New rules give closed end funds more options

Recent changes to tax rules for investment trusts – allowing shareholders to receive capital profits as dividends – could give rise to a new breed of closed-end fund.

Such rules also increase the scope for investment trusts to differentiate themselves from open-ended funds, as the RDR looms.

The tax change came into effect at the start of this year. In more conventional trusts the tax changes now make much higher distributions feasible at a time when investors, concerned about low interest rates, are putting income at the top of their list of requirements.

Investment trusts, or ‘closed-end’ funds, differ from ‘open-ended’ unit trusts and open-ended investment companies (Oeics) in many ways. One key distinction is how they distribute the income they earn from their investments.

Unit trusts are obliged to pay out all the dividends received from their portfolio companies each year, regardless of the level of these payments. In good years dividends overall usually rise, and therefore maintaining or growing a unit trust’s payout is easy. But during recessions, companies often need to cut payouts to preserve cash when, for instance, balance sheets are stretched and agreements with lenders begin to bite. On rare occasions dividends can be suspended entirely if, say, the company is suddenly faced with an unexpected crisis, such as when BP’s Deepwater Horizon oil rig exploded in 2010.

Investment trusts have long been allowed to save up to 15 per cent of their income in reserves and use it to help boost their payouts in tough times. The recent tax rules, now harmonised with similar changes to company law, mean they can go even further by distributing realised capital gains, giving even greater scope to smooth out payments if dividends have been under pressure.

Another advantage investment trusts have traditionally enjoyed is the ability to borrow money, or use ‘gearing’, an option not open to unit trusts or Oeics. This ability to employ leverage allows investment trusts, unlike their open-ended counterparts, to raise their exposure to the markets (or ‘beta’) to capture more of the upside when markets rise. Higher yielding share portfolios often tend to be less sensitive to market movements (or have lower beta) than the market overall.

Using gearing can remove this tilt, allowing the managers to allow their stock picks to drive their performance. This can be a useful tool for managers who place greater confidence in their ability to pick outperforming stocks than their ability to time the market in the short term. A current by-product of gearing is that, at current interest rates, borrowing usually enhances an investment trust’s revenues because of the way some of the cost is allocated to the trust’s capital account.