Investors often wish they had a time machine. Seekers of reliable dividend income in Britain would have been quids in if they had scooped up shares in three British investment trusts in the late 1960s. The City of London Investment Trust, the Bankers Investment Trust and the Alliance Trust are the only three in the UK to have increased their dividend payouts every year for more than half a century. But where should investors be looking for this sort of performance now?
An encouraging backdrop for income
Although we've been mired in an era of low growth and low interest rates for years, the overall outlook for income investors seems encouraging for now. The yield on the FTSE All-Share Index is around 4.8% about the highest it has been since the financial crisis. Job Curtis, manager of the City of London Investment Trust, is optimistic about the level of income being generated from the UK equity market.
"We are seeing mid single-digit figure growth in dividends... so overall, the equity market is not a bad place to look." The main drivers of this growth recently have been British American Tobacco, as well as the banking and mining sectors. And with 70% of UK-listed company sales coming from overseas, this yield should be able to weather domestic turmoil.
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But choose your stocks carefully. Companies making large payouts to the detriment of capital growth may find it becomes unsustainable, as Ben Lofthouse, manager of the Henderson International Income Trust, told The Times last week.
"If you get caught in a dividend trap, you might find the income you hoped for has no prospect of sustainable growth. This eliminates one of the main advantages of investing in equities. Dividend growth not only protects investors from inflation, it drives share prices higher over the long term, meaning investors can benefit from capital gains."
In a recent example of a promised dividend which failed to deliver, last month telecoms giant Vodafone cut its dividend by 40%, having told investors in November that it would maintain it for the financial year. Unfortunately, the high cost of investing in 5G technology thwarted this optimism. Before the dividend cut it had been yielding 9.3%.
Investors are keeping an eye on BT Group, which will also be thinking about the cost of 5G technology. The dividends of utilities SSE, Centrica and National Grid also appear shaky. Given the uncertainty surrounding dividend payouts at several individual companies, it's no wonder investment trusts with long records of increasing dividends are so popular.
Why investment trusts?
A unique characteristic that explains the appeal of investment trusts to income investors is managers' ability to hold back up to 15% of their gross annual income as revenue reserves. Managers can therefore build up a "rainy day fund" they top up in good years and draw upon in difficult ones years.
This enables them to smooth out dividend payments, rather than axing them completely one year and reinstating them when markets have improved. This suits investors who are looking for a steady and reliable income.
However, there is another way that managers can juggle things so as to keep dividends on an even keel. As of 2012, investment trusts have been allowed to dip into their capital (as well as the income they make from their holdings) to top up or completely fund their dividend payouts, as long as shareholders agree.
This means that when they sell holdings, they can direct some of the profits to their dividend payouts, rather than just putting that capital to use in the future to buy new holdings. More than 20 funds have now changed their dividend policy to allow for this tactic, and this number is likely to go up in future. Private-equity funds are especially inclined to use this approach: they tend to invest in early-stage companies which do not yet pay dividends.
Is this a bad thing?
Not necessarily. Investors want income. These investment trusts are providing them with regular, reliable dividends. "However, we believe the jury is still out on the success of this strategy," says Sam Murphy of broker Numis. "In our view, boards of investment trusts need to consider whether an enhanced yield is sustainable over the long term."
Indeed, the approach has not yet been tested during a market downturn. When markets are going up, as they have been doing for the past few years, the occasional raiding of a trust's capital account might not be especially noticeable. But the practice would be "dangerous" during a bear market, says Curtis. If the market is down 10% and the manager then takes 1% out of the capital account, people will start taking note. "That is when the managers might start getting angry letters from shareholders."
Murphy gives the example of European Assets investment trust. The fund had been popular with individual investors, partly because of its high yield, which is funded largely through a distribution from capital. Helped by rising markets, it had grown its dividend over the past few years.
However, a 22% cut in the dividend for 2019, as a result of falling equity markets, shows that investors relying on funds paying dividends from capital are "likely to face greater income volatility than from traditional equity income funds that pay covered dividends supported by revenue reserves".
With demand for income showing no signs of abating, broker Winterflood believes that more funds will consider paying so-called "enhanced dividends", particularly those trading on wide discounts. Indeed, some fund managers have taken advantage of their ability to convert capital into income in order to alleviate their discount, with five funds adopting this strategy in 2018 alone. Generally, shares in an investment trust trade at a discount to the value of the fund's underlying assets (net asset value, or NAV) when investors don't think those assets are worth paying full value for. If the discount gets too wide, this can make the trust look unappealing to outside investors. However, if the trust maintains a stellar dividend record this may make people change their minds about buying in, therefore boosting the trust's share price and narrowing the discount.
This is good for those who have already invested, as they benefit from the capital growth. Examples of funds which have taken this approach include JPMorgan Global Growth & Income, Securities Trust of Scotland, JPMorgan Asian, BlackRock Latin American, JPMorgan Japanese Smaller Companies and International Biotechnology, as well as several private-equity funds.
"There is some evidence than an enhanced yield broadens the potential investor universe," admits Murphy. "However, simply adding a yield to a fund with a poor track record, or in an asset class that is out of favour, is unlikely to turn around investor sentiment."
For instance, asset manager JPMorgan has seen its Global Growth & Income re-rated following the adoption of an enhanced income policy, and it is now trading on a premium, notes Winterflood. However, its Asian fund, which operates in a sector that has fallen out of favour for now, remains on an 11% discount, despite a 4.5% yield and a superior performance record to Asian Income funds such as Schroder Oriental Income or HendersonFar East Income.
