The Split Capital Investment Trust Crisis / Edition 1

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"Nearly three years after the crisis affecting the split capitalinvestment trust industry, only now is it possible to understand atleast some of the causes of the failures. With the true benefits ofhindsight, this book clearly and effectively highlights the keyinterconnecting issues such as the narrow cross holding of heavilygeared investment trusts by other heavily geared investment trusts,and the absence of sufficient transparency and control. In tellingthe story, this book now shows why neither the financial communityin general, the market, the regulators, let alone the investor,were aware that the unforeseen catastrophic fall in equity marketswould in turn wipe out historically stable zeros.

This important contribution to the debate looks forward too tothe results of the current and proposed changes. Will theinvestment trust industry recover? Can it happen again? The bestperforming sector over the last 18 months has interestingly beensplit capital investment trusts and many recent individualinvestors have made substantial profits. There will always be ademand for investments that produce a better return than a bankdeposit and are tax efficient. As this book so rightly concludes,the bottom line has to be to provide full information so that therisks can be properly assessed. I congratulate the authors."
—Angela Knight, Chief Executive, APCIMS

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Editorial Reviews

From the Publisher
"...the definitive work on the scandal" (The Express, 08/10/04)

"...features a wealth of expertise on the tricky questions ofethics." (The Glasgow Herald, 13th Oct 2004)

"...intended to explain what went wrong and the lessons to belearnt..." (Financial Times - Money, 13th November2004)

"...explains clearly and authoritatively how what used to be asmall, safe part of the investment world took the low road todisaster." (Professional Investor, April 2005)

"This book provides an excellent record of perhaps the worstcalamity ever to hit the investment trust is timely,beautifully produced...and comprehensive..." (IEA Economic Affairs,September 2005)

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Product Details

  • ISBN-13: 9780470868584
  • Publisher: Wiley
  • Publication date: 11/28/2004
  • Series: Wiley Finance Series, #273
  • Edition number: 1
  • Pages: 276
  • Product dimensions: 6.81 (w) x 9.86 (h) x 0.86 (d)

Meet the Author

DR ANDREW ADAMS is Senior Lecturer in Finance and Director of the Centre for Financial Markets Research at the University of Edinburgh. His research interests focus mainly on the pricing and risk assessment of investment trust shares. He wrote the warning article "For Whom the Barbell Tolls…" with Robin Angus, which was published in April 2001, and his memorandum to the Treasury Select Committee entitled "The Split Capital Investment Trust Crisis: Underlying Reasons and Historical Developments" is published as an appendix to the Committee’s main report. Dr Adams is author and co-author of a number of books about investment.

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Table of Contents

List of Contributors.

About the Contributors.



1 Introduction, Andrew Adams.

1.1 Aims of the book.

1.2 The investment trust industry.

1.3 Types of splits.

1.4 The crisis and its significance.

1.5 Overview of the five parts of the book.


2 Past Financial Crises, John Newlands.

2.1 Introduction.

2.2 The trust boom of 1888–89.

2.3 The 1920s’ trust boom and the Wall Street crash.

2.4 The 1970s’ trust boom.

2.5 The trust boom of 1993–94.

2.6 The hurdle-rate warning of 1872.

2.7 Conclusion.

2.8 References.

3 Evolution of the Split Trust Sector, John Newlands.

3.1 Introduction.

3.2 The first investment trust.

3.3 The second milestone.

3.4 Edinburgh, 1873 – the split capital concept isborn.

3.5 The first major crisis – Sykes v. Beadon, 1878.

3.6 1929 to 1965 – back to basics.

3.7 The birth of Dualvest.

3.8 Splits terminology.

3.9 Other early splits.

3.10 Tax changes after 1979.

3.11 New boost to the attractions of splits.

3.12 The hybrid, or quasi-split capital trust.

3.13 1997 – beginnings of the new splits era.

3.14 Technical developments and structural changes.

3.15 Aberdeen New Preferred breaks the mould.

3.16 Key figures in the history of splits.

3.17 Conclusion.

3.18 References.

4 The Crisis Unfolds, Andrew Adams.

4.1 Introduction.

4.2 Aggressive structures.

4.3 Barbells.

4.4 Big fees.

4.5 Lack of information.

4.6 The zero market expands.

4.7 Mounting concern.

4.8 “For whom the barbell tolls . . .”

