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Monday, 22 October, 2001, 13:40 GMT 14:40 UK
Q&A: What are split caps and zeros?

The mere utterance of the words split-cap trusts and zeros may make you switch off, but they are far from complicated. The BBC Personal Finance Reporter Andrew Verity cuts through the jargon.

What are split-cap trusts?

Investment trusts are essentially companies that invest in other companies, whose success or failure depends on the investments they pick.

Split-capital investment trusts grew popular in the 1970s with wealthy investors wanting to reduce their exposure to income tax rates as high as 83%.

Most investment trusts get their capital by issuing one class of ordinary shares.

Investors in ordinary shares get both income - through a dividend paid by the trust - and capital growth - through the rise in the price of the shares.

How do they work?

Split-cap trusts split the income from the capital growth.

When they started, two classes of share were issued - income shares and capital shares.

By taking capital shares, investors give up their right to income in exchange for getting the lion's share of its capital growth.

By taking income shares, other investors give up their right to capital growth in exchange for taking the lion's share of its income.

Because those with income shares give up their right to capital growth, those with capital shares could double their share of the trust's capital growth - and avoid income tax.

Those with income shares hope to increase their income while taking less risk with their capital.

On the downside those with capital shares are gambling on the share price - and they are at risk of losing heavily if it falls. If the trust collapses in value, they are last in line to retrieve any of their initial investment.

Those with income shares will be hurt by cuts in dividends by the companies the trust invests in.

And while they hope to recoup their capital when the trust winds up, they may not do so if the trust collapses in value.

What are zeros?

In the late 1970s, managers of split cap trusts sought to capitalise on rising share prices.

They aimed to boost returns by "gearing" - effectively borrowing more to buy more shares and feel more of the benefit of rising share prices.

Instead of borrowing from banks, they issued zero dividend preference shares ("zeros"). These offered investors no dividend but did promise a fixed level of capital growth.

Zeros have been very popular with private investors, especially those planning for school fees who need to achieve a fixed sum at a set date in the future.

They were particularly attractive because they were regarded as the safest sort of share that could be purchased - nearly as safe as bonds but offering a higher rate of growth.

When do they pay out?

Split-cap trusts have a fixed date for when they wind up.

Holders of zeros were promised that on that date they would get a fixed sum equivalent to what they would have earned had their investment been growing at a fixed rate of interest.

The only condition was that the trust's investments achieved a set return every year - known as the "hurdle rate".

Often this was as low as 2%, and in some cases the trusts could produce a negative return - shrinking in value - and the zeros would still pay out.

However, the stock market's ongoing slump has meant that even these safe investments may fail to perform.

See also:

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02 Jul 01 | Northern Ireland
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