Investment Trusts  

How open-ended funds and closed-ended funds generate income

This article is part of
Guide to closed-ended vs open-ended funds

How open-ended funds and closed-ended funds generate income

Open and closed-ended funds can both generate income for investors, but how do they differ on this? 

As Alasdair McKinnon, lead manager of the Scottish Investment Trust, points out, in open-ended funds the size of fund depends on the underlying demand for it. 

“While it’s not a concern when the fund is expanding, when multiple investors choose to leave the trust at the same time, the fund manager of a unit trust may be forced to sell investments to buy back units from the departing investors, which can be particularly problematic if some of the underlying investments are illiquid,” he adds. 

Dividends

Open ended funds typically pay out dividends to investors, a number of commentators point out. 

Christine Cantrell, sales director at BMO GAM, says: “Open-ended funds typically distribute the dividends they collect from their equities, the coupons from their bonds or the rental income from the property they own.”

She adds: “Closed-ended investment trusts can employ additional tools to increase and/or smooth out distributions, such as leverage and distributing capital from the portfolio.

"This partly explains why you can typically find more generous yields from the investment trust universe.”

Jason Hollands, managing director at Tilney Investment Management, highlights that the difference in income between both types of funds does not lie in how it is distributed, but more in retention of the income made. 

“Fundamentally [they generate income in the same way]. Depending on the strategy, this might include dividends from equities, coupons from bonds, rental yield if the fund or trust invests in property and any interest from cash.”

He adds: ”The main difference is that an investment company can retain up to 15 per cent of the income it receives each year as a revenue reserve, providing the board with the option of releasing cash to support payments in future years.”

Alasdair McKinnon, lead of the Scottish Investment Trust, also highlights this view. 

He says: “Investment trusts are generally recognised as suitable for investors seeking income.

"At least 85 per cent of income generated by investment trusts must be passed onto their shareholders, with the balance put into reserves to allow a more stable income stream.”

Mr McKinnon adds: “At the Scottish Investment Trust, we have income reserves equivalent to over three years of our regular dividend. This means that we could pay our current regular dividend for over three years, even if the trust’s underlying portfolio produced no income.”

Alternative assets

According to Mr Hollands, investment companies are useful at diversifying returns when investing in alternative assets which in turn can provide stable income. 

He says: “Where investment companies can be a useful component of an income portfolio, is in diversifying beyond equities and bonds into areas like operational infrastructure projects, renewable energy infrastructure and, of course, physical commercial property.”

He explains that because all of the asset classes listed above are illiquid in nature, they “don’t lend themselves to open-ended structures”.