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What are ‘split capital’ investment trusts?

This is Gavatar’s fourteenth beginners’ video guide to investment trusts. See ‘related news’ for previous videos in the series.

Can’t watch now? Read the script

There’s a small band of investment trusts known as ‘split capital’ investment trusts.

‘Splits’ get their name because they offer more than one share class to investors. That’s different from most investment trusts and companies which have just one class of ‘ordinary’ shares.

The idea behind splits is that while their share classes invest in the same assets, they can offer different amounts of capital growth and income to investors.

The most basic splits issue two share classes: one offering steady capital growth but no income; and one offering a mix of growth and income.

The first type is called the ‘zero dividend preference share’, or ‘zero’, for short.

As the name indicates, zeros don’t pay dividends but offer a predetermined level of capital growth over a fixed period of time, often seven years.

For example, in 2017 a new split launched to invest in UK smaller companies. It offered new zeros at 100 pence each which it intended to grow to 127.35p by 2024.

That’s equivalent to a ‘gross redemption yield’ or annual return of 3.5%.

It’s not a huge return and there are no dividends but as ‘preference’ shares the zeros will be at the front of the queue when the trust winds up and distributes its assets to investors. The return is fairly secure but not guaranteed.

Alongside the zeros are the ‘ordinary’ shares. These receive all the income from the trust’s investments, including the portion that would normally have gone to the zeros. As a result they can pay higher dividends than conventional trusts.

The ‘ordinary’ shares also get any capital growth left over once the zeros have received their share at wind-up.

Splits talk about ‘hurdle’ rates. This is the annual rate of growth required for the zeros to hit their target, or for ordinary shareholders to get back the original capital of 100p per share.

Hurdle rates for zeros can sometimes be negative which sounds strange but all it means is that there is enough money in the bag already to pay their targeted return.

For example, the split we looked at got off to a good start. By 2018 its zeros had a hurdle rate of minus 20%. In other words the trust’s assets could crash by 20% a year for six years and still repay the zeros.

That’s good news for the zeros and the ordinary shares whose hurdle rate was just 1.2%. That meant their assets only had to grow by 1.2% a year by 2024 to ensure they could repay the 100p per share with which they started. In the meantime they received a growing dividend.

Some splits go a step further and offer a third class of ‘capital’ shares! These higher-risk shares get any capital growth at wind-up that doesn’t go to ordinary shareholders.

As a structure, splits are riskier than conventional trusts. Instead of taking a loan from the bank, splits effectively borrow dividends off their zeros to give to the ordinary shares. Borrowing is a form of gearing which is why trusts are described as ‘highly geared’.

There used to be far more splits than today. Many collapsed in the splits crisis at the start of the century when a stock market crash and holdings in other splits trapped these highly-geared funds in a downward spiral.

Today’s splits are safer and better designed but they have quite a history.

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