Let us start with the last bit, paying it out. Unlike open-ended funds, which must pay out all the income they receive in a year, investment companies can reserve up to 15 per cent of that income to distribute in a subsequent year. Any income not paid out goes into a ‘revenue reserve’ that can be used in future to top up dividends.
If investment companies are clever about how they use this flexibility, it enables them to hold back income in good years and pay it out in leaner times, helping to provide a smoother and more predictable income stream for investors.
The success of the dividend heroes – investment companies that have increased their dividends year-on-year for decades in a row – in providing dependable payouts is reflected in the wider UK equity income sector. Let us say you invested £100,000 in the average company in this sector 20 years ago. The income you received would have grown steadily at an compounded annual rate of 4.8 per cent, comfortably beating inflation of 2.8 per cent over the same period. Incidentally, even if you had you taken all this income as cash, the capital would still have grown to just over £260,000.
The revenue reserve is a long-established way of smoothing dividends, but since 2012, investment companies have also been able to pay dividends out of capital profits.
This is not totally new (venture capital trusts have always had this ability, as have many offshore investment companies) but it is considered rather unusual for investment trusts investing in mainstream equities. A few have decided to beef up their dividends in this way, such as Securities Trust of Scotland, Invesco Perpetual UK Smaller Companies and European Assets, but it is more common in asset classes that do not naturally produce income, like private equity. It is important that when companies are paying out capital profits as income, you are aware that it is happening and realise the obvious consequence: some erosion of your capital (less jam tomorrow) in return for the extra income (more jam today).
The income drought resulting from near-zero interest rates and wafer-thin bond yields has driven investors to hunt for income in all sorts of places, including illiquid assets like property, infrastructure projects and specialist debt (such as peer-to-peer loans or asset-backed securities). The good thing about illiquid assets is that some investors cannot hold them or do not want to. This lower demand can lead to higher yields without having to stomach the sort of risk of default you would have to accept when investing in more liquid assets with the same level of yield, such as junk bonds.
This does not mean illiquid assets are risk-free, of course. By definition, they carry the risk that you may not be able to sell them when you want to; but if you buy shares in an investment company that invests in these assets, that risk is much reduced. You may also get the benefit of an income stream that is less correlated to equity and bond markets.
Then there is commercial property. This could be accessed through open-ended funds or investment companies, but the latter have the advantage that they do not need to hold large amounts of cash in the fund to meet possible redemptions. They can also use gearing to increase yields further, though this is clearly going to make capital returns more volatile. Options range from broad portfolios of offices, shops and warehouses such as F&C Commercial Property (yielding 4.1 per cent) or Standard Life Investments Property Income (5.3 per cent), to more specialist funds such as Medicx (7.1 per cent), which buys GPs’ surgeries for a comparatively low-risk income stream, to Empiric Student Property (5.5 per cent), which does what it says on the tin.
You can even get quite high dividends from VCTs, generated mainly from capital profits. Although a higher-risk stream of income, it has the benefit of being tax-free. At present, VCTs yield an average 8.3 per cent.
You can start to see how you could use investment companies to build up an income portfolio with just about any risk/reward profile you were after. The only income-generating asset that investment companies are not big on is mainstream bonds. For these, open-ended funds offer a greater variety.
It is important to bear in mind the effect of discounts and premiums on the income you receive. For example, if you buy an investment company on a 10 per cent discount, you are essentially buying 90p of assets for 100p, but still getting income on the 100p. That means a higher yield.
Conversely, buying investment companies on premiums gives you a lower yield. Several income-producing sectors, such as property and infrastructure, are trading at premiums at the moment due to the high demand for those income streams. Of course, just about any time you see the yield quoted, including in this article, it is the yield based on the current share price (that is, taking the current discount or premium into account).
Nick Britton is head of training at the AIC
Investment companies have much more flexibility when it comes to paying it out.
The income drought has driven investors to hunt for income in all sorts of places.
You can even get quite high dividends from VCTs, generated mainly from capital profits.