A world fit for zeros

Ihave long been curious about the demise of the split capital sector. What started off as a good idea in the 1990s fast descended into financial catastrophe. Managers of split cap funds had invested in each others’ funds, which only worked as long as the underlying share prices continued to rise. When the tech bubble burst in 2002, the funds could not pay investors.

But scratch beneath the surface and you had a very neat idea – now largely being developed by the structured products sector. At its core, the split cap is simple. It addresses the issue that different investors want different things from their investments. Some want the certainty of returns with the possibility of capital protection – and for that privilege they will trade away the right to above average returns. These investors could opt for either income shares or zeros, which rolled up the annual return in the form of a final redemption
payout.

In contrast, those investors only interested in a geared play on bullish equity markets could buy the capital shares, which creamed off any above-
average returns as a final redemption rollover. These speculators would be wiped out if the shares tanked.

This split capital structure worked all fine and dandy as long as the underlying funds didn’t take on too much debt (which they did), didn’t invest in rubbish assets (again, guilty), didn’t invest in each other (ditto), and didn’t charge too much in the way of fees (ditto).

But I keep going back to the original idea – parcelling up return profiles in a simple structure that, in particular, allows for a defined return through zeros. As a concept it actually never went away. A few reputable groups, such as Jupiter and Ecofin, kept plugging away at the idea with a range of classes that included zeros. The Jupiter Second Split still provides a defined return of 6.6 per cent until maturity in 2014 – a decent though hardly inspiring return.

Some of the listed private equity funds that continued to use split capital structures (such as JZ and JPMorgan Private Equity) have also reissued zeros that currently pay out between 5.5 and 6.5 per cent a year. These very specialist funds deserve full marks for innovation – they managed to buy relatively cheap, long-dated money with no covenants – but I can’t quite see why any private investor would be scrambling to buy the stuff. The zeros might be well covered (this term describes the amount of times the final redemption payment is covered by current assets) but they are still backed by highly volatile underlying assets in a risky asset space.

But one of the reasons why private investors seem to have snapped up this exotic new issuance is the tax structure.

Gains on zeros are taxed as capital gains, not income – making them very attractive to higher rate taxpayers. That’s clearly having a huge impact on this tiny sector, pushing up prices and prompting structured product providers to bring out simple zeros (see box).

Overall, I think Charles Cade, an analyst at Numis, is probably right to be cautious about any revival in split capitals. He said in a recent report that it was “far too early” to claim a significant resurgence in the split capital market.

My own view is that the recently launched Invesco Perpetual Dual Return fund could be the one to watch. A diversified, blue chip, conservatively managed fund that pays out a stable 7 per cent per annum with low risk could prove a wondrous thing for most investors. Even better if they get issued some zeros to go along with the investment.

adventurous@ft.com