Select Committee on Treasury Minutes of Evidence


Annex G

ARTICLES BY ROBIN ANGUS AND ANDY ADAMS FOR WHOM THE BARBELL TOLLS—APRIL 2001

For whom the barbell tolls . . .

  ``The most notable piece of speculative [financial] architecture of the late Twenties, and the one by which, more than any other device, the public demand for stock was satisfied, was the investment trust or company."

  J K Galbraith, The Great Crash 1929, Pelican Books, 1975, page 72

  Attention-grabbing but slightly ominous words from J K Galbraith in a book all investment professionals should read. Investment trusts are, of course, still with us, and many of them are the souls of simplicity and caution. However, the public demand for investment trust stock in the UK is today being satisfied partly by the issue of trusts of a novel type—the so-called "barbell trusts". These are designed to offer their shareholders, at issue, the growth prospects of a fashionable investment area together with a good income. On the strictest definition of the term, three barbell trusts were issued in 1999 and 15 in 2000, raising £2.7 billion of new money in all—a figure that would double were a looser definition of "barbell" to be employed. Supporters of barbell trusts argue that they are an attractive way for income investors to gain exposure to growth sectors. We believe, however, that barbell trusts may be more costly and riskier than investors, especially retail investors, realise. As keen supporters of the investment trust sector our motive in writing this aricle is to increase investor awareness of the issues and risks involved.

What are barbell trusts?

  Most investment trusts hold one single portfolio of investments as backing for all their classes of capital. By contrast, barbell trusts hold two distinct portfolios of investments—a growth portfolio and an income portfolio. In pictorial form this structure can look like a "barbell" such as is used in weightlifting.1 The diagram illustrates the structure of one common type of barbell trust. On the assets side of the balance sheet are two portfolios, one of growth-oriented investments such as Japanese equities or technology stocks, and the other of UK bonds and high yielding investment trust securities. On the liabilities side of the balance sheet are bank debt and two classes of share capital. The zero dividend preference shares (zeros) are entitled to a fixed annual capital increment. The ordinary shares (often called ``income & residual capital shares'' in this type of structure) are entitled to all the trust's distributable income together with whatever capital remains after the bank debt and the zero dividend preference shares have been repaid.

  The structure shown in the diagram happens to be that of a split capital trust (split ie. a trust with more than one main class of share captial. However, barbell trusts and splits must not be confused. 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 barbell2.

How barbell trusts emerged

  The recent boom is new issues of split capital trusts is nevertheless bound up with the emergence of barbells. Why? One reason is that both splits an barbells typically offer at least one class of high yielding paper. While the yields available in both equity and fixed-interest markets have fallen sharply in recent years, investors continue to clamour for the high yields they have been used to for decades. So high-yielding equity securities such as those offered by barbells have found a ready market. Furthermore, investors and fund managers alike have grown accustomed to remarkably high annual total returns from equities—17.7 per cent per annum nominal and 10.7 per cent per annum real from the FTSE All-Share Index over the past 25 years (source: Datastream).

  This has had two effects:

    —  Investors in and promoters of new trusts assume continuing high returns. While the past is not necessarily a guide to the future, 25 years is a lot of "past"!

    —  Investors in high yield securities, anxious not to miss out on what they see a freely available capital growth, understandably are attracted to investments offering "high yield with a touch of equity", such as the ordinary shares of split captial trusts and barbells.

  Lastly, banks have of late been eager to lend to the investment trust sector, whereas until recent years it was uncommon for trusts to have significant amounts of bank debt. The bank know their lending is safe because there is ample collateral. It is very unlikely that a bank loan to a trust would be defaulted on, because the bank ranks first in order of priority and the bank checks the convenanted cover on the debt each month. Therefore, although bank lending inevitably increases the risk of capital loss to holders of lower-ranking classes of capital, the banks cannot be blamed for making large sums of money available. The Boards, not the banks, are responsible for trusts' borrowing decisions and how these affect shareholders.

  Barbell trusts may be more costly and riskier than investors, especially retail investors, realise.