Winterflood takes a more relaxed view of the practice than some, and believes that paying so-called "enhanced dividends" is merely one of the advantages of the investment trust structure. There's also the argument that in being able to dip into capital, managers can avoid turning to riskier high-yielding companies merely to maintain their dividend.
The key issue here, though, is whether or not investors are actually aware of where their income is coming from. Many investors might not realise that this is what their fund manager is doing. Unless they're very interested in the inner workings of how a trust is run, it's unlikely that this subject will come up on most people's radar. And although the strategy is only permitted subject to shareholder approval, it is news to no one that many shareholders don't bother to participate in such votes, or have their vote cast by a nominee, their broker.
Charging fees to the capital account
One final thing to be aware of when looking at an investment trust's dividend history is that managers can take a proportion of fees and finance costs out of the capital account. This leaves the money in the revenue account to be used to pay dividends, but comes at the cost of the capital account. The practice is more prevalent in equity income funds than in those that strive to maintain capital growth and are therefore are under less pressure to increase their dividend. Most equity trusts charge 60% to 70% of management fees and finance costs to capital, analysts from Numis noted in 2017. If all fees and finance charges were instead charged to revenue, the average yields for UK equity income investment trusts would, in all likelihood, fall. So it's useful for investors to be able to see exactly how their capital gains are drawn on by managers.
If you're concerned about the reliability of the income from an investment trust, there are several things you can do to get a clearer idea of how things stand. First, go to the annual accounts, which you can find in the investor relations section of any trust's website. Look back over five or ten years to get an idea of whether the managers have been able to maintain or grow their dividend.
Then, look at their revenue reserve fund, the "rainy day" fund where they keep revenue back. If the revenue reserve cover figure is more than one it means that they can cover the dividend for one year should the holdings earn nothing at all. If it's less than one, they would not be able to fully cover the dividend in such a scenario. Within the UK Equity Income investment company peer group, the average revenue reserve cover figure is 0.76.
Next, look at the trust's dividend cover. Different to the revenue reserve figure, this shows the trust's annual earnings, relative to the dividend it pays. So it should give you an idea of just how capable the trust is of funding the planned dividend with the amount it's currently earning. This figure will either be expressed as a percentage, so would be more than 100% if the trust is earning more than enough to cover its dividend, or as a multiple, so if a trust has dividend cover of 0.5, it is only earning half the amount necessary to pay the dividend. In this situation, investors could take the cover figure as a sign that the dividend is not very sustainable.
If you go to the website of the Association of Investment Companies (AIC), you can easily look up a trust's dividend history and revenue reserve cover figures, as well as how the dividend is funded. This is especially handy for those who can't quite face trawling through page after page of funds' accounts (though that can be a good way of familiarising yourself with the nuts and bolts of your investment). Investors should also keep in mind that just because an investment trust has a long history of increasing its dividend payments, it doesn't mean you should automatically buy it.For example, Perpetual Income & Growth is the newest entrant to the AIC's list of funds which have increased their dividend every year for 20 consecutive years. It is currently trading at a fairly significant 12.4% discount to NAV, which is probably explained by the fact that it has had a fairly dismal past few years, having suffered setbacks with several portfolio companies, including doorstep lender Provident Financial and outsourcer Capital.
The trust's NAV has gone up by 7.8% over three years, compared with 33.3% for the FTSE All Share. Yet it has been able to increase its dividend payments for 20 consecutive years. It has revenue reserves of £30m, enough to cover ten months of future dividends, and has been granted permission to dip into capital in order to pay dividends, but has not yet taken advantage of this. It remains to be seen whether manager Mark Burnett can reverse the portfolio's fortunes in terms of capital growth. For now, the poor performance of the portfolio undermines the trust's appeal, the steady income increases notwithstanding.
Similarly, just because a trust has drawn on its capital reserves to pay dividends doesn't necessarily mean you should avoid it. Some well-established and popular trusts have done so, including MoneyWeek favourite the Scottish Mortgage Trust. Below, we look at some investment trusts which have a proven dividend record and appear well placed to continue providing investors with income.
Today's investment trust dividend heroes
On the AIC's list of "dividend heroes" there are three trusts with 51-year records: City of London, Bankers Investment Trust and Alliance Trust. Caledonia Investments is not far behind, on 50, with F&C Global Smaller Companies and Foreign & Colonial Investment Trust both on 47.
Of the three trusts with 51-year records, UK-focused City of London (LSE: CTY) has the highest yield, with a current figure of 4.52%. It is trading at a 2% premium to net asset value (NAV), and has an ongoing charge figure of 0.41%. City has a revenue reserve cover of 0.76 and dividend cover of 106%. If you're looking for a globally diversified alternative, Bankers Investment Trust (LSE: BNKR) is currently yielding 2.2%. It is trading at a 1.2% discount to its NAV, with revenue reserve cover of 1.75 and dividend cover of 83%. Caledonia Investments(LSE: CLDN) sits within MoneyWeek's portfolio of investment trusts. It is trading at an 18% discount to NAV, has dividend cover of 1.01 and an impressive revenue reserve cover of 8.72. Note, though, that it is more focused on wealth preservation than dividend growth.
Numis highlights JPMorgan Claverhouse (LSE: JCH), which invests in UK-listed blue chips