It is more than 15 years since the split-capital trust scandal broke. Up to 50,000 investors lost money after investing in the late 1990s in trusts that were described as low-risk, but turned out to be anything but. These trusts had share capital divided between zero-dividend preference shares (“ZDPs” – see below), whose value accumulated year by year in fixed steps during a limited life, and ordinary share capital, sometimes further divided into income and capital shares. In the 1990s, all sets of shareholders prospered. But the 2000-2003 bear market often wiped out not only the ordinary shareholders, but also the preferred shareholders.
The aftermath of the crash
Losses to investors were estimated at £620m, with up to 40 trusts going bust and 21 investment firms being censored. The surviving trusts had limited lives and so were, in due course, wound up.
A small number of split-capital trusts still survive, having refinanced their ZDPs when they matured at a lower cost and a lower proportion of total capital. Prominent among these is Aberforth Split Level Income Trust (LSE: ASIT). The ZDPs made up only 20% of the capital at relaunch, escalating in value at 3.5% per annum.
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This made the hurdle for the ordinary shares to produce a positive return modest. Alongside Aberforth’s other funds, including the better-known Aberforth Smaller Companies Trust, ASIT invests in smaller companies with a focus on value, rather than the growth style that predominates in the sector. Aberforth avoids Aim-listed companies and ASIT has a firm tilt towards income, resulting in the shares yielding 4.6%.
With £51m of ZDPs compared with £174m of ordinary capital at the end of November, ASIT is still highly geared relative to conventionally structured trusts. This, the focus on value and the underperformance of smaller companies all resulted in disappointing performance for the first two years of the new company’s life.
But there has been a marked pick-up in recent months. The shares, at 94p, still trade at a 9% discount to net asset value (NAV), a discount destined to disappear when the trust winds up in 2024. Until then, a better climate for smaller companies in general and value stocks in particular, compounded by the leverage offered by the ZDPs, promises an exciting ride.
There are 66 holdings, none worth more than 3% of the portfolio. The largest are Brewin Dolphin, Rank Group, Go-Ahead and Bovis Homes. Exposure to industrials and consumer services is high (a combined 67%), but exposure to technology, resources and healthcare is low (6%). Just under 40% of the portfolio is invested in FTSE 250 mid-cap stocks, which, together with the value style, should reduce the risks in the portfolio.
A nimbler alternative
Chelverton UK Dividend Trust (LSE: SDV) is similar, but 40% of the portfolio is invested in Aim and only 17% in the FTSE 250. Around £62m of assets are divided between £47m of ordinary shares and £15m of ZDPs, so it’s a lot smaller than ASIT, but perhaps it can be nimbler in the less liquid stocks.
A portfolio yield of 4.9% enables a dividend yield of 4.4%, well covered by earnings, with the shares trading on a discount to net asset value of below 5%. As with ASIT, performance has picked up recently after a dull few years, but the long-term record is excellent. Its 74 holdings (26 on Aim), with only one over 3%, are also similar to ASIT, but the sector exposure looks better spread. Both trusts have highly regarded veteran managers.
In 2020 smaller firms are likely to perform well, while a UK-orientated portfolio should turn from a liability into an asset. Throw in the potential for returns to be enhanced by the gearing offered by the low-cost ZDPs and both trusts could continue their recent run.
I wish I knew what zeroes were but I'm too embarrassed to ask
A zero-dividend preference share (also known as a “zero” or “ZDP”) is a type of preference share issued by investment trusts. Like ordinary shares, they are bought and sold on the stockmarket. But unlike ordinary shares, a zero has a limited life span.
A zero aims to pay investors a fixed amount when the investment trust winds up – this is known as the “redemption value”. The “promised yield” on a zero is the effective annual yield paid out to those who hold the shares until maturity.
As with other preference shares, zeroes are typically higher up the queue than ordinary shareholders when it comes to being paid (although they still rank behind debt). So while zero holders won’t share in any upside if the trust does better than expected, they are also more likely to get their money back if the trust underperforms (although this is not guaranteed).
The reverse is true for ordinary shareholders in such a trust – the “gearing” provided by the zeroes will amplify both gains and losses for the trust.
Zeroes can be useful for investors who require predictable (though not guaranteed) payouts at fixed points. They can also be useful for tax planning – profits are taxed as capital gains rather than income, which may appeal to those who don’t typically use up their full annual capital-gains allowance. As with other shares, they can be held in a tax wrapper, such as a pension or individual savings account (Isa).
Similarly to bonds, all zeroes have different conditions attached, so do be sure to check the small print before you invest.
