How do investment trusts meet income requirements?

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How do investment trusts meet income requirements?

Whether it’s income to supplement the low interest rate environment the UK has been in for many years now, or income to fund retirement, there is undoubtedly a need for yield.

What many advisers and investors do not perhaps realise is that investment trusts have a longstanding reputation for delivering income year in, year out.

Dividend heroes

The Association of Investment Companies (AIC) has a list of dividend heroes – “the investment companies that have consecutively increased their dividends for 20 years or more”.

In fact, recent research from the AIC reveals 46 per cent of investment companies are now paying a quarterly dividend.

Dion Di Miceli, head of investment companies at Gravis Capital Partners, says savvy investors will be familiar with the old market adage “investment trusts for income, Oeics for capital”. 

Whereas many open-ended funds are restricted to investing in certain types of shares and securities, investment companies don’t have this restriction.Annabel Brodie-Smith

He explains: “Firstly, investment trusts can accrue revenue reserves of up to 15 per cent of the portfolio income on an annual basis. 

“This enables them to preserve cash reserves over time and maintain (and grow) dividend payments to shareholders even where there are dividend cuts in the underlying portfolio holdings.”

Annabel Brodie-Smith, communications director at the AIC, agrees investment trusts have the ability to smooth dividends.

“This means that investment companies can hold back up to 15 per cent of the income generated in good times to pay it out when times are tough.”

She notes, in comparison, open-ended funds have to pay out all their income each year.

Investing far and wide

Another reason investment companies are suited to providing income is the access they have to a wide range of investments, points out Ms Brodie-Smith.

“Whereas many open-ended funds are restricted to investing in certain types of shares and securities, investment companies don’t have this restriction,” she explains. 

“In addition, asset classes such as property and infrastructure can offer a higher level of income, and being illiquid, are better suited to the closed-ended structure of an investment company.”

Investment trusts have a third feature which allows them to pay out a steady income stream, although this is more of a last resort.

Ms Brodie-Smith says: “Lastly, investment companies have the ability to pay income out of capital profits. While used quite sparingly, this can be useful and helps meet shareholder demand for income in a low interest rate environment and potentially can lead to investment companies being re-rated to trade on lower discounts – another benefit for shareholders. 

“Clearly investment company boards have an important role to play overseeing any change in the dividend policy and ensuring it is in shareholders’ best interests.” 

She reiterates shareholders have to approve the change in policy to allow the investment company to pay income out of capital profits.

Some of the AIC’s dividend heroes include investment trusts which have clocked up 50 years of consecutive dividend increases.

Figure 1: Dividend heroes

CompanySectorNumber of consecutive years’ dividend increased
City of London Investment TrustUK Equity Income50
Bankers Investment TrustGlobal50
Alliance TrustGlobal50
Caledonia InvestmentsGlobal49
F&C Global Smaller CompaniesGlobal46
Foreign & Colonial Investment TrustGlobal46
Brunner Investment TrustGlobal45
JPMorgan Claverhouse Investment TrustUK Equity Income44
Murray IncomeUK Equity Income43
Witan Investment TrustGlobal42
Scottish AmericanGlobal Equity Income37
Merchants TrustUK Equity Income34
Scottish Mortgage Investment TrustGlobal33
Scottish Investment TrustGlobal33
Temple BarUK Equity Income33
Value & IncomeUK Equity Income29
F&C Capital & IncomeUK Equity Income23
British & AmericanUK Equity Income21
Schroder Income GrowthUK Equity Income21
 Source: AIC 

There are three trusts which have reached this significant milestone: City of London Investment Trust, Bankers Investment Trust and Alliance Trust.

The managers acknowledge the structural advantages of closed-ended funds, but there is more to it than that.

The key is to invest in companies that themselves focus on cash generation and distributing dividends throughout economic cycles.Alex Crooke

In a press release sent out by the AIC in March this year, Job Curtis, manager of the City of London Investment Trust explains: “City of London’s record of growing its dividend every year for 50 years has been achieved both by investing in good companies and also through the investment trust structure. 

