The rewards from pooling different investors' risks

Split-capital trusts: Andrew Verity on a variation on an old idea

Investors who want to pay the minimum tax on their funds will next week be given financial advice directly by a slimline Nigel Lawson, the former chancellor.

Lord Lawson of Blaby stars in a new TV advertising campaign lauding the benefits of personal equity plans (PEPs), a savings scheme he devised back in 1987.

"If you want to lose pounds try this slim volume," he will say, plugging his diet book. "But if you hope to gain some, try a PEP."

For those who want to take Mr Lawson's advice, one method is growing in favour with financial advisers: using a PEP to invest in a split-capital investment trust.

Split-capital trusts are a variation on the method, now more than a century old, of allowing those with a small amount to invest to gain access to stock market investments by pooling their resources within an investment trust company.

Investors buy shares in the trust, which is then invested professionally and supervised by an independent board of directors.

But whereas conventional investment trusts may have only one kind of share - income or growth shares for example - split capital trusts always have at least two classes of share.

The idea is that if you pool the resources of those who want income, those who want growth and those who want security for their capital, you can get advantages for each.

The trusts are set up with a fixed period of time to achieve their objectives, ranging between seven and 20 years, after which they are wound up.

The cautious investor can buy zero dividend preference shares, which means you receive no ongoing income from dividends as the trust's assets grow in value (zero dividend). Instead you get a pre-set amount, the redemption value, when it winds up.

When it does wind up, your redemption value will take priority over paying off others within the trust with other classes of share.

Other investors buy income shares, which pay out all of the income from dividends paid to the trust by the companies it has invested in.

These may also pay back some of the investors' capital when the trust winds up. But they are often bought on the understanding that the income comes both from dividends and from the investor's own capital, paying little back on wind-up.

Those who do not mind riskier investments can buy capital shares. These do not pay income and their holders are entitled only to what is left within the trust after paying off the holders of other classes of share. But if all works well, the gains can be greater than with other growth trusts.

Split-capital trusts work by combining the different classes of share. Because some are foregoing growth and income for the sake of safety, those taking a punt on income or growth have a larger share of the proceeds.

Equally, if investment performance is poor, the losses are born more by the risk-takers. Putting the product inside a PEP wrapper also exempts investors from income or capital gains tax, depending on which class of share they own.

Gerrard Vivian Gray split-capital expert Bill Fowler points out some spectacular returns for those willing to risk buying capital shares.

For example, by far the best performing trust is Henderson Touche Remnant's Technology trust. This has benefited over five years from the boom in US technology stocks, with the underlying value of its stocks rising by 302 per cent - against a world-wide average of just 89 per cent in the same period.

Investing in the growth of stocks like these carries an even higher risk than usual with a split-capital trust. But cautious investors can tap into zero-dividend preference shares with a safe promise (though not a guarantee) of much better returns - known as a gross redemption yield - than any building society.

For example, zero dividend preference shares in M&G's Income split-capital trust currently cost 73p. M&G offers to pay back 102p on these shares when it winds up in 2001 - or growth of net assets of 7.5 per cent per year. To meet this offer, M&G's trust needs to have assets worth pounds 254m in 2001. But its assets are already worth pounds 357m.

In other words, assets would need to fall by 6.9 per cent per year (called its "hurdle rate") for that promise not to be met.

Many other trusts need to shrink by unusual amounts not to meet their promises to holders of zero-dividend shares (see table). For school fees, weddings or other savings they can provide predictability and a good but cautious return.

Split-capital investment trust specialists: Stephen Philips, Citywall Financial Services, 01392 422592; Gerry Gray, Walsh Lucas IFA, 01904 610 495; Andy Merricks, Simpsons IFA, 01273 270222; Jonathan Whittenbury, Jonathan Whittenbury Financial Services, 01494 67188; Graham Hooper, Chase de Vere, 0171 604 5766.