4.9 “Barbells unbalanced”

4.10 Change in market sentiment.

4.11 Aberdeen’s half-day forum.

4.12 Suspensions and liquidations.

4.13 Conclusion.

4.14 References.


5 The Impact of the Structures, Peter Moles.

5.1 Introduction.

5.2 Future values for a trust with a prior claim.

5.3 Valuing the claims.

5.4 Value of shares in a traditional split.

5.5 Traditional split with prior claim.

5.6 Effect of the different structures on projected returns.

5.7 Value sensitivity.

5.8 Conclusion.

5.9 References.

6 The Risks, James Clunie.

6.1 Introduction.

6.2 Major influences on risk: asset allocation and capitalstructure.

6.3 Risk for different share classes.

6.4 Increasing risks and the onset of the splits crisis.

6.5 Liquidity risk.

6.6 Reputational risk.

6.7 Traditional risk assessment measures.

6.8 Traditional risk assessment measures became misleading.

6.9 Improvements to traditional statistics.

6.10 Using Monte Carlo simulation outcomes to illustraterisk.

6.11 Conclusion.

6.12 References.

7 Valuing the Shares, James Clunie.

7.1 Introduction.

7.2 Background to valuing splits using closed-form optionpricing.

7.3 Problems with closed-form option pricing.

7.4 A worked example using closed-form option pricing.

7.5 Monte Carlo simulation.

7.6 Pricing during the splits crisis.

7.7 Pricing of splits compared with conventional investmenttrusts.

7.8 Conclusion.

7.9 References.


8 The Media Response, Andrew Adams.

8.1 Introduction.

8.2 Favourable view.

8.3 The early warnings.

8.4 Stronger warnings.

8.5 Rupert Walker steps out of line.

8.6 Increasing concern over zeros.

8.7 The FSA steps in.

8.8 More bad news.

8.9 The men who wiped out billions.

8.10 The Treasury Select Committee hearings.

8.11 Bust-up in the trust industry?

8.12 Adverse sentiment goes too far.

8.13 Comparison with other mis-selling disasters.

8.14 Implications for the media’s personal financecolumns.

8.15 Conclusion.

8.16 References.

9 The Regulatory Response, Peter Gardner and GeoffreyWood.

9.1 Introduction.

9.2 The Financial Services Authority.

9.3 The FSA’s approach to regulation.

9.4 The regulations.

9.5 The tasks and impact of the FSA.

9.6 Financial market background.

9.7 The FSA’s initial response.

9.8 The FSA proposals and questions.

9.9 Objections from the investment trust sector.

9.10 The FSA’s powers and investigations.

9.11 The FSA’s response.

9.12 Conclusion.

9.13 References.

10 The Political Response, John McFall MP.

10.1 Introduction.

10.2 The Committee’s enquiry.

10.3 Misleading impressions.

10.4 Responsibility within the industry.

10.5 Compensation.

10.6 Looking to the future.

10.7 Conclusion.

10.8 References.


11 Corporate Governance, Robin Angus.

11.1 Introduction.

11.2 What legislation can – and cannot – do.

11.3 The splits crisis really was different.

11.4 How much could directors have been expected to foresee?

11.5 The new AITC Code of Corporate Governance.

11.6 How can directors provide an “objectiveview”?

11.7 Monitoring managers, communicating with shareholders.

11.8 Initial involvement and continuing information flow.

11.9 Changes to the Listing Rules.

11.10 Conclusion.

11.11 References.

12 Some Ethical Considerations, Andrew McCosh.

12.1 Introduction.

12.2 The existence of senior debt.

12.3 Pressing the press.

12.4 Peddling the paper.

12.5 Forced sales of assets.

12.6 Charges.

12.7 Mutual assistance programme.

12.8 It pays to advertise.

12.9 If it isn’t working, reconstruct it.

12.10 Why did the shareholders not rebel?

12.11 Conclusion.

12.12 References.

13 Reputational Risk, Piers Currie.

13.1 Introduction.

13.2 Reputational risk.

13.3 The downward slide of reputation.

13.4 The rise and fall of equity funds’ reputation.

13.5 Reputational risk in the regulatory framework.

13.6 An introvertedfaçade: “The best kept secret inthe City”.

13.7 Tensions: Barbarians within.

13.8 Recognising outside stakeholders.

13.9 Knowledge, rocket science and disclosure.

13.10 Gossip, fat cats and fast cars: The public gallery.

13.11 Image restoration strategies.

13.12 Reputational consequences.

13.13 Conclusion.

13.14 References.


14 Product Innovation and Marketing, James Clunie.

14.1 Introduction.

14.2 Understanding investors’ needs.

14.3 Managing investor expectations.

14.4 Product design.

14.5 Stress-testing new products.

14.6 A decision-making framework for complex investmentproducts.

14.7 New launch documentation and risk warnings.

