Three innovative new ways to gain an equity-based income

Three relatively new products can help deliver total shareholder returns, says David C Stevenson.

This week, I want to return to the recurring theme of building a robust, sustainable equity-based income, highlighting three relatively new products that I think could hit the sweet spot.

First though, I want to emphasise that investors need to focus on funds that deliver total shareholder returns. This sounds like a complicated term, but it reminds us that we can make a return in three different ways.

The first is from receiving a regular dividend. Next, investors can also receive a capital gain, ie, the share price increases in value. Last, but not least, you can also reinvest that dividend back into the underlying shares.

In fund terms, this is achieved in one of two ways – in traditional unit trusts you can invest in an accumulation version of the fund, whereas in exchange-traded products you might invest in a total returns version of an index tracker. Both achieve the same end purpose – they reinvest that income stream.

This can strike some income-hungry older investors as a bizarre idea – “but I need the income so why accumulate and reinvest?”. The answer to this very much depends on your tax status.

Remember that in the 2014/2015 tax year, you are allowed to sell down assets and generate a profit of £11,000 before you pay any tax at all (anything over £11,000 has capital gains tax (CGT) of between 18% and 28%).

Let’s assume, for argument’s sake, that you have a £200,000 capital pot with an average income yield of 5%. If you already receive an income from work, those dividends taken as a distribution will attract your marginal tax rate in full (assuming you have no unused tax allowances).

But if you use an accumulation version of a fund or product and then sell down units equivalent to that 5%, you’d entirely escape capital gains tax. For wealthier investors the logic is even more compelling, especially those paying tax at 40% or 45%.

However, those focused on equity income need to diversify their investments. Too many funds dedicated to equity income invest in a narrow bunch of FTSE 100-based assets with a relatively simple strategy – focus on dividends and then make sure those dividends are growing over time, backed by a decent business. It’s an eminently tried and trusted idea.

But some interesting new ideas have begun to emerge, especially around combining rules-driven investing strategies with a focus on absolute returns. One in particular, from a partnership between a hedge fund – Hinde Capital – and French bank Société Générale, looks to add a number of innovative twists on this idea.

Last week saw the launch of the SG Hinde UK Dynamic Equity ETN (LSE: HALF). This new exchange-traded note (it’s not a fund, but a note, where the counterparty is SocGen itself) shares many of the same characteristics of what’s called the smart beta movement – passive funds that use various rules to narrow down the universe of stocks in an index.

The ETN uses measures such as the dividend yield, the timing of dividend payments, as well as metrics based around the balance sheet and relative stock performance to identify its stocks within the universe of the FTSE 350 (the FTSE 100 and the mid-cap 250).

This ETN takes these fairly standard ideas and adds a new twist or two. They reckon that equity income investors need to capture more of the upside from equities and less of the downside.

In their new dividend-focused ETN they do this in two ways: on the upside, the portfolio is very concentrated on just 20 names (ten from the FTSE 100 and ten from the FTSE 250), equally weighted while the index is rebalanced quarterly.

On the downside, those systematic rules mean that exposure to certain sectors is capped. But the big addition is that the portfolio is 50% hedged on the downside, which helps explain why the fees on this product are a bit pricier than some peers, at 1.3% per annum.

This hedging won’t do away with all losses in every market but it will (hopefully) dampen down volatility, while a backtest suggests that returns would have been around 12% per annum on average over the last decade.

This ETN is a total returns product, which means investors can make use of that CGT allowance I mentioned earlier.

Another very recent launch looks for income in an entirely different part of the world and stockmarket sector.

A new index tracker from ETF Securities called ETFS US Energy Infrastructure MLP GO UCITS ETF (LSE: MLPX) was launched just last week. The product tracks something called the Solactive US Energy Infrastructure MLP Index TR, which follows the share price of Master Limited Partnerships (MLPs).

I have written before about these fascinating creatures – they are like real estate investment trusts (Reits) in that they own equities in partnerships that invest in actual assets, in this case stuff like pipelines and storage units for the energy sector (oil and natural gas).

Business has been booming for these infrastructure players, helped along by the US shale gas revolution, steadily rising resource prices over the last few decades, and advantageous tax treatment for US investors – they’re what’s called see-through entities in that they attract no tax as long as they pass their income onto investors. But European investors who own the shares directly will be hit with a withholding tax.

So, ETF Securities (like a rival product from Source) has mitigated any US tax by entering into a deal with an investment bank to provide what’s called a total return swap – the bank makes a total return payout based on that index, including any US tax bills.

That swap fee costs you 0.80% in charges every year (the fund also charges 0.45% per annum) but you get access to an equally weighted basket of 25 different businesses all screened so that the index favours those shares with the best forward-looking distribution yield and distribution growth.

In my experience, an average distribution yield of between 4% and 7% is entirely reasonable for these MLP funds, although you have to bear in mind that this is a total return index again – which means you sell units to get your income.

Also, this isn’t the only MLP ETF in the UK – rival firm Source has one based on a rival Morningstar index (which I own). But ETF Securities says that its index is more focused on mid-stream high-yielding stocks and has delivered significantly better returns in 2013 and is slightly outperforming this year as well.

I love the idea of investing in energy infrastructure in the US as I think it provides a relatively lowly correlated way of playing US shares, using businesses with a toll road-based income model backed by real, inflation-linked assets.

One final idea on the subject – an update on my mini-Reit and infrastructure portfolio discussed a few weeks back. I’m inclined to add a new Reit that was launched in 2013 but somehow escaped my notice. This is called the Target Healthcare REIT (LSE: THRL) and it owns 16 retirement homes in the north of England and Scotland.

This fund sits somewhere between an outfit like Primary Health Properties that invest in doctors’ surgeries and more traditional commercial property funds. At 102p a share (and a net asset value of 96p), analysts at Numis reckon it’ll deliver a yield of about 5.8% from a diversified portfolio of modern, purpose built, higher-end properties with long, inflation-linked leases.


    I think you will find that the use of an accumulation unit does not render notional income exempt from income tax liability. The Fund provider will issue a Tax Certificate at the end of each financial year to show the income added to the investment and the relevant tax credit. Higher rate payers do not escape by holding Accumulation units

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