From zeroes to heroes

Income chasing investors can zero in on low risk, long term 9% yields - and those gains will be income tax free.

Or thanks to commissions and charges they could buy the same investments via a unit trust instead of directly from the stock market and settle for a meagre 6% to 7%. A new unit trust due out next month even locks in vestors in with exit charges which can further shrink the yield.

However they are packaged, these returns come from zero dividend preference shares - or "zeroes" as they are known.

These are the lowest risk facet of split level funds, which are investment trusts whose return is sliced to give the promise of extra income to income seekers and of larger than average gains to capital chasers.

Investment trust managers are currently launching zeroes at around one a fortnight. Last month, Jupiter closed the lists for its £150m Financial and Income Trust which featured an £18.75m zero offering an initial 9%.

Later this month, Aberdeen will launch a £700m Real Estate Opportunities - REO will have a zero coupon element worth around £40m

And Friends Ivory & Sime is rolling over the Investors Capital trust resulting in a further £30m of zeroes.

New zero issues typically yield 9% - a return that is relatively safe. So far no zero has failed to pay up in the two decades since they were first invented.

Now unit trust managers are trying to latch on to income seekers needs with launches of zero funds - from Gartmore, Framlington and Premier to add to the three existing vehicles set up by Exeter, Investec and Aberdeen.

So what's the catch? Should investors aim for the ultra high income on offer and buy direct or shun the shares as an example of a good idea that's bound to go wrong as soon as unit trusts adopt the concept?

The yields are not guaranteed. They depend on the underlying fund performance but provided that beats often undemanding targets and the zero is held until redemption, investor cash plus capital gain should be assured.

But unit trust advertised returns are riskier as well as being lower. Fund managers may try to enhance performance with active trading - and fail.

Gartmore's new Stable Growth Fund - due to be launched on July 11 - starts off with an underlying 8.4% yield. But once charges come off, the estimated return falls to 7%. The annual charge is 1.5% and withdrawals cost a further 1.5% during the first five years.

Gartmore says "this is taken from the capital and may restrict capital growth." But investors with £10,000 or more can select a monthly payment option without an exit penalty.

Investment trust specialists like zeroes but suggest private investors should stay away from unit trust funds.

"We arrange portfolios for clients with £50,000 or more - they often use them for educational fees or for a tax free income boost," says Simon Moore, investment trust analyst at stockbrokers Teather & Greenwood.

"But they are rarely traded and generally held until their final redemption date so the overall costs are far cheaper than the specialist unit trusts which have a double layer of charges," he adds.

Mr Moore believes investors should apply for new zero launches. "The average new zero goes out with a 8.5 to 9% yield. By the time it reaches the stock market, the return tends to fall to around 7% and then you have to pay management fees in a unit trust. Investment trusts want more private clients so they tend to treat smaller holders better than institutions if an issue is oversubscribed," he says.

Minimum investment levels are low - usually £1,000 - though most advisers will recommend a portfolio that matures on different dates because zeroes have a risk spectrum. Those based on other zeroes tend to have the highest yields; "barbells" or trusts with high bank borrowings are also risky while those investing in blue chip shares have the best ratings.

Sue Whitbread at Chartwell Asset Management also likes zeroes but not funds.

"Any active management advantages are unlikely to overcome the drag of costs. There are only 75 to 80 zeroes, so diversification is not that significant. These funds are expensive and you don't know where they're going. If you buy your own - you can do this through a low cost investment trust purchase scheme if you don't have a broker - you are locking into a yield and a final date. Our clients like a regular stream of redemptions to minimise costs and maximise tax benefits," she says.

Craig Walton at Framlington, whose zero based Absolute Growth Fund took in £4m in its recent launch period, says his fund is designed to yield 8% before charges and 6% after costs.

"The gap is due to the way we now have to show expenses - it would be less through a discount broker. We can offer cost-free regular income withdrawals, a spread of risk, and the smoothing out of redemption dates. We also take care of all the corporate activity," he says.

Jonathon Fry at Premier offers portfolios of zeroes. But investors need a minimum £150,000 - and pay a 1% annual fee. His "zero" unit trust charges 1.25%.

"The fees are worth it," he claims. "We offer diversification for those whose funds are too small and allow small encashments at no cost which can be useful for paying university expenses and for phased retirement."

How a zero works


Zero dividend preference shares are stock market traded shares which constitute the least risky portion of split level investment trusts.

They do not pay an income because the dividend is rolled up into the trust. Instead they offer a capital gain on a set future date. For example, a zero is launched at 100p with the promise of 200p in eight years' time - equal to a 9% annualised yield if held to its final redemption date.

The return is a capital gain. Sellers have to pay capital gains tax but can cash in on the annual free slice - currently £7,500 - to give a tax free income each year.

Analysts look at two main factors to assess a zero.

The hurdle rate is the percentage the underlying portfolio has to grow the capital each year before dividend payments to ensure the zero is paid out in full. A zero should have a negative hurdle rate - the bigger the better.

Capital cover shows how the trust's net assets meet the zero's final payout value -the higher the figure, the better with two times recommended for conservative investors.

The Association of Investment Trust Companies has a free booklet - phone 0800 707 707. Framlington offers its Guide to Zeroes free on 0845 777 5511.

Capital gains tax cut will boost AIM market


Investor interest in AIM, the lightly regulated alternative investment market for small company shares, could take off again.

Hopes are rising that investors will look again at AIM shares following chancellor Gordon Brown's decision to cut capital gains tax on "business assets" earlier this week.

This includes shares which are technically unquoted including those on

AIM and the even less regulated Ofex market.

The intention is to cut capital gains tax after two years from the present 30% to 10% in the Budget next March. This compares with up to 40% for mainstream shares sold after the same holding period.

Jason Hollands at IFA Bestinvest, predicts "rising fortunes for AIM thanks to the proposed changes".

But the AIM market has some way to go before recapturing last year's record highs. Over the past 12 months, the FTSE AIM index is down 32%. It is 60% lower from the March 2000 peak.

"AIM has had quite a few failures. But if you're choosy, there are some well-run companies in areas such as fitness clubs and print shops," says Hollands. "Investors with possible CGT bills should direct their small company involvement towards AIM."

The move makes no difference to investors who buy into AIM funds. Most of these are already in tax-free venture capital trusts.

And the CGT reduction does not apply to holders of AIM unit trusts. They will still have to pay full CGT on profits, although no tax is paid on switches within the fund.