Fees and expenses

  Initial and recurring costs to ordinary shareholders of barbells are much higher than may appear at first sight. First come issue expenses, which include a significant element of marketing costs. Issue expenses can be anything from 2 per cent to as high as 4 per cent of the gross capital sum raised by a new trust, including bank debt. So expenses expressed as a percentage of the starting net asset value attributable to the trust's ordinary shares will be every much higher.

  If ordinary shares reprsented 50 per cent of the gross capital subscribed incuding bank debt (as is the case for the aggregate figures shown in Table 1) and issue expenses were 4 per cent of the gross captial subscribed, the expenses would approach 9 per cent of the ordinary shares' starting NAV.

  If the ordinary shares were 33 per cent of gross capital and issue expenses gain were 4 per cent of the gross capital subscribed, expenses would be nearly 14 per cent of starting NAV. There are startlingly high percentages. Perhaps it is not surprising that such trusts often do not put a starting NAV of their ordinary shares "up front" in the Prospectus. Then there are management fees. These are typically 1 per cent of gross assets per annum. At first glance, the figure looks reasonable by today's investment trust sector standards and modest compared to the management fees for many unit trusts and OEICs. However, the key point is that again, management fees are charged as a proportion of gross assets rather than net assets. This includes assets financed by bank debt and zero dividend preference capital as well as by ordinary share capital. So the holders of the ordinary share capital may be paying management fees at the rate of 2 per cent or 3 per cent per annum of the assets actually attributable to them. By contrast with unit trusts, total expenses may be significantly higher than management fees alone. Fitzrovia, a company that specialises in monitoring expenses of funds, estimates that on average two-thirds of total expenses for investment trusts are represented by the management fees.

  Hence, other expenses could boost the figures quoted above to an annual 3 per cent or 4 per cent of the assets attributable to the holders of the ordinary share captial—a massive hurdle to clear before one even reaches the starting line. Finally, most barbell trusts hold shares in other investment trusts. So there are management expenses upon management expenses.

Accounting—the new flexibility

  The investment trust Statement of Recommended Practice (SORP) allows management expenses and debt interest to be allocated between income and capital in different ways. Hasn't this made the impact of costs and expenses less onerous?

  Not quite. In fact, the SORP raises as many questions as it answers. The SORP sets out the principle that mangement expenses and interest costs should be allocated in line with expected returns.[26] So if the Board expects 25 per cent of a trust's total return to come from captial, one would expect that it would charge 25 per cent of management expenses and 25 per cent of interest costs to capital. What, then, are we to make of those trusts, and there are many, which charge no less than 75 per cent of such expenses and costs to capital? It is clearly unrealistic to expect that 75 per cent of a trust's returns will come from capital if (as is not unusual) it has a total portfolio yield more than double that of the FTSE All-Share Index. We believe that the directors, whose responsibility it is to sign the Directors' Responsibility Statement in the Report and Accounts, should give this matter careful consideration. If some Boards go against the spirit of the SORP in charging to much to capital, others are not subject to the SORP at all. 13 of the 18 barbells referred to in Table 1 are not investment companies under Section 842 of the Companies Act and for them the SORP's writ does not run. Such companies tend to charge even more to capital than do Section 842 trusts—sometimes as much as 100 per cent.

Risks from bank debt

  Universal to barbell trusts, whether conventional or split captial in structure, is a sizeable layer of bank debt. This is quite new in the trust sector, where gearing was traditionally in the form of debentures or preference capital. The inclusion of bank debt in trusts' capital structures means that a major subscriber of capital to a trust now has the right to blow the whistle and demand either repayment or changes to the portfolio before the end of the game, regardless of the effect on the other subscribers of capital (the various classes of shareholder). This has already happened in the case of two barbells, European Technology & Income and Framlington NetNet Income. It could happen to others.

Misleading expectations

  "We remain nervous about some of the barbell portfolios underlying these funds. The growth portofolio 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 (née junk) bonds that are popular in some structures are quasi equity. The worst case scenario for investors is therefore a gowth 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 Trust Companies Annual Review, 10 January 2001.

