Make-ups to measure

Split-capital investment trusts are for the investor with a specific purpose in mind. Fiona Monro explains how they work

ARE you looking for steady income with the prospect of capital growth over the long term? Or do you require a lump sum in, say, five years with no income in between? Or perhaps you are looking to squeeze the maximum amount of income out of limited capital.

If the first option sounds like you, then it is more than likely that one of the many mainstream investment trusts will suit your needs, offering you income in the form of dividends and the potential for a capital gain when you decide to sell your shares. But if you fit the second or third descriptions, you may be interested in the shares of a split- capital investment trust.

These trusts can tailor an investment to your needs. They may appear complicated at first but behind their sophisticated structure lies a useful means of investing for a specific purpose.

Split-level investment trusts offer exposure to a single portfolio of investments just like normal investment trusts. The difference is that "splits" offer several different classes of share, each with a specific investment aim in mind. Splits were designed in the 1960s when taxation on investment income was heading for 98 per cent. They offered income shares that received all the income from the fund, and capital shares that received no income but shared the remains of the funds between them when the trust was wound up.

By the mid-1980s tax avoidance was less important, but the split-capital structure was recognised as a useful tool and the range of shares available extended from the original simple structures of income and capital shares to include zero-dividend preference shares and highly geared ordinary shares.

Split-capital trusts have a variety of make-ups, but they all have finite lives and offer some combination of the following:

Zero-dividend preference shares

These are a low-risk and predetermined investment. They offer a fixed capital return, paid when the trust is wound up. They have no entitlement to income, which means there is no income tax to pay. Their value at the end of the trust's life is not guaranteed, but they are the first shares to be paid out, and the trusts are designed to ensure that they will be "covered" when that time comes. They are suitable for cautious investors who need a fixed capital sum at a specific time.

Stepped preferences shares

These are similar to zero-dividend preference shares but they also offer a predetermined dividend during the life of the trust.

Income shares

These are very diverse. They all offer high income but there the similarity ends. Some offer a predetermined capital return (redemption price) at the end of the trust's life.

Some have a fixed redemption price and an additional entitlement to a proportion of any extra capital remaining after the entitlements of other shares have been met. Others are similar to annuities, again offering high income, but repaying only a minimal capital sum when the trust is wound up, resulting in a marked capital loss.

Income shares are suitable for investors requiring high and rising income but who are less concerned about capital perfor- mance, and taxpayers can avoid tax by putting the shares in a personal equity plan (PEP). Non- working spouses looking for income-producing assets under separate taxation for married couples can also benefit.

Highly geared ordinary shares

They offer high income as well as an entitlement to assets remaining at wind-up, but only after preference shareholders have been paid their entitlement. So it is possible there will be little or nothing left for the ordinaries.

They are suitable for experienced investors who need to increase their income and can accept a capital risk in return for the potential of high gains.

Capital shares

These pay no income but offer the possibility of high capital returns. They receive all the remaining assets of the trust at wind-up after other shares' fixed capital entitlements have been met. Capital shares are suitable for experienced investors prepared to take the chance of receiving nothing, in return for the possibility of high capital gains.

Some split-capital trusts have arranged for a combination of their shares to be traded together in what is known as a "unit". This should not be confused with the unit in a unit trust. It will usually have all the characteristics of an ordinary share issued by a conventional investment trust but it is capable of being split into its component parts.

What happens when the trust is wound up?

During the life of the split trust all the various shares are traded on the Stock Exchange just like other shares. As well as reflecting the performance of their underlying investments, their price is also influenced by the stage the trust has reached in its life, the market's view of whether it is likely to be able to repay all the entitlements and whether it will have cash left over for the optional capital payments.

When a split is created a procedure is laid down for winding it up. Usually the shareholders will be asked to vote towards the end of its planned life on whether the trust is to be wound up or continued. Whatever they decide, classes of share with a predetermined wind-up value have the right (in nearly all cases) to take their cash at this point.

Split-capital trusts are complex, and the underlying mathematics can be fearsome. The Association of Investment Trust Companies (AITC) strongly advises anyone considering investment in a split to research the market carefully or, preferably, take professional advice from a stockbroker or independent financial adviser.

The annual reports of split- capital trusts include explanations of the qualities of the various classes of share. The AITC publishes free fact sheets giving information on various aspects of investment trusts. Telephone: 0171-431 5222.

q Fiona Monro works for the Association of Investment Trust Companies.