a fixed yield. Consequently the return is guaranteed." Daily Telegraph

    21 October 1998:

    "The risk of less back at maturity than you invested in a zero is very small. Stock markets would have to fall through the floor." Daily Mail

    30 June 1999:

    "The risk on this is pretty low. A good idea for risk averse investors, for school fees planning and those approaching retirement." Daily Mail

    13 July 2000:

    "Historically, the volatility characteristics of portfolios of zeros have been very similar to gilts and significantly lower than UK equities . . . Indeed, since the first zero was issued in 1987, no zero has yet failed to be repaid in full." Money Marketing

    8 February 2001:

    "Zeros currently display more safety features than a Volvo." Money Marketing

    26 March 2001:

    "It is now widely accepted that clients who require low risk should have some exposure to zeros." Investment Adviser

    21 April 2001:

    "A meltdown of the splits sector remains a remote possibility, and so long as investors choose wisely, zeros will continue to be a low-risk way of wringing out a better return from your money than if you put it on deposit with the building society." The Times

  Then by the middle of 2001, more negative coverage began to appear in the financial pages, for example:

    11 August 2001:

    "Many investors . . . have been seduced by what they have been told is another safe investment. Zeros have been around for two decades and are often billed as a halfway house between gilts and equities . . . However, share prices of some zeros have fallen sharply—in some cases as much as 25 per cent—on fears that if stock markets do not recover, for the first time in their history, some may not have enough assets to repay their zero shareholders. As a result adviser R J Temple is advising its clients that zeros have moved up the risk scale. It rates them as a bigger risk than corporate bonds . . . `We feel that many investors may yet be unpleasantly surprised by what they have bought. A lot of the perceived protections in many of these investments are more illusory than real,' warns Temple." Financial Times

    10 September 2001:

    "But how safe are [zeros] now that markets are tumbling and split capital trusts are being forced to increase their gearing all the time? Well the answer is, not as safe as they once were . . . for the first time, there is a real danger that a zero may fail to return to investors the fixed sum it said it would . . . Aberdeen's run of form looks like it may be coming to an end. Two months ago it was forced to suspend the dividend of its European Growth & Income Trust which has run into dire straits after borrowing heavily to invest in telecoms bonds, and its technology fund, long a top-performing unit trust, has also suffered. There is a chance it may meet the repayment but it's not big. It would be best to steer well clear of Broadgate Trust and its zeros." Business a.m.

  The next day, terrorist attacks on the World Trade Center precipitated even greater troubles in the already falling world markets. By October 2001, Brewin Dolphin Securities commented on the press coverage of the split sector thus:

    "Manhattan on 11 September produced the tail spin and panic selling by private clients after an event which has no precedent and which was a complete surprise. The flames of greater client anxiety were then fanned by ignorant but often wilfully misleading press comment which has continued from August until [19 March 2002] when the Financial Times once more promoted bearish prognostications about the split sector against the more reassuring evidence . . . which is becoming apparent today . . . sensational and ill-informed press comment has been largely responsible for this situation and prolonged it to a stage where small shareholders have lost a lot of money quite needlessly."

9.  CONCLUSION

  Aberdeen Asset Management PLC is concerned about the level of confusion surrounding the debate on splits and is naturally anxious about the level of falling returns for many investors.

  We are working closely with trade bodies and FSA alike to help restore investor confidence.

  Aberdeen Asset Management has proposed a number of initiatives for the sector going forwards, including recommending increased transparency of reporting and a new risk rating system. It has also taken the lead in waiving fees and proposing other recovery initiatives for the sector.

  We would be pleased to supply any further information as well as Aberdeen's briefing document of 15 April 2002 and a monthly sector monitor. Aberdeen has established a consumer website at www.aberdeen-asset.com/splits where investors are able to source additional information about splits managed by the Aberdeen Asset Management Group. Aberdeen initiated and sponsors www.splitsonline.co.uk, a dedicated information site updated daily.





1   Merrill Lynch, 2001, Zero Dividend Preference Shares: The developing marketplace-a comparative analysis. Back

2   Merrill Lynch, 2001, Zero Dividend Preference Shares: Understanding the risks and how to price them. Back

3   Merrill Lynch, 2001, Zero Dividend Preference Shares: Understanding the risks and how to price them. Back

4   Merrill Lynch, 2001, Zero Dividend Preference Shares: The developing marketplace-a comparative analysis. Back

5   Merrill Lynch, 2001, Zero Dividend Preference Shares: The developing marketplace-a comparative analysis. Back

6   Daniel Godfrey quoted in Investment Adviser FT Supplement December 2001 at pp 16 and 19. Back

7   First written in October 2000, updated 2001, by Mr Gemmill of City University. Back

8   Address by Rolly Crawford, an analyst at ABN Amro Hoare Govett, at "The Regulation of Split Capital Closed End Funds", a one-day conference on 1 February 2002. Back


 
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