Savings in cutting edge trusts at risk

Thousands of small investors have money tied-up

		Andrew Verity BBC personal finance reporter

Tens of thousands of investors who used a special kind of investment vehicle to save for school fees or boost their retirement incomes are facing a risk that the value of their investments may plummet.

More than 30 of the investment vehicles, called split-capital investment trusts, are described as being in "intensive care" - with rescue efforts underway.

If the rescue efforts fail, thousands of small investors risk losing most of their investment.

Institutions could also lose substantial sums. More than £14bn is invested in "split-caps" - though the biggest risks are confined to around a quarter of them.

Magic circle

The riskiest split-cap trusts are those run by a string of fund managers mostly based in London and Edinburgh - known as the "Magic Circle".

Media interest in the Magic Circle has focused on peers and MPs, including former cabinet ministers, who sit on the boards of investment trusts, including former chancellors Ken Clarke and Norman Lamont, Viscount Astor and Lord Gowrie.

But insiders say the true Magic Circle is the fund managers who run the day-to-day operation of the trusts.

They include well-known names in fund management such as Jupiter, Aberdeen, Gartmore, Exeter, Framlington, Morley, Legg Mason and Govett.

In many cases the fund managers have increased the risks involved in the trusts because they have invested in each other's funds.

These "cross-holdings" helped to boost the value of shares in split-cap funds launched in the last two to three years.

The cross-holdings have increased the risk of "systemic collapse".

If one trust were to collapse in value, it would drag down the value of the other trusts that have bought shares in it, making them more likely to collapse themselves.

Private investors would then lose thousands of pounds because the prices of shares in the trusts would plummet.

Investment warnings

Analysts at the City stockbroker Cazenove have warned that one £200m trust, run by the specialist fund manager BFS and called the "Geared Income Trust", must be rescued - or the split-cap sector could collapse.

City watchdogs say fears that the entire £14bn sector could collapse are "hysteria".

But they have admitted that six unnamed trusts are at risk if the value of their assets falls by 10% below their end of September levels.

Because most of the trusts' assets are in listed shares, observers have deduced that a fall in the FTSE-100 index to 4,500 - momentarily realised after the 11 September attacks - would ring alarm bells.

Tens of thousands of small investors have money tied up in investment trusts.

While some have been led to expect a high-risk investment, others have been told their investment was very low-risk.

Zeros concerns

These are investors with zero-dividend preference shares (see Q&A) in the trusts, supposedly the least risky form of shares available.

Thousands of investors have bought the shares to plan for school fees.

These low-risk investors have been advised that "zeros" would be appropriate because they promise a fixed capital sum and a set date in the future - even if the stock market were to stay flat.

However, the dire performance of the stock market has meant that even these very low risk investments are in danger of failing to perform.

Observers are warning that zeros may not pay out a fixed sum, leaving thousands short of the money they need to pay school fees.

The Financial Services Authority added that if the value of trusts' shareholdings fell by more than a quarter, then 30 or 40 could collapse.

However, it stressed it believed this scenario was unlikely.

Daniel Godfrey, director of the Association of Investment Trust Companies, said: "When you have funds with cross-holdings in each other it is a House of Cards. But that House of Cards may be more stable than people think."

Breaching covenant

However, some of the investment trusts have increased their level of risk by borrowing from both investors and banks.

Banks typically lend them money on condition that what they borrow never amounts to more half the value of the trust's assets.

That agreement is known as a covenant.

But the fall in share prices has severely depressed the value of trusts' assets.

Around 15 trusts - of a total of 113 - are now in danger of breaching their covenants.

That gives the bank the right to call in its loans, forcing the trust to sell its assets and sending its share price - and consequently those of other trusts - down.

So far the banks have been patient with investment trusts.

They know that if they call in their loans, they may never get their money back, because the value of their security - the trusts' assets - would be damaged.

The banks and investment trusts are trying to renegotiate their loans.

Split-cap trusts are also trying to re-order their portfolios of investments to reduce their exposure to risk.

Bank debt

Until three years ago, most split-cap trusts avoided borrowing from banks to "gear up".

However, in the late 1990s a number of trusts were launched with the aim of capitalising on the anticipated growth of the stock market owing to the internet and new technology.

That led them to "gear" the trusts further with bank debt.

However, the gearing also increased the risks for other investors in split-cap trusts.

The bank has first call on the trust's assets should it collapse, while shareholders have to wait in line.