“In the good years for dividends, we add to our revenue reserves which we are then able to use in more difficult periods. Indeed, in seven of the 25 years during my period as fund manager, we have dipped into revenue reserves to help grow the dividend.”

Alex Crooke, manager of the Bankers Investment Trust, recalls the trust last held its dividend flat in the year 1966, after a “bumper year” of dividends in 1965 when companies tried to avoid the introduction of capital gains tax for the first time.

He agrees: “The key is to invest in companies that themselves focus on cash generation and distributing dividends throughout economic cycles. The current outlook for income is more muted than previous years, partly because dividends, after lagging the recovery of corporate earnings post the 2008 crash, have now caught up. 

“Many companies in the US and Europe are now paying out a relatively high percentage of their earnings as dividends and therefore fund managers need to carefully focus on those industries where earnings are rising.”

Regular payouts

Investment trusts have responded to the growing need for income by increasing dividend payouts.

As QuotedData’s head of research James Carthew observes: “Many investment companies now make quarterly or even monthly dividend payments, a change which has progressed in response to demand and opportunity.”

Much of the growing demand for income has come from pension freedoms as savers seek ways of funding their retirement.

Does this mean investment trusts will find a place in retirement portfolios?

James Burns, a partner at Smith & Williamson, suggests they will as part of portfolio construction but cautions investment trusts “are not a perfect vehicle”.

“But from an income point of view they’re very useful for clients,” he says. “If you retire and you have a pot to pay some income into, you want that income to be consistently growing ahead of inflation and I’m not saying you couldn’t do that with just a portfolio of open-ended funds but you are more open to the vagaries of the broader market than you would be if you have the ability to smooth payouts from revenue reserves that trusts do.”

He expands on Ms Brodie-Smith’s point investment trusts now invest in a wider range of asset classes, some of which are fairly niche.

“Areas such as aircraft leasing or commercial property debt which we couldn’t access 10 years ago, there are three or four vehicles each in those asset classes alone in the investment company space that we can now look at which are giving premium yields to that available with bonds,” he notes. 

“They are less correlated asset classes and so not just from the ability to keep revenue back on the equity side, being able to access different asset classes which are suited to the closed-ended structure as opposed to open-ended funds is also really attractive to people who are retired or looking to live off income.”

Data from the AIC shows there is a pipeline of investment trusts waiting to join the dividend heroes, building up strong track records of dividend payouts.

Figure 2: Next generation dividend heroes

CompanySectorNumber of consecutive years’ dividend increased
Invesco Income GrowthUK Equity Income19
Perpetual Income & GrowthUK Equity Income17
Standard Life Equity IncomeUK Equity Income16
TR European GrowthEuropean Smaller Companies14
AthelneyUK Smaller Companies14
BlackRock Throgmorton TrustUK Smaller Companies13
BlackRock Smaller CompaniesUK Smaller Companies13
Establishment Investment TrustGlobal13
Henderson Smaller CompaniesUK Smaller Companies13
Artemis Alpha TrustUK All Companies12
Aberdeen New DawnAsia Pacific – Excluding Japan12
Witan PacificAsia Pacific – Including Japan12
Henderson EuroTrustEurope12
Murray InternationalGlobal Equity Income12
Edinburgh InvestmentUK Equity Income11
BlackRock Greater EuropeEurope11
Schroder Oriental IncomeAsia Pacific – Excluding Japan10
Henderson European FocusEurope10

Source: AIC using Morningstar

These are the trusts which have increased their dividends for 10 years or more but less than 20 years, with two new additions this year already – Henderson European Focus Trust and Schroder Oriental Income.

With inflation having hit 2.3 per cent in February, where it remained in March, the prospect of growing dividends will be a welcome one for many investors and savers.

Ms Brodie-Smith adds: “It’s encouraging in this time of rising inflation that 12 per cent of the investment company sector have increased their dividend every year for 10 years or longer. 

“There are a healthy number of next generation dividend heroes waiting in the wings, which have increased their dividends each year for between 10 and 20 years.”

eleanor.duncan@ft.com