Zeros are positive for adventurous investors

When deciding where to put their money, smart investors compare a prospective fund with its peers in terms of its performance and objectives.

When deciding where to put their money, smart investors compare a prospective fund with its peers in terms of its performance and objectives.

That, at least, is the reasoning behind last week's launch by the Investment Management Association (IMA) of a new sector for zero dividend preference shares - a form of split capital investment trust. Zeros tend to be lumped in the "UK Other Bond" sector, but the IMA says a separate category will enable investors to compare the merits of such funds more easily.

But with split capital trusts under investigation by City regulator the Financial Services Authority (FSA), should savers consider touching zeros at all?

Split caps, which differ from ordinary investment trusts in that they issue more than one type of share, were sold as low- risk investments with above-average returns. There are three classes - zeros, income shares and ordinary shares - each with a different risk rating.

Zeros pay no dividends to the holder and mature at a set date for a pre-determined value, but investors can lose money if the split performs poorly.

And this is just what happened when the stock market plunged in 2000: many trusts plummeted in value as it turned out that they were, in fact, high risk because of the amount of gearing (bank loans) and cross-holdings. Managers had bought each other's shares, so when one fund collapsed, the others followed.

The FSA is discussing what compensation is due to savers caught up in the scandal with 21 fund providers. Some 29 split caps have been suspended and thousands of retail inves- tors have lost an estimated ?620m.

Despite this bad publicity, zeros have performed well recently. New Star Zero Portfolio has returned 42.74 per cent over the past year, followed by Jupiter Preference (41.23 per cent), Framlington Absolute Growth (31.94 per cent) and Premier Zero Preference (29.54 per cent), according to ratings agency Standard & Poor's.

Zeros have outperformed the average Other Bond fund, which produced a return of 10.9 per cent during the same period, and the FTSE All Share, which generated returns of 15.3 per cent.

But investors shouldn't simply assume there will be a similar performance this year. While there are still opportunities to make money, you must understand what you are getting into.

Nick Sketch, divisional direc- tor at broker Carr Sheppards Crosthwaite, cites the example of JZ Equity Partners, which finances loans to unquoted US companies. "Some investors may think this is a high-risk approach. But there is sufficient capital in the trust to mean that even if assets halved in value, zero holders would still have their capital paid in full."

He says that choosing zeros is the same as deciding on any form of investment: ask yourself what the fund invests in, how well managed and well financed it is, and whether there is an attractive risk/reward trade-off.

"There are no shortcuts," Mr Sketch insists. "Also, look at the size of the trust. Many only have ?5m or ?10m in assets. Such small trusts can be difficult or expensive to invest in and even harder to sell if the market falls."

Zeros do not need to meet their capital-return objectives in order for investors to make money. Mr Sketch cites Second Scottish National, which winds up on 31 October 2004 and needs the FTSE All Share to rise by about 25 per cent to meet its originally promised return. The price is currently 130p, but investors would receive 138p if the trust was wound up today because of the assets it holds - a return of 6 per cent.

"That repayment will rise and fall, as it is fully exposed to the UK stock market. But if you had bought a year ago at under 100p, you would already have seen index-beating performance."

Paul Craig, manager of New Star Zero Portfolio, says retail investors can analyse zeros but need a lot of information. He recommends www.splitsonline.co.uk.

Despite the gains made by the sector in the past year, he believes there are still buying opportunities, depending on your tolerance for risk. He cites Gartmore SNT, which according to www.splitsonline.co.uk will return 8.9 per cent a year even if assets do not grow before the wind-up date of 30 September 2005. If assets decline 2.5 per cent a year, zero holders still gain a return of 6.25 per cent.

Bear in mind, though, that split caps may have a finite life. It has been estimated that nearly half the sector will wind up in the next 18 months unless there are new issues. This means funds predominantly invested in zeros will have to consider other assets as well.