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FOOL'S EYE VIEW
Understanding ZDPs

By James Carlisle
September 5, 2001

All investors have slightly different priorities regarding income, capital growth and risk, so what could be better than pooling your money together to share the risk and reward of a portfolio as it suits each investor? This is what Split Capital Investment Trusts are designed to achieve. You have one pot of money but, as the name suggests, different classes of share capital. The plan is that there's something in it for everyone.

The concept is relatively straightforward. Let's say two investors have 10,000 each to invest. One wants income, and relative safety, while the other wants capital growth and is happy to take a bit of risk. They could put their combined 20,000 into, say Marks & Spencer (LSE: MKS) shares and agree that the first gets all of the dividends, while the other gets all of any capital gains. They agree to sell the shares in ten years' time, with Ian Income taking the first 10,000 of whatever's there and Colin Capital-Growth pocketing the rest.

Because he's getting the dividends from Colin's 10,000 as well as his own, Ian effectively gets double the income that he'd have got if he stuck on his own. In the case of Marks & Spencer shares, he'd be getting 6.8% per year, instead of the 3.4% dividend yield that the shares offer. On top of this, the shares would have to halve over ten years for him to lose any of his capital. Colin, meanwhile, gets any capital growth from the full 20,000, even though he's only put 10,000 in.

It's a bit like the gearing you get when you buy a house with a mortgage. If the M&S shares double over 10 years (not impossible even for M&S), then the combined fund would rise to 40,000 and Colin's 10,000 would have tripled to 30,000. Wahey!

In the Real World

Of course, putting everything into Marks & Spencer is more than a little risky. In the real world, people play this game with diversified portfolios of shares in the form of investment trusts. They also, as you'd expect, take a lot of care to write down the agreement between the various types of shareholder. The types you'll most normally come across are:

Zero Dividend Preference Shares

Also known as ZDPs or Zeros, these deliver no income, but a pre-set rate of capital growth. Since they get the first call on any money when it's shared out at the end, they tend to be pretty safe. There's more about them here.

Income Shares

These get the income that isn't being paid out on the other types of share, but there is little or no prospect of capital growth. They generally get the second call on the money at divvy-up time, so can range from pretty safe to really quite risky.

Capital Shares

These basically get anything that's left over. That could be an awful lot or it could very easily be nothing at all. In terms of risk, they vary from not for the fainthearted to wild punt.

Complications

Unfortunately, as ever, there are one or two complications. The first is that they're just too complicated. Let's go back to the Marks & Spencer example. Who's got the best deal? Would you rather be in Ian's shoes or Colin's? Personally, I couldn't say whether Marks & Spencer looks good for the next ten years in the first place, let alone try to say how the return is likely to be shared between the dividends and the capital growth. And then what about the risk?

To get an idea of how this sort of thing works in the real world, we can look at an example. Let's take the LeggMason Investments International Utilities Trust. The fund is due to be wound up in December 2003 and it will pay the full dues to holders of its ZDP, so long as the overall fund doesn't fall by more than 15.6% per year between now and then (this is known as the hurdle rate). The fund is invested roughly 35% in US utility companies, 35% in UK utilities and the rest is mostly in continental Europe. Bear in mind that some of these utilities are telecom companies and a Californian power company recently went bust...

The market reckons it's worth taking this risk in exchange for a growth rate of 6.3%, since that is what the ZDP will deliver if it pays out in full (this is called the redemption yield). Don't ask me how it comes to this view, but I'd want a fair bit more than 6.3% myself. And we haven't even thought about valuing the income shares and the capital shares.

...And More Complications

This balance between risk and reward is further upset if the underlying investment trust has borrowings. These will normally need to be paid off before even the ZDP gets any money. Take the Govett European Technology and Income Trust. It needs to grow by an average of 2.9% per year to repay its ZDPs in full when it winds up in 2007. The market reckons this is worth taking on for a redemption yield of 14.9%. That may or may not be about right, but you'd want to make that decision knowing that the trust carries a large slab of debt and missing the hurdle rate by a little could wipe the ZDPs out entirely.

As if we needed further complications, several funds have been launched recently that invest solely in ZDPs. There have also been warnings that investment trusts are developing an unheathly habit of investing in one another. The problem is that if one fails to pay its various classes of shareholders, then others might soon follow. You might think you're in a low-risk fund that itself invests in twenty different ZDPs but, if they're all invested in eachother, then the risk is concentrated because the same event could affect all twenty.

Split capital investment trusts can have their uses. But, just as with any other investment, you need to do your own research. What is the underlying fund invested in? Does it have any debt and, if so, what are the terms? What is the precise relationship between the different classes of share? Having found all this out, do you have any confidence in your ability to weigh it all up? If the answer's no, then it's probably best to stick to what you know.

More: Investment Trusts and Unit Trusts discussion board | ZDPs explained