Zeros are heroes when it comes to profit

There is another great way to save tax and build up funds for the once-dreaded school fees.

If you want a tax-free investment income, Individual Savings Accounts are not the only option. Zeros, their fans say, are high-yield and low risk. And if you don't already make use of your annual capital gains tax allowance, zeros can provide you with an income with no tax to pay.

If you want a tax-free investment income, Individual Savings Accounts are not the only option. Zeros, their fans say, are high-yield and low risk. And if you don't already make use of your annual capital gains tax allowance, zeros can provide you with an income with no tax to pay.

Zeros, or zero-dividend preference shares, are designed to produce capital growth rather than income. "But if you have a series of them, you can cash them in over time and effectively they are income," says Clive Scott-Hopkins of independent financial advisers Towry Law. "You can argue that this is tax-free within your (capital gains tax) allowance."

The zeros are a type of share issued by a split-capital investment trust. Like any other investment trust, split-capital investment trusts are collective investments holding a wide range of assets. Investors benefit from the returns of those underlying assets by holding shares issued by the trust. But two things set split-capital investment trusts apart. They have a fixed life and they issue types of shares to investors. Traditional investment trusts issue ordinary shares but split capital investment trusts issue a variety, each type designed to fulfil different investment needs.

Capital shares and income shares are the main types issued, but others such as zeros are often issued too. Although the zeros pay no dividend, when the trust is wound up, they have first call on the funds. Zero holders are then paid a set capital value for their shares.

Annabel Brodie-Smith, of the Association of Investment Trust Companies, says zeros have become popular, particularly when interest rates are low. "People look for sources of income elsewhere ... when you invest in zeros, you know exactly how much you'll get back," she says.

The annual return on zeros can be significantly higher than other low-risk investments. Zeros in BFS Overseas Income & Growth investment trust, for example, have a redemption yield of 8.9 per cent, meaning this would be the annual rate of return if you held the shares until the trust was wound up.

And zeros can be an additional tax-free source of income on top of your ISA and national savings allowances. With the help of a stockbroker, you can compile a portfolio of zeros, which mature at regular intervals, effectively producing an income. But, because the return is capital growth, you can make gains of up to your annual allowance of £7,100 before you pay any tax at all.

Although they are based on the notoriously volatile equities market, they are considered low-risk investments. "No zero has not paid out," says Ms Brodie-Smith.

But though the amount payable when the trust winds up is fixed, the market price of zeros can fluctuate. So if you have to cash in zeros early, you may get less than you expect.

You can buy zeros through a stockbroker, or directly from the group running the investment trust. When buying though a stockbroker, as with any other share purchase, you pay commission and stamp duty. You can cut out the commission, by buying through a savings scheme run by an investment group.

Zeros are particularly useful for investors who need a fixed sum at a certain point in the future. For school fees, say, investors can buy a series of zeros set to mature in a different year.

If you want to take advantage of the low-risk capital growth of zeros but do not need the shares to mature at any particular point, a fund of zeros could be better. These have several advantages over holding zeros directly, though there is an additional layer of costs.

Exeter Fund Managers runs its Zero Preference unit trust, which has been running for nine years holds nothing but zeros. It makes an annual management charge of 1.3 per cent as well as an initial charge of 5 per cent. Last year, Investec Guinness Flight launched its Capital Accumulator unit trust for the same purpose.

Richard Prvulovich, UK fund manager at Investec Guinness Flight, says for knowledgeable investors saving for a known expense in the future, holding zeros directly is best. For others, investing in a fund has the advantage of putting an expert in control of your investment.

"It's not the easiest market, there's a lot of diversification," he says. "The quality of the portfolio which underlies zeros is key." Though zeros are a particularly safe asset class, it is still important to judge whether the trust has enough assets to cover the zero redemptions if market conditions turned sour, he says.

The number of zeros in issue has risen fast during the 1990s as split capital investment trusts have become more popular. Philip Thitchener, of Exeter Fund Managers, says when the group's Zero Preference unit trust was launched in 1991, there were 18 zeros. Now there are 68.

Recent issuance has led to an oversupply in the market which has kept performance sluggish to stagnant. But Mr Prvulovich argues this extra supply could have benefits for investors. "We've seen a plethora of new issues recently," he says. "The zero market has been swamped and valuations are extremely low as a result."

The AITC publishes a free factsheet on split-capital investment trusts. Call 0800 707 707

Towry Law: 01753 868244

Gee & Company: 01743 236982

Exeter Fund Managers: 0800 807807

Investec Guinness Flight:0171 597 1800