Investment Trusts: Beware the fall of a House of Cards

IF YOU have placed your money in an investment trust, you do so on the understanding that its fund manager will out-perform compared to a relevant index, based on his or her own individual flair. What you are unlikely to expect is that that fund manager has invested a large slice of his cash in another investment trust, which has placed a portion of its money in a third investment trust, which in turn is investing heavily in your own trust, or the shares of its parent company.

Some experts distrust this practice, fearing the collapse of shares held through an interconnected spiral of cross-ownership. Others argue that the practice of cross-holding trusts within a group can be used to narrow the discounts of ailing funds.

The "discount" is where the shares of an investment trust cost less to buy than the actual assets it holds. It is usually measured as a percentage, so if a share stands at a discount of 12 per cent to net asset value (NAV), this means you are buying 100p of assets for 88p. This may be attractive to the shareholders of the funds whose shares are being bought, but it may not be the best strategy for the investment trust doing the buying. Again, a conflict of interest could arise where shares in internal funds are favoured over those of external companies or funds that might otherwise be placed in the investment trusts portfolio.

Cross-holdings do provide an extra layer of individual investment diversification, because the trust being bought will have invested in a wide range of companies. But the investor will lose diversification in terms of management house style. Trusts become dependent on the success of the investment house and the investment trust team.

Peter Walls, investment trust analyst at Credit Lyonnais, believes there is little evidence that investment trusts buy shares in internal funds to reduce the discount, and adds that levels of cross-holdings are reducing across the industry as a whole. He says: "It is fair to say that cross-holdings in investment trusts of the same parent company are less common than they were 10 or 15 years ago in conventional investment trusts."

Investors should be aware of the potential problems related to cross- holdings in split capital investment trusts. The cross-holdings in the split capital sector have led to the feared "house of cards" scenario, where the failure of one trust severely affects the others in the circle.

A survey by Bloomberg Money reveals that out of the split capital trust sector, five funds typically have large numbers of investments in other split capital trusts among their top 10 holdings. These funds are BFS Income & Growth, Aberdeen's Danae and Jove trusts, Dartmoor (run by Exeter fund managers), Geared Income (run by Broker Financial Services) and INVESCO's City & Commercial split capital trust. All these companies, except INVESCO, have holdings in split capital trusts that invest in other split capital trusts as well - namely themselves. The split capital trusts held by INVESCO's fund invest in non-split capital investment trust shares or shares of non-investment trust companies.

This is illustrated in the table on this page. For example, Danae has eight holdings of split capital investment trusts in its top 10, making up 26.7 per cent of the fund. Of these, two are split capital trusts that invest in other split capitals - Dartmoor and Geared Income (income shares and ordinary shares). But neither of these two trusts invest in Danae, so the circle between the three trusts is not complete.

But a true circle and "house of cards" scenario exists between Dartmoor and Geared Income, both of which invest in each other. This is highlighted by the fact that 3.1 per cent of Dartmoor is held in Geared Income trust, which has 8.4 per cent of Dartmoor. The performance of these two funds is highly interdependent. Mr Walls says: "At present, split capital funds with cross-holdings are doing well because interest rates have fallen and people invest in split capital trusts because they can generate a reasonable level of income. But problems might occur if that trend were to change and investors moved out of the funds."

Despite the possibility of increased risk, some industry experts believe split capital cross-holdings are no bad thing. Robin Minter Kemp, deputy managing director of HSBC, says split capital investors provide a steady base of investment in split capital funds. He says: "Because of the current economic environment of low interest rates, there is high demand for high- yielding split capital shares, but a shortage of supply. As a result, many split capital funds invest in each other and this helps support the share price."

Although it is hard to imagine this beneficial circle turning into a vicious circle, that is exactly what happened in 1929 when the stockmarkets in the US and the UK crashed. Investors in closed-end funds, such as investment trusts, suffered particularly badly because the value of their shares fell even faster than the value of the assets in which such funds were invested.

Although the 1929 scenario is unlikely to occur again, the cross- holdings throughout the industry clearly increase risk and can confuse investors. Cross-holdings can make it more difficult for investors to assess exactly what a trust has invested in at the bottom line and such detailed information is often difficult to obtain.

Graham Campbell, head of UK large company investment at Edinburgh Fund Managers, believes investors should be wary of split capital trusts that have cross-holdings. He says: "Split capital trusts are already geared investments whose performance is more sharply affected by market conditions than standard trusts. So, if they invest in other split capital trusts, they are effectively increasing their gearing and risk even more for their investors."

Investors clearly deserve greater transparency from investment trust groups and should look with caution on trusts with large numbers of cross- holdings.

Katharine Lewis is senior writer at Bloomberg Money magazine