InvestmentsMar 10 2014

Diversifying is harder than it used to be

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Before Deepwater Horizon, BP was one of the most generous, reliable distributors in the FTSE, deemed a stalwart holding in most income investors’ portfolios.

Then it cut its dividend, which should have seen investors receive roughly $10bn (£6bn) that year alone. Investors in open-ended funds were hit hard whereas investors favouring investment trusts (ITs) were shielded by the use of revenue reserves, seen as a key benefit to using investment trusts over Oeics or unit trusts.

David Smith, co-manager of the Henderson High Income Trust, cites this as one of their main advantages.

“You don’t have to pay out 100 per cent of the income [HMRC stipulates only 85 per cent must be distributed]. The ability to hold some of that income back, giving yourself a cash buffer to see you through the more difficult times and therefore a more sustainable income stream, is a huge benefit,” he says.

F&C Investments’ Peter Hewitt, manager of the Managed Portfolio Trust, cites the case of Investec’s Alastair Mundy, manager of the Temple Bar investment trust (as well as Investec’s Cautious Managed and Special Situations funds), who held BP across both structures pre-Deepwater disaster.

“Temple Bar was able to maintain its dividend simply through its ability to dip into its revenue reserves, whereas his Oeics cut theirs by 15 per cent and again the following year.”

The average yield on IMA UK Equity Income funds is currently 3.8 per cent, according to FE Analytics. This compares with 3.31 per cent for the comparable investment trust sector, so arguably yields are only marginally lower for ITs and for a small sacrifice you enjoy regularity of income. So how much does it cost?

Mr Hewitt says any investment with an above-average yield that is also quite sustainable will tend to trade either at a very narrow discount, par, or a small premium.

“I am a medium-to-long-term investor, so if I get the right manager who will grow the asset as well as the dividend, I’m not bothered about paying a 2 per cent premium. I wouldn’t pay 8-12 per cent as I think that’s probably a bit much, but you will find most of the equity income sector’s investment companies on discounts up to a 1-2 per cent premium.”

Nick Sketch, Investec Wealth & Investment senior investment director, suggests there is more to it than simply certainty of income. He explains: “The importance of smoothing dividends can be overstated and a long-term policy of turning capital into income at the margin is hardly tax-efficient. However, IT income reserves can mean that a manager can buy a stock that does not meet his income target this year, in the expectation that it will do well over three or four years.

“That extra flexibility can be useful, particularly if – as today – many equities with a yield of, say, 5 per cent look comparatively expensive in terms of expected total risk-adjusted return, compared with those yielding 3 per cent.”

The ability to gear is another major benefit of using closed-ended funds. Mr Smith explains: “Gearing allows you to generate additional income and also a bit of capital over time – useful when yields are still low, even on high quality equities.”

London-based financial planner Dennis Hall, managing director at Yellowtail, believes the ability to better manage inflows and outflows is worth noting.

“I class a decent investment trust as a very low turnover fund – almost a buy-and-hold approach. They are somewhat insulated from the day-to-day buying and selling of shares. So, even if investors are selling a manager’s fund, they can retain the underlying assets.”

Mr Smith also highlights the generally lower costs of investment trusts versus Oeics, which, when compounded over a long timeframe, can make a significant difference to performance.

“Large capital inflows can grow an Oeic quicker and therefore the annual management charge per shareholder comes down. But it can also make it harder to manage. Large outflows can lead to forced selling to gain liquidity in order to honour redemptions.”

Mr Sketch notes that specialist ITs can bring investors diversification benefits, especially where niche areas, more lowly correlated to equities, are sought.

“Liquidity matters a lot at the moment. In part, this reflects that a lot of dividends from the UK stockmarket come from about 20 shares – that doesn’t give much room for diversification, and few of those stocks look very cheap today.

“More generally, diversifying an equity-based portfolio is always important, but it is harder than it used to be, most obviously because cash and mainstream bonds are the most obvious diversifiers and they offer very low returns.”

Sam Shaw is a freelance journalist

INVESTMENT TRUSTS

JARGON BUSTER - What do the terms mean?

• Closed-ended - A closed-ended investment company has a fixed number of shares in issue at any one time. These are traded on the stockmarket but has no impact on the underlying portfolio.

• Discount - The amount, expressed as a percentage, by which the share price is less than the net asset value per share.

• Dividend - Income from an investment in the shares. Dividends are usually paid twice a year but can also be paid quarterly or monthly, but not all investment companies pay dividends.

• Gearing - A way that investment companies can magnify income and capital returns, but also magnify losses. It usually means borrowing money to buy more assets in the hope it makes enough profit to pay back the debt and leave something extra for shareholders.

• Illiquid Assets - Investments that can’t be sold at short notice, examples include private equity, property and venture capital.

• Net Asset Value (NAV) - This is the value of the investment company’s assets, less any liabilities it has.

• Net Asset Value (NAV) per Share - This is the NAV divided by the number of shares in issue. This is often very different to the share price, which results in a discount or premium to NAV.

• Premium - The amount, expressed as a percentage, by which the share price is more than the net asset value per share.

Source: AIC