Split Share Funds: The Fund You've Probably Never Heard Of

Most investors who want exposure to a portfolio of stocks might buy a mutual fund or ETF, in which everyone who owns the fund generally participates in the same gains, losses and income. But what if you were more interested in the dividend income that the portfolio generates? Or you were willing to take on more risk for the potential of greater gains?

With split share funds, investors can make that choice. Also called split-share corporations, these investments divide a portfolio of dividend-paying companies into two types of securities: preferred shares and Class A shares. Preferred shareholders get priority on dividend payments, while Class A shareholders get greater exposure to the portfolio’s potential gains, but also take on more of the risk if those investments fall.

Here’s how split shares work, why investors might consider them and what to know about the risks before investing.

How do split shares work?

A split-share corporation takes a portfolio of stocks and divides its dividends and growth components into two separate investment vehicles.

The preferred-share component is generally designed for investors who are more focused on income. If you buy into that part, you’ll receive a fixed distribution, paid before any dividends go to Class A shareholders. Preferred shares are also typically rated by a credit-rating agency, which can help investors assess their risk.

Class A shares, meanwhile, are geared toward investors seeking growth. Once the preferred shareholders’ dividend payments have been accounted for, Class A shareholders participate in the remaining gains – or losses – of the underlying portfolio. They may also receive dividends left over after the preferred distributions have been paid.

Both types of shares trade on a stock exchange, which means they can be purchased through a regular brokerage account.

Why can Class A shares rise or fall more?

Why might Class A shares rise or fall more than the stocks held in the underlying portfolio? It’s because preferred shareholders get paid first, leaving Class A shareholders with what remains. Consider a simple example. Imagine a split-share corporation has $20 in assets, with $10 supporting a preferred share and the remaining $10 supporting a Class A share.

If the overall portfolio rises 10%, its value increases from $20 to $22. Assuming the amount owed to the preferred shareholder remains $10, there is now $12 left for the Class A shareholder. That’s a 20% increase on the original $10.

But leverage cuts both ways. If that $20 portfolio instead falls 10% to $18, there would be only $8 left after accounting for the $10 preferred share, a 20% decline for the Class A shareholder.

That potential for amplified gains is one of the attractions of Class A shares, but the possibility of amplified losses is one of their biggest risks.

Why might investors consider preferred shares?

For investors who prioritize income over growth, preferred shares offer a different proposition.

The corporations’ distributions are established in advance, which can provide a more predictable source of income than dividends paid to Class A shareholders. Preferred shareholders also have priority over Class A shareholders, giving them some protection if the underlying portfolio declines.

Of course, greater stability comes with a trade-off. Preferred shareholders generally don’t participate in the portfolio’s capital appreciation to the same extent as Class A shareholders.

What are the risks of split shares?

The risks depend on which class you own.

For Class A shareholders, the biggest consideration is leverage. A declining market can reduce the value of the underlying portfolio much faster from the Class A shareholder’s perspective.

Preferred shareholders have greater protection because of their priority, but they aren’t immune to losses. Ultimately, both classes depend on the value and performance of the same underlying portfolio.

That’s why investors will likely want to start by looking at what’s actually inside the split-share corporation. Usually, these portfolios hold well-established, financially stable companies, but holdings can vary from one split-share corporation to another.

What else should you consider before buying?

Split share funds have some additional features to consider. One is net asset value (NAV), which is essentially the value of all the investments held by the split-share corporation, minus any liabilities. That value matters because it ultimately supports both the preferred and Class A shares.

However, since split shares trade on an exchange, the price you pay for a share can differ from the value of the assets supporting it. A share trading above that value is said to trade at a premium, while one trading below it trades at a discount. That difference could affect your return. For example, if you buy at a significant premium and that premium later disappears, the share price could fall even if the value of the underlying investments hasn’t changed.

Another consideration is redemption features. Some split-share corporations also allow investors to sell their shares back to the corporation at specified times. The amount an investor receives is calculated according to rules set out in the corporation’s prospectus, and may differ from the share’s market price.

Split-share corporations may also have a final redemption date, when the corporation is scheduled to redeem its outstanding shares. There is typically also a monthly redemption feature whereby the investor can sell capital shares or preferred shares back to the company on a monthly basis. Investors should understand both the monthly and final redemption terms before investing.

It’s also worth looking closely at the size and composition of the underlying portfolio, distributions and, for preferred shares, any available credit rating.

Are split share funds right for every investor?

Split share funds aren’t necessarily a good fit for everyone. What makes the funds unusual is also what makes them more complicated than simply buying the underlying stocks.

An income-oriented investor may be attracted to the preferred shares and their more predictable distributions. An investor with a higher risk tolerance may find the leveraged growth potential of Class A shares appealing. But neither should be considered in isolation from the underlying portfolio.

Dividing an investment into two classes doesn’t eliminate risk – it just changes how that risk is distributed between investors.

The bottom line

Split shares provide two very different ways to invest in the same portfolio. Preferred shareholders get priority on distributions and generally take on less risk, while Class A shareholders accept greater risk in exchange for the potential for amplified gains.

For investors, the key is understanding not only what’s in the underlying portfolio, but which part of the split you’re buying. Before investing, consider the holdings, NAV, distributions, redemption terms and how the particular share class fits with your risk tolerance and investment goals.