14.8 Risk awareness and client suitability.

14.9 Client servicing.

14.10 Conclusion.

14.11 References.

15 Some Implications for the Fund Management Industry, DavidHarris.

15.1 Introduction.

15.2 Where did the industry go wrong?

15.3 A role in education.

15.4 Stakeholder investment products.

15.5 Compensation and the AITC Foundation.

15.6 Conclusion.

15.7 References.

16 Lessons for the Future, Andrew Adams.

16.1 Introduction.

16.2 Corporate governance.

16.3 The Association of Investment Trust Companies.

16.4 Financial advisers.

16.5 Financial education.

16.6 The financial press.

16.7 The regulators.

16.8 Conclusion.

16.9 References.

Appendix A: For Whom the Barbell Tolls . . . , Andrew Adams andRobin Angus.

Appendix B: Response to FSA Consultation Paper 164, Andrew Adamsand Robin Angus.


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First Chapter

The Split Capital Investment Trust Crisis

John Wiley & Sons

ISBN: 0-470-86858-9

Chapter One




The crisis surrounding the UK split capital investment trust sector broke in late 2001. It led to a major Financial Services Authority (FSA) investigation and a House of Commons Treasury Select Committee enquiry that called as witnesses a number of well-known personalities from the investment trust industry. Some of these Treasury Select Committee hearings produced moments of great theatre that were widely reported in the mainstream press.

This book aims to provide an in-depth and authoritative analysis of the crisis. Although it is generally regarded as a difficult subject even for investment professionals, most chapters are suitable for the interested lay reader. An unusual feature of the book is the large number of contributors, each with expert knowledge of his chosen topic. This inevitably means that varying views are expressed but this I consider to be a strength of the book. It is important that different sides of the story are told if the reader is to obtain a balanced view of what happened.

The FSA investigation and the large number of interested parties with legal representation have made editing a book of this kind a considerable challenge. Some people have suggested that it is too early for a book on the splits saga. However, the alternative is to wait until the court battles are over, which could be years away. By then, many of the details of thecrisis will have faded from memory. But there was more to this saga than a simple admonition that it represented "the unacceptable face of capitalism". While memories are fresh, it is useful to look beyond the casual soundbite and analyse the causes and effects of this serious crisis. There may be lessons to learn.


An investment company invests in a portfolio of shares or other securities for the benefit of its own shareholders. It enables investors to purchase an interest in a professionally managed fund.

An investment trust company (also sometimes referred to as an "investment trust" or just "trust") is a UK investment company whose ordinary shares must be listed on the London Stock Exchange. It is subject to the regulation of the Companies Act and the UK Listing Rules. It is not a product regulated directly by the FSA unlike a unit trust or an open-ended investment company (OEIC).

Ultimate responsibility for running the affairs of an investment trust lies with the board of directors, but day-to-day investment management and administration is normally delegated to a fund management firm. This firm may also manage other investment trusts together with other types of fund, such as pension funds or unit trusts. The conduct of the fund manager in managing the portfolio of the investment trust is regulated by the FSA, as is its marketing activities.

In common with any other company, an investment trust has a fixed number of issued shares. To liquidate their holdings, investors must normally sell their shares to other investors. An advantage of this "closed-end" structure is that the fund managers can invest for the best long-term interests of the trust shareholders without having to worry about a possible reduction in the underlying portfolio of assets in adverse market conditions. Such a problem can arise in the case of unit trusts or OEICs because investors buy or redeem their investments directly with the managers, and if there are a significant number of redemptions the managers will be forced to sell assets in the underlying portfolio.

