Select Committee on Treasury Minutes of Evidence

Annex F


  Split Capital Investment Trusts: Just too close for comfort?: The split cap managers: Jean Eaglesham finds a "magic circle" at the centre and wonders if this is entirely healthy:

Financial Times; 28 November 1998

  It is an image transformation of which any spin doctor would be proud. Split capital investments trusts, once an obscure and sleepy backwater of the trust sector, are now portrayed as a sought-after investment that could point the way to the sector's survival. But critics claim this renaissance is at least in part illusory. They believe that some private investors may be hurt as a result. Splits are on a money-raising roll, mainly because there are few other sources of high yieds for income-seeking investors. Their structure means investors can get shres that offer either a very high income or a potentially high capital return (see "Split cap formula" this page).

  The falling rates on gilts, bonds and deposits have increased the attraction of the pre-tax yields of 10 per cent or more paid by some splits' income shares (see "Split cap performance"). "You name it, the sources of income that used to be relied upon have dried up," says Chris Whittingslow at Exeter Investment Management, one of the big split cap managers. "You are left with splits and quasi-splits as the only place whre you can easily find high income." Split cap managers appear confident that this influx of money will continue.

  Chris Fishwick, at Aberdeen Asset Management, says: "I predict the sector (which contains about Pounds 5.8 billion of assets) will double in size in the next three years." But critics question whether the growth of the sector is being inflated artificially—and if private investors really understand what they are taking on.

  The concern centres on a small "magic circle" of split cap managers who hold stakes in each other's apprarently rival funds. The biggest three split cap managers—Aberdeen, Exeter and BFS Investments—are at the centre of the circle. The diagram shows the position for just two of these managers, but the web of cross-holdings stretches across the sector. Each member appears keen to help the other. Indeed, just under half the Pounds 40 million raised recently by Exeter for its Enhanced trust came from the other two groups. Even so, the managers stress that there is no collusion. "We don't get involved in the area of `You have a few of these, we have a few of those'. . . it would be unduly jaundiced to say there's a gang of three in charge," says Whittingslow. "I don't think it's entirely surprising the large players turn to one another as sources of the very high yield that clients are clamouring for." But the technique used to generate that income, known to insiders as "pig on pork", remains highly controversial. Some splits operate as a type of fund of funds, building at least part of their portfolio by using shares in other splits.

  This has raised fears of a "pack of cards" effect. The easiest way to understand this is to look at a couple of typical trusts. Aberdeen High Income (AHI) owns 10 per cent of the ordinary shares of Dartmoor (one of Exeter's trusts) which, in turn, owns 7 per cent of the ordinary shares of AHI. Suppose Dartmoor hit an extremely bad investment patch and its ordinary share price fell significantly. The fall in the value of the Datmoor shares held by AHI might affect the price of its own ordinary shares. This could, in turn, hit Dartmoor, setting off a domino effect. Splits' defenders scoff at such concerns. "On the surface, it's very easy to say `shock scandal'. But it's scaremongering and drivel," says Rolly Crawford , an analyst at ABN Amro Hoare Govett. He argues that most of the fund of fund-style splits are buying into other trusts to get income, rather than heavily geared capital growth, and should prove relatively resilent to stockmarket movements as a result. He also makes the point, echoed by the fund managers, that most of the big splits have very diversified portfolios, which reduces their dependence on other managers. For instance, the holdings of the five Aberdeen trust in BFS Income and Growth, shown in the diagram, account for less than 2 per cent of each trust's market capitalisation. This argument is backed by an analysis of the four trusts with the highest degree of income share overlap, carried out last year by stockbroker Brewin Dolphin Bell Lawrie. It suggested that only about 13 per cent of their combined gross income was recirculated—and so at risk—if the chain between them collapsed.

  But not everyone is entirely convinced. "Quite clearly, the private clients holding these pieces of paper don't understand the underlying risks," says one analyst. "True, most have come via (independent financial advisers), but how many of those IFAs understand either?"

  Split Capital Investment Trusts: A trade-off between risk and reward: Split cap performance:

Financial Times; 28 November 1998

  Split capital trust have had a good run recently—and, it seems, the higher the risk, the better the results, writes Jean Eaglesham. The figures for some trusts appear at first glance to defy the investment truism that you can have either a high income or a decent capital return, but not both. Aberdeen Preferred's shares, for example, which have a pre-tax yield of more than 12 per cent, increased their capital value by 48 per cent in the year to 31 October. Dartmoor achieved a similar feat: the shares yield over 9 per cent, yet increased in capital value by more than 40 per cent. Split caps which have conventional portfolios, rather than investing at least some of their assets in other split caps, suffered by comparison. The ordinary income shares of Second Scottish National, which yield more than 10 per cent, fell slightly in value over the year. Conventional trusts also lagged, as the chart shows.

  Stockbroker Brewin Dolphin, which sponsored the launch of Aberdeen Preferred and so has a vested interest in its success, maintains in a reasearch note published this week that the figures demonstrate the vitrues of high yields and high gearing. "The use of gearing as high as 50 to 60 per cent is to be encouraged, rather than the reverse, particularly as the cost of borrowing money is decreasing," it says. Brewin Dolphin contrasts the "high returns" from the likes of Aberdeen Preferred with the "woeful performance of large, under-geared and low-yielding (conventional trusts), which we liken to beached whales". The broker also points out that split caps appear to have a clear edge over their conventional cousins in terms of drumming up demand from both private and institutional investors.

  The key indicator of demand—the average discount between trusts' share prices and the value of their underlying net assets—is only about 3 per cent for splits, compared with 13 per cent for conventional trusts. Brewin Dolphin concludes: "The trust industry may be adept at identifying its apparent problems but it is obviously unwilling to recognise a solution (high-yielding, highly geared splits) even when one is staring it in the face." Investors, however, should take these arguments with a hefty pinch of salt. According to Michael Wrobel at Gartmore, which managed Second Scottish National, comparing the performance of trusts that invest in other trusts with that of normal splits, let alone conventional trusts, is "comparing apples and pears . . . Aberdeen Preferred is a very unusual animal with very high gearing". Anyone who is impressed with the recent outperformance of the specialised splits should bear in mind that gearing can have a dramatic effect when markets are going down as well as up. "It's a risk/reward trade-off," says Simon Moore, at Williams de Broe.

  This broker's figures show that the ordinary shares of Aberdeen Preferred, for example, will rise—or fall—by 10.3 per cent in value for every 5 per cent movement in the stock market. The effect is even more marked for Geared Income trust, where every 5 per cent market movement produces a 13.1 per cent change in the shares.

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