Understanding the different Investment trust share classes is probably the most comlex aspect of the UK investment trust market.
To show why this is a complex area, consider that there are:
Ordinary shares
Preference shares
Split capital shares - which include income shares, capital shares and zero dividend preference shares
'C' shares
Warrants
The private investor is well advised to read carefully about the characteristics of these different holdings as it can make a huge difference to understanding the potential risks and rewards of investing.
Regrettably,
there has been much controversy about the way that split capital
investments were described and sold which lead to investors losing lots
of money - as these scandals always seem to to - in the early 2000s. In
part, these losses happened because of greed, certainly on the part of
the salesmen and fund marketers, and probably also on the part of the
investors looking for guaranteed 'easy' profits. As is often the case in
these circumstances, the financial professionals seemed to have won...
Ordinary Shares are the main investment trust share class and have
rights to both income and capital growth produced by the assets they
own.
Preference shares work in an almost identical manner to any others issued on the London Stock Exchange. They would normally pay a fixed annual dividend distribution before any money is paid to ordinary shareholders. The dividend from these shares is paid in preference to others. Should the investment trust be 'wound up', holders of preference shares will be paid ahead of other owners.
'C' shares can be created by the board of directors. The 'C' stands for conversion. Normally, such shares would be created if the trust stands at a premium to net asset value - which is a rarity - and there is clearly a demand for them. These new shares would usually bear the cost of their issue and will be quoted separately from other share classes. After a pre-determined time period, these will be converted into ordinary shares.
Warrants offer a right to buy shares at a fixed price within or on a pre-set date. They are not actually shares themselves and have no rights to income. They are traded as a separate issue on the London Stock Exchange until the date of their exercising. If they are still held after expiry they have no value.
This means that the warrants are traded at a very significant discount to the actual shares. It also means that they are a very high risk for investment and would normally be more suited to those with a trading mentality.
The world of the split capital investment trust was first concieved in the 1960s. The plan was to split ownership of assets into two forms - capital shares and income shares.
The split capital investment trust would be set up with a specific end date in mind at the outset. This is usually no more than ten years. All income paid out and a pre-determined capital repayment at closure would be paid to income shares, whilst the remainder of the capital - hopefully including lots of growth - would be paid to the capital shares are closure.
Needless to say, this has not been enough for the complex minds at play in the markets and since then there have more developments, otherwise known as 'financial innovations'...
At the top of the pecking order comes zeros - more fully known as zero dividend preference shares. As the name suggests, they have a preference to any capital at the end of the life of the trust but receive no dividend income. Any borrowings with a charge will be repaid first.
A zero is issued at the start of the life of the trust with an initial value. By the end of the trust that value will have grown (compounded) at a pre-set annual rate.
However, because it is possible to trade zeros on the London Stock Exchange, their value will often not correspond exactly with the current growth rate. Since they have no income element, it follows that a zero would be taxed as capital gains to the investor. Since most - apparently around 99 percent - of UK residents will never pay any Capital Gains Taxes, this has advantages to the private investor.
Next in line come income shares. These days there are several sorts with different charachteristics. We do not want to shy away from explaining an area of finance, but in our experience this is a very complex part of the split capital market. If you are planning to purchase any split capital investment trust shares - and specifically income shares - we recommend that you take very specialised advice. There will not be many investment or financial advisers with the required specialised knowledge, but that is who you need to find!
Capital shares are considered to be quite high risk investments. In theory, they should perform excellently as they benefit from capital growth and potentially the impact of borrowed money which has been well invested. However, the capital repayment is made when the trust is wound up and capital shares are repaid after other classes of share. So not only are there no guarantees, but it is possible to make a total loss!
There are also, rather oddly, packaged units. These
units are mixture of income, capital and zero shares which in total
resemble something akin to an ordinary share! A cynic might argue that
this is just a way for higher fees to be earned by city companies and
trust management - though we could not possibly agree with such a
sentiment...
In the early 'noughties' - around 2002 - the split capital investment trust market had something of a
meltdown
in confidence. The issue essentially related to trusts investing in other trusts stock. Rather like the Lloyds of London
problems
this meant that much of the market was highly interrelated and any one
problem would rebound through dozens of trusts. This meant that
investors found it almost impossible to understand or accurately value
their holdings.
On a separate note, this is clearly a problem with human nature and small illiquid markets... Do these problems sound familiar? Does the mention of 'funds of hedge funds' or the derivates meltdown of 2008 provide any reminders?
This video interview of a fund manager will help to explain some of the work and operations of these trusts.
Clearly, such a problem did not impact all trusts, but a loss of confidence is infectious.
To read more about related topics, please visit:
What Is An Investment Trust?
What Are The Investment Trust Sectors?
Learn Some Background Investment Trust Information
How Does Investment Trust Net Asset Value Work?
How Do Investment Trust Share Buybacks Work?
What Are Investment Trust Savings Schemes?
How Much Are Investment Trust Annual Charges?