A number of barbells are splits, most splits are not barbells

  These words, from one of the most respected brokers in the sector, are reminder of the portfolio risks run by barbell trusts. The most obvious risk is that of investing in a fashionable specialist area like technology. Whereas traditional splits tended to invest in a broad UK portfolio with an income flavour, follows of TMT over 2000 know only too well how risky it is investing in a single ``gowth'' area. However, high-yielding split securities and bonds can be risky too. It is therefore important not to be misled by the illusion of conservatism offered by the two portfolios of barbell trusts—and legally, of course, there is only one portfolio anyway. Assessment of risk for investment trust securities often involves looking at hurdle rates, which can be defined as the required annual growth rate of total assets to repay a given class of shareholder at the wind-up date. The hurdle rate does allow for the fact that the interest cost of part, and in some cases all, of the bank debt (and possibly other prior ranking capital too) is being met out of capital. However, a significant proportion of a barbell trust's assets will be held to generate income. Such assets may not preserve their capital value. Because promoters' and investors' expectations of rates of return from equities have been shaped by the experience of the bull market of the last quarter of a century, the hurdle rates for the ordinary shares of barbells may be perceived as being less demanding than they actually are. Yes, there will have been ``wealth warnings'' galore. But how many investors in the ordinary shares of barbells really expect to receive back significantly less than the captial they have subscribed?

The "Magic Circle"

  "As reverse leverage did its work, investment trust managements were much more concerned over the collapse in the value of their own stock than over the adverse movements in the stock list as a whole. The investment trusts had invested heavily in each other. As a result the fall in Blue Ridge hit Shenandoah, and the resulting collapse in Shenandoah was even more horrible for the GoldmanSachs Trading Corporation."'

J K Galbraith, The Great Crash 1929, Pelican books, 1975, page 145.

  Translate today's so-called "Magic Circle" of split capital trust mangers (ie those whose trusts hold shares in one another) back to the Wall Street of 1929 about which J K Galbraith wrote, and it is easy to see what the worries are.

  To begin with, cross-holdings make it hard to disentangle the ownership of these trusts. It is also very difficult, if not impossible, to pin down where unit trusts managed by fund mangement groups within the "Magic Circle" hold shares in them. So there is a problem of accountability and transparency. Who owns What? But of even greater importance is what the inter-related structure of cross-holdings could lead to in a falling market. The risks created by geared trusts investing in other geared trusts are very real. Substantial price declines in the ordinary shares of some individual barbell trusts might all too easily become a self-feeding downward spiral as the net asset values of the ordinary shares of other trusts that held them fell in their turn. Confidence in barbell trusts in general could thus ebb away, causing still further price declines in their ordinary shares. If this happened, many retail investors who were direct holders of such shares would be disadvantaged and it is inevitable that their confidence in the investment trust sector as a whole would suffer.

Conclusion

  If barbell trusts started to unravel, confidence, in the investment trust sector as a whole would be affected by the adverse publicity. The ordinary shares of barbell trusts are also more costly than some investors assume, in terms of fees and expenses deducted from net asset value. Because barbells are complicated and difficult to understand, they should put more emphasis on communicating their investment characteristics to investors. In particular, there is an urgent need for the significant risks and expenses involved to be spelt out more clearly in their Prospectuses and Report and Accounts.

  Andy Adams is Director of the Centre for Financial Markets Research, University of Edinburgh and Robin Angus is an Adviser to the Centre.1 The term "barbell", in a financial context, orignated in the bond market. "A spread or portfolio position made up of short-maturity and long-maturity fixed income securities with nothing in the middle." P Moles and N Terry, The Handbook of International Financial Terms, Oxford 1997.2 For a lucid exposition of the split capital prinicple see "Dual Purpose Funds" by John Newlands, September 2000, Professional Investor (pp 14-17). For unit trusts on average there is roughly a 90 per cent/10 per cent split for management fees vs other expenses.4 Other (non-mangement) expenses in most cases are charged to revenue account. The uplift in zeros each year is taken to capital account.

  "How many investors in the ordinary shares of barbells really expect to receive back significantly less than the capital they have subscribed?"



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


 
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