Again, in common with any other company, an investment trust can borrow money and thereby obtain the benefits and risks of "gearing". This can be done by issuing listed or unlisted loan capital or simply by borrowing from a bank. Ignoring the cost of borrowing, if the value of the underlying portfolio of the investment trust rises (or falls) by a certain percentage, the residual assets attributable to shareholders will rise (or fall) by a greater percentage. So, gearing exaggerates movements in the value of underlying assets from the investment trust shareholders' viewpoint.

Conventional trusts (i.e., trusts with only one class of share) generally invest almost entirely in equities, often with a heavy overseas exposure. "Generalist" investment trusts combine investment flexibility with the opportunity to diversify by spreading investments over several markets and sectors. "Specialist" investment trusts provide a vehicle for investment in some specialist area, such as a particular geographical region or a specific industry sector. Split capital closed-end funds (splits) may be defined as investment companies5 or investment trust companies with more than one main class of share capital, offering different rights to income and capital. They aim to match simultaneously the risk, income and tax preferences of different types of potential investor. Splits are usually designed to be wound up at some future date, with most splits having an original term of seven to ten years. If the company is wound up, its assets are sold and the proceeds are used to pay off the various classes of share capital after meeting the entitlements of holders of debt, if any. Shareholders always have the option to take cash, but in practice the directors and managers normally try to retain some of the funds under management by encouraging shareholders to roll over into an existing trust or by restructuring, rather than liquidation.

Table 1.1 shows the estimated total assets (including assets financed by borrowings) of the conventional trust and splits sectors on three dates around the crisis period. It can be seen that the total assets of the splits sector doubled over the three-year period up to end-2000, but then roughly halved over the three-year period to end-2003.


There are two basic types of splits: "traditional splits" and "quasi-splits". However, many more complicated splits were launched, particularly over the period from 1999 to 2001, some of which have defied simple catagorisation.

Traditional splits

A simple "traditional split" has its ordinary share capital divided into two distinct categories: income shares and capital shares. Dualvest, the first split, launched in 1965, was of this type, as were many of the splits launched up to the late 1980s. They generally invested in a broad portfolio of UK equities with an above average yield and commonly had no borrowings.

Holders of the income shares of traditional splits are entitled to all or most of the distributed income and a predetermined capital value on liquidation. Thus, they receive a much higher income yield than that of the underlying portfolio. They are considered suitable for investors who require a high income, such as elderly people. Most income shares are entitled to a capital repayment when the trust is wound up, but some are more like annuities, with very little capital repayment.

Holders of the capital shares of traditional splits receive little or no income but are entitled to the remaining assets on liquidation after the income shares have been redeemed. So they obtain geared returns which depend on the growth of underlying assets up to the wind-up date. They are a risky type of share, which may appeal to high-rate taxpayers looking for potential strong capital gains.


A "quasi-split" always has zero-dividend preference shares (zeros) in issue but, in its most straightforward form, there is only one class of ordinary share capital, namely ordinary income shares (also known as income & residual capital shares). This type of structure was common from 1988, shortly after the first zero was invented, through to the late 1990s. Again, such splits generally adhered to prudent investment principles, holding a broad portfolio of UK or international equities, and did not incorporate additional complexities, such as bank borrowings.

Zeros are designed to pay a predetermined capital sum when the trust is wound up before any distribution can be made to ordinary income shareholders. They have no entitlement to income so that, importantly, there is no liability to income tax. Provided the underlying portfolio is widely spread and does not have overly demanding yield requirements, and there are no prior ranking charges (e.g. bank debt), the zeros in these simple structures are generally low risk. Such zeros are attractive to private investors who need a fixed sum at a future point in time and are able to use their annual exemption allowance to avoid paying capital gains tax. If sums of money are required at different points in time, an appropriate portfolio of zeros can be created. The zeros in these simple structures are suitable for such things as school fees planning and retirement planning.

Ordinary income shares offer high income plus all the remaining assets of a quasi-split trust at the wind-up date, after the zeros have received their capital entitlement. They are analogous to holding an equity portfolio partly financed through a prior claim (the zeros) repayable at wind-up.

