Investing in an investment that invests in itself
That is a rather bizarre title but it reflects something that has happened and could happen again.
A quite serious investment crisis arose not so long ago with a group of investment companies called split capital investment trusts. These are standard investment trusts in that they are listed on the stock market as shares and operate as investment companies, buying portfolios of other shares. What is different about split capital investment trusts is that they have multiple share classes. They also usually have a fixed life so will be wound up and have their assets distributed at a known future date.
Doing the ‘splits’
For example, there may be income shares that receive all the income coming in from the investments owned (the assets of the trust) and zero dividend shares that get no income. Say each class of shares represent 50% of the issued share capital. Then 50% of the shares get all the dividends (100%), so effectively get double the normal payout. So if the portfolio of investments pays 3.5%, then the income shareholders get 7%. Lovely! But there is catch, of course.
The zero dividend shareholders, possibly not wanting to pay income tax have been happy to give up their dividends because they get all the capital on winding up and the income shareholders get nothing at all. The income shareholders have in fact bought something like a fixed term annuity – the right to an income stream in return for giving up a lump sum. If the term is long enough, then that is fine, they will still get a good deal because the income is so high it will make up for the loss of capital if received over many years.
As an aside, at the time of the “splits” crisis quite a few income shareholders advised by stock brokers did not appreciate that the very high income stream was financed partly from their own capital, and got a nasty surprise in due course. That was part of a mis-selling investigation by the then regulator and some compensation was paid out.
The other aspect of the crisis at that time is what is behind the title to this article. Because there was a demand for higher and higher income yields, some split capital trust managers started buying the income shares of other split capital trusts so they could pass on even more extra income. Headline income rates are often important in attracting money from (arguably naïve) investors and managers wanted to be able to advertise the top rates.
An example
Imagine that Investment Trust A now owns shares in Investment Trust B. Both pay their income share holders all the yield they get in dividends and Trust A’s yield will go up because it now owns Trust B’s high yielding shares. 7% might be now coming from these income shares compared to 3.5% on the market as a whole. That means the income shareholders in Trust A will get 14% because they get all the income even though they only 50% of the assets (as explained above).
Now suppose that deliberately, or carelessly, Trust B now buys Trust A’s shares. It also boosts its yield payout for the same reasons but hang on, something is not right here, surely? Some of Trust B’s new super yield is dividends coming into Trust A from its (Trust B’s) own shares. If it decides that on paper it now has a higher yield again, it pays out more income to Trust A and because it owns Trust A’s shares it gets back even more income! Round and round the Mulberry bush!
Of course, this is a process that is fictionally inventing investment returns. It can be to invent money because financial fictions are quite commonplace. The Ponzi scheme is something most people have heard of but if you have not, take a look at Wikipedia. That is just the best known example. Some digital currencies are also pretty much fictions.
This process was at the time entirely legal but of cause collapsed painfully with unpleasant repercussions and regulatory handwringing. Regulators in financial services, like all regulators, take special exams in bolting up empty stable doors!
Lessons
As always with these notes, there is a lesson to be taken from the tale. Investment trusts (and there are many that are not ‘split capital’ of course) are often promoted as somehow better then collective funds, because the managers take lower fees, an inarguable advantage. However, they are a completely different beast. As listed companies, they are regulated in a totally different way and their value will alter according to not only ordinary changes in the value of the assets they own, as is the case with collective funds like OEICs, but also for reasons of supply and demand, whether or not they have borrowed money and other factors.
The other risk and the one this piece is designed to highlight which is not understood by many commentators is that it is perfectly legal for an investment trust to own shares in an overseas company that has normal trading activities but which also owns shares (as well as trading in its business area) under the rules of a totally different legal jurisdiction. So the company whose shares the investment trust owns can also own the shares of the investment trust. Thus the investment trust is indeed thereby investing in itself!
Investment trusts with unusually strong price growth should always be thoroughly investigated by someone who understands company law, but as not all overseas jurisdiction provide transparent access to company annual reports, it will never be possible for a retail investor to identify every example of such additional risk.