Investing For Growth: It's a two-way stretch if you do the splits

INVESTORS looking for growth should not ignore split-capital investment trusts. Although these vehicles are slightly more arcane than other collective investment funds (see box below for full explanation), they can deliver fantastic returns if you pick the right one at the right time.

In a rising stock market the capital shares issued by some split-capital trusts often turn in outstanding performances. Figures from performance- monitoring specialist HSW show that over the three years to 1 January 1999 the price of the average capital share rose by 110 per cent - better than any other investment or unit trust sector over the same period.

Moreover, individual capital shares have generated some amazing returns of late. According to HSW, if you'd invested pounds 1,000 in the capital shares of Second St David's investment trust on 1 January 1996, your holding would have been worth pounds 6,800 by the beginning of this year. That wasn't a fluke: several other trusts produced similar sorts of performances on their capital shares over the same period.

Nevertheless, capital shares aren't for nervy investors. They are much more risky than other types of collective fund holding. It's important to remember that those spectacular performances were generated over a period when the UK stock market as a whole did very well. When times aren't so good, capital shares are just as capable of registering spectacularly negative returns.

Before you invest you must understand how capital shares, and split- capital trusts in general, work. The reason capital shares do so well in rising markets is that they are the most risky class of share held by a split-capital trust. As the box explains, capital shareholders get all the growth in the value of the fund's assets when the trust winds up - but only after all other shareholders have been paid what they are owed. In other words, while most split-capital trust shareholders are entitled to a fixed return on their investment, capital shareholders' gains are open-ended.

Past a certain point, the more the split's assets grow, the more capital shareholders get. So beyond that point, the value of capital shares ratchets up disproportionately quickly.

This phenomenon is known as gearing and, unfortunately, it works just as well in reverse. The faster a split's assets shrink, the worse capital shareholders do. Gearing can quickly mean that capital shareholders are entitled to nothing. So in a falling market it's entirely possible to lose your whole investment.

Growth investors therefore need to approach capital shares with great care. Around 25 split-capital investment trusts currently offer capital shares and picking the right stocks will require a little research. In particular, pay great attention to the "hurdle rate" quoted on any shares you consider buying. This tells you the annual rate of return the trust must achieve for you to qualify for a capital repayment when the split winds up. The higher the hurdle rate, the more unlikely it is you will get a capital repayment on wind-up.

One option, if you're concerned about losses, is to buy a portfolio of capital shares to spread your risk. Alternatively, Exeter Asset Management runs an investment trust, Exeter Preferred Capital, which invests only in the shares of other split-capital trusts, including capital shares. Its performance over the last five years has been better than all other investment trusts that invest solely in their peers, but not as good as the average capital share.

This is the price you pay for the reduction in risk offered by investing in capital shares via a collective fund.

David Prosser is personal finance editor of 'Investors Chronicle'.

The Association of Investment Trust Companies (0171-431 5222) publishes a factsheet on split-capital trusts. For Exeter Asset Management, call 01392 412122.

how splits work

Every split has a fixed wind-up date and issues at least two classes of share. During the life of the trust, investors receive income and growth according to the rights attached to their shares. On the specified date, the trust is wound up and shareholders repaid - if the trust has sufficient assets - according to a pecking order. Some splits offer several of the share classes below:

Capital shares, the riskiest, pay no income during the life of a split and only pay out on wind-up after all other investors have been paid. But since capital shareholders are entitled to all the assets remaining, there is the potential for big gains.

Income and residual capital shares entitle holders to all the income from the split, once other shareholders have been paid.

Income shareholders get whatever income remains once a split has paid any stepped preference shareholders. Income shares pay a fixed capital sum at wind-up.

Stepped preference shares. Holders get a fixed income each year, which rises at a predetermined rate, and a fixed capital sum on wind-up.

Annuity shares qualify holders for a high income over the life of the split but investors only get a nominal capital sum back at the end.

Zero dividend preference shares are the least risky type. They pay no income during the life of the split but shareholders get a pre-fixed capital sum on wind-up.