More aggressively structured splits

A common variation of the above theme was to combine the traditional split and quasi-split concepts. In other words there could be three classes of shares: zeros, income shares and capital shares. When such a trust is wound up, zeros are (in the absence of borrowings) repaid first. So, other things being equal, the risk/return profile of the zeros is no different from that of zeros in a simple quasi-split. But, the income shares are likely to be more risky than in a simple traditional split because they rank after the zeros for capital repayment. The capital shares would have the lowest priority for repayment in either case.

In the buoyant markets of the late 1990s, it became fashionable to launch splits that used complicated capital structures, often with significant levels of bank debt and other devices, to make the shares appear attractive to investors. Some of them had a narrow thematic investment policy or invested in the high-yielding shares of other splits (hence "cross-holdings"). Their complexity made it almost impossible to "stress-test" the products adequately before launch. As always, one of the main driving forces behind the creation of these vehicles was the pursuit of fees by fund management firms and their broker/advisers. Some sections of the firms involved became highly profitable.

The shares in these aggressive structures often did not have the same well-known characteristics as shares with the same title (e.g., zeros) issued by earlier simple splits. It was often very difficult to understand the investment attributes of the different shares, not least because sufficient information was not readily available to outsiders. Traditional risk statistics used to assess the risk of shares in a split often became dangerously misleading for the new splits. As a result, there was a general lack of understanding of the true risks involved. The obvious risk created by geared trusts investing in other geared trusts was generally missed by private investors and their advisers.


Many analysts with specialist knowledge of splits felt that there was "an accident waiting to happen" by the end of 2000. But, it took a severe bear market to drive home the dangers of bank debt and cross-holdings to the majority of investors and their advisers. The impact of falling markets accompanied by equity dividend cuts led to collapsing market prices and dividend cuts for the income-bearing shares of many splits. The substantial cross-holdings then caused dividend cuts to compound themselves across a section of the splits sector, and share prices fell yet further. Even the market prices of a number of zeros fell sharply, a type of share which until then had generally been regarded as low risk. By the end of 2001, desperate measures were being taken by fund management firms and their broker/advisers to save many of the new splits, and the FSA started to take a much keener interest. Confidence in splits then collapsed. But the splits crisis will be remembered most for the Treasury Select Committee hearings in the second half of 2002 and for the financial losses suffered by private investors, some of whom are suffering real financial hardship as a result.

According to the Association of Investment Trust Companies (AITC), retail investors have lost over £700m across all share classes in splits11 that have gone bust. Of course, there are other shares in splits that are unlikely to recover their full launch value, but according to the AITC retail losses here stood at less than £500m based on end-February 2004 share prices.

The crisis itself may arguably be over, allowing this book to be written, but it will be a long time before every compensation decision has been taken and we learn what disciplinary action, if any, the FSA has imposed on the firms and individuals it is currently investigating. While the principle of "caveat emptor" should never be forgotten, it is clear that both the Treasury Select Committee and the FSA believe that there has been some serious wrongdoing.

One obvious consequence of the crisis will be to reduce the complexity of future splits. But, as we will see in this book, the splits crisis will have a permanent effect on the whole investment trust industry in such areas as corporate governance, disclosure of information and the freedom of trusts to invest in other trusts. For better or worse, there is now a stricter regulatory environment for investment trusts.

I should stress that most investment trusts are not splits, not all splits were a problem and the splits crisis was wildly out of character for the traditionally cautious investment trust industry. It is most unfortunate that the splits crisis has adversely affected the image of the investment trust industry as a whole, an industry which has served investors well for over 130 years. In my view, investment trusts remain an excellent vehicle for long-term investors.

The publicity surrounding the splits crisis has not helped the reputation of the savings industry. Along with other financial disasters, such as Equitable Life, endowment policy shortfalls, pensions mis-selling and precipice bonds, the splits crisis has discouraged people from saving sufficiently for their future. Given the urgent need for a rise in the UK savings ratio, so that people will be better able to provide for themselves when growing old, this could in the end prove to be the most significant aspect of the splits crisis.


This book is divided into five parts, each dealing with a different aspect of the crisis.


Excerpted from The Split Capital Investment Trust Crisis Excerpted by permission.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

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