Investment Trusts: Do the splits for best of both worlds

SPLIT capital investment trusts are a delightfully clever financial device which offer something for everyone. Alternatively, they are a fiendishly complicated invention that leave ordinary investors baffled and vulnerable.

In a sense both statements are true. The complexity of a split capital trust is undeniable and investors run an increased risk of taking a wrong decision. However the basic idea is easy to grasp: an investment trust issues different categories of share, so that shareholders can choose whether they want to benefit, say, from income or capital growth. Splits were first invented in the early 1960s but the concept really took off after 1986. Many split capital trusts from this period will be reaching their redemption date shortly.

Nigel Sidebottom, managing director of GVG Asset Management, part of Gerrard Vivian Gray stockbrokers, says: 'You can make a lot of money from split trusts, and there are fantastic opportunities for investors to regulate their risks. But split trusts are a very complex field, fraught with pitfalls.

John Korwin-Szymanowski of SG Warburg Securities adds: 'In order to analyse the attractiveness of any split, you really need to have mastered the complexities of gross redemption yield.'

The exact way that an investment trust chooses to parcel up its shares varies, but a simple split capital trust might have two categories of share on offer: zero dividend preference shares and ordinary income shares. Zero shares, as their name suggests, provide no income from dividends but instead offer long-term prospects for capital growth. Most zeros are established with fixed gross yields over the period to redemption of between 10 per cent and 13 per cent. This is not absolutely guaranteed - the assets might not be adequate at redemption to meet the full return, but zero preference shareholders have first claim to the asset pool.

Returns on zero dividend shares are taxed as capital gains. This has made them a useful bolt-hole for higher-rate taxpayers, especially when taking into account the annual exemption from capital gains tax on the first pounds 5,800. 'This is the least utilised tax break we have,' says Mr Korwin- Szymanowski. An assumed 10 per cent growth on a zero dividend shareholding suggests that up to pounds 58,000 can be invested in a tax-free environment - considerably more than can be sheltered through a PEP. 'The question to consider is how attractive zeros are relative to gilts,' he adds.

Shareholders who opt for ordinary income shares in a split trust benefit from the full dividends paid out during its lifetime, and may also mop up any remaining assets left after the zero dividend shareholders have had their cut. (There would be a loss if there were insufficient assets to pay back the original cost of the shares.)

Some split trusts divide their shares further, between income and capital shares. It is worth bearing in mind that Capital shares, particularly where zero dividend preference shares have also been issued, are a highly geared and therefore much more risky investment.

Redemption arrangements are another area of potential confusion for investors. Trusts are likely to try to persuade shareholders to reinvest their assets through some form of roll-over scheme. 'There will be lots of lengthy documentation which investors will need to respond to,' says Mr Sidebottom. 'The important thing is that shareholders are given the opportunity to exit if they want, without unnecessary costs.'