Can investment trusts save income investors?

Prudent use of the revenue reserve has enabled some investment companies to build up multi-decade track records of dividend increases.

There are 19 ‘dividend hero’ investment companies that have increased their annual dividends for at least 20 years in a row, of which five have been raising their dividends without interruption for more than half a century. City of London Investment Trust, for example, boasts a 54-year record.

While long track records are no guarantee, they inspire confidence and promote investors’ peace of mind, as the AIC’s survey results clearly show. 

It is worth addressing some common misconceptions about the revenue reserve.

It is not a ‘pot of cash’ sitting inside the investment company – it is part of the investment company’s assets. So having a revenue reserve has no influence on how much of those assets is held in cash.

Instead, it should be seen as a line in the investment company’s accounts. It allows the company to smooth dividend increases over time by holding some income back in juicier years in order to top up dividends in leaner ones.

Traditionally, this smoothing of income is done without touching the investment company’s reserves of capital – though this is also possible, and we’ll come to that later.

Revenue reserves are not bottomless.

While long track records are no guarantee, they inspire confidence and promote investors’ peace of mind.

That became clear this year when former dividend hero Temple Bar cut its dividend by 25 per cent after the departure of long-serving manager Alastair Mundy.

Nevertheless, many investment companies still have healthy levels of reserves.

In the UK Equity Income sector, the average investment company could cover its dividends for 15 months from reserves, even if it received no income from its portfolio. That increases to more than two years for the Global sector.

The ability to invest in less liquid assets

The failure of Shell to hold or increase its dividend illustrates the wisdom of diversifying an income portfolio away from the usual blue-chip suspects. 

Respondents to the AIC’s survey are looking at a range of asset classes to replace lost income.

These include infrastructure, property (especially warehouse properties), bond funds and even mining companies.

Other investors have tilted their portfolios away from natural income producers altogether and towards growth.

Technology funds and stocks, including biotech, have been beneficiaries of this trend. 

Clearly there is a debate to be had between those who adhere to a ‘natural income’ strategy and those who prefer to invest on a total return basis and rely on safe withdrawal rates to guide retirement planning. 

Revenue reserves are not bottomless.