Capital growth 'icing on the cake'

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Capital growth 'icing on the cake'

Where I particularly feel that investment trusts can add value is in the income space.

The vast majority of my clients are in retirement and require income from their investment portfolios.

Some advisers still use what I consider to be the old-fashioned route of selling units regularly from all funds within a portfolio on the assumption that the price of the funds will increase while the number of units will fall.

This method has probably worked well since the financial crisis, but in a bear market it can have serious consequences for a client’s capital.

With inflation rising, how can an adviser or self-invested client gain greater assurance of an increasing income?

I believe that the most appropriate way to provide income is to invest into income-producing funds.

Providing this generates sufficient income, the clients’ units remain intact.

Most companies that use this method will only use a portfolio of income-producing unit trusts. The benefits are plenty: there is a good choice, you can choose income funds at a sector level (UK equity, global equity, etc) or put their faith in multi-asset income funds.

Typically this should be able to produce an income yield of between 3 per cent and 3.5 per cent a year after charges, which in the current low-interest market is a very attractive level of income and gives the clients the opportunity of benefiting from any potential upside of the investments.

But there is a problem with this approach. Although many funds’ objectives include growth in income, there can be no guarantee of this because unit trusts and Oeics must pay out all the income earned each year and hope that the following year, their investments will produce a bigger income.

The alternative is to take a risk and chase income, which could have a detrimental effect on capital if they make the wrong investment decisions.

Inflation

With inflation rising, how can an adviser or self-invested client gain greater assurance of an increasing income? One option is to use investment trusts, which can reserve up to 15 per cent of their income to smooth dividends in future years.

At my wealth management company Milestone, we understand that investment trusts, as listed securities on the stock market, can and will fluctuate in price more than the underlying assets they own.

This is particularly the case when markets are stressed, and therefore investment trusts are considered riskier than a unit trust equivalent.

However, long-term investors should not be too concerned about this ‘noise’.

 2008200920102011201220132014201520162017
Bankers6997277658038418939369991,0751,176
City of London1,0881,1561,1881,2381,2891,3411,3841,4351,4911,566
Murray International8419791,1601,3411,4681,5591,6311,6861,7221,813
Scottish American1,0161,0451,0681,0911,1321,1781,2121,2361,2501,282
Total3,6443,9064,1804,4734,7294,9715,1645,3555,5385,836

To try and create a bit more certainty of at least a level and at best a rising income, we add to our portfolio of multi-asset unit trust funds a number of large, liquid investment trusts.

Our typical mix of 70 per cent multi-asset unit trusts, 25 per cent investment trusts and 5 per cent cash has served us well and has helped manage the downside risk.

It is difficult to provide long-term performance figures for this blend of portfolio because many multi-asset income funds have track records of no more than five years – but what we can focus on is the benefits that investments trusts have in the income space.

Ten years of income

It is now 10 years since the great financial crisis, when the banking system almost broke the capitalist system that we all know, but investment trusts have not only survived this crisis but also many others over the past 50 years.

My example focuses on what would be considered as a higher-risk investor, investing £100,000 on March 27 2008 into a portfolio to produce income.

I must emphasise this is a client who has other capital to access but only requires income from this investment.

I have chosen a portfolio of four of the largest investment trusts. Three of these are considered dividend heroes, having increased their dividends for at least 20 consecutive years: these are City of London Investment Trust (with 52 years of dividend increases), Bankers Investment Trust (51 years) and Scottish American Investment Company (38 years).

The other, Murray International Trust, now has a progressive dividend policy and a track record of 13 years of successive increases.

An investment of £25,000 into each of these funds would have provided a starting yield of 3.64 per cent in 2008, when the Bank of England base rate was 5 per cent and you could receive 7 per cent from some of the most competitive building societies.

I would guess that a year later the investor would have been kicking himself, to see the value of his investment fall to a low of £71,600, although the yield based on that valuation had jumped to 5.44 per cent.

In hindsight, that was a better time to invest.

The key thing to remember is that in adverse conditions everything falls due to market sentiment. Just evaluate your holdings and if you are happy, be patient and wait for confidence to return.

Looking back

Looking back over the history of many crashes, the recovery from this crisis was relatively short and providing that income was still being paid the investor could sit back and spend it.

In fact, in 2009, the collective dividend income from the portfolio of four investment trusts increased by 7.1 per cent to £3,906.27 and in 2010 by a further 7 per cent to £4,180.43, at a time when the client saw his portfolio return back to its original value and the BoE base rate was cut to 0.5 per cent.

To date we have seen markets continue to climb with a few wobbles along the way; most recently between May 2015 and February 2016, when the portfolio dropped by 19 per cent.

Looking back over the past 10 years, the original objective of the client was to receive a growing income.

This has clearly been met because today that income would have grown from £3,644.23 a year to £5,836.37 a year, a 60 per cent increase, which compares to a 30.1 per cent increase in inflation over the same period.

The client would have received total income payments of £47,797.40, almost half of his original investment – and talking of his original investment, this would have grown to £178,000.

We must remember that markets have been particularly kind to us over the past 10 years and just as night follows day, at some point in the future we will experience another bear market.

But despite that, these companies should be able to continue to provide an increasing income for clients in a world where interest rates are unlikely to return to 2008 levels for some considerable time.

Income investors should look on any capital growth as the icing on the cake.

Investing purely in investment trusts is not for the faint-hearted, but when blended with other multi-asset funds they can help provide a satisfactory level of income for most people while also minimising the downside risk.

Happy income investing.

Neil Mumford is a chartered financial planner at Milestone Wealth Management