SNAPSHOT: Investment Trusts

SNAPSHOT: Investment Trusts

The impact of recent market volatility has spread across asset classes and investments and is a big concern for investors. In the closed-ended space, some trusts that employ gearing have had a rocky time as this strategy amplifies the impact of market movements upon performance.

Many associate gearing with bank debt, but it can also be achieved by adopting a split capital structure. A ‘split’ separates the capital structure into two or more different types of shares, hence the name. Often the objective in doing this is to enhance, gear up or leverage the return earned by ordinary shareholders.

Split capital companies try to take advantage of the flexibility of capital structures to create new opportunities for investors with different risk and reward characteristics than ordinary shares. The most common type of such a firm is one that includes zero-dividend preference shares (ZDPs) within its capital structure.

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ZDPs are shares that will be redeemed at a fixed price at some defined point in the future – provided that sufficient assets are available. While they are not entitled to receive dividends themselves, the financing that they can provide to the ordinary shares boosts the overall dividends available.

Put another way, because a trust is able to generate income for its ordinary shares using the entire portfolio, and because the ZDP shares do not draw the vehicle’s income, the ordinary shares end up with a higher dividend. The quid pro quo for this is that the capital value of the ordinary shares is geared by the ZDPs, so moves in the value of the underlying portfolio are amplified.

Some advisers may be wary of split capital trusts, as excessive gearing, and indeed the wrong type of gearing, saw the sector suffer in 2000 when the market fell.

In addition, some of these vehicles were investing in each other. This led to allegations of a ‘magic circle’, which implied that this investing was in the interests of fund managers rather than investors, but amplified the damage caused by the fall in value of some trusts in 2000.

The wrong type of gearing meant that some of these split capital funds were gearing themselves with bank debt. In falling markets bank debt is much less forgiving than gearing using the capital structure, because bank debt comes with covenants.

Many funds found that as the value of their assets had fallen, the asset cover covenants – the ratio of assets to bank debt – were breached. These funds were forced to sell assets into the bear market to pay down or pay off their debt and some went bust.

As the sector has matured, and following the introduction of rules designed to prevent a recurrence of the problem, there are now few cross-holdings between splits. There is also much less bank debt in the split capital structure, which makes balance sheets more robust.

The flexibility of the closed-ended structure means that gearing can be changed to suit the market environment and the particular trust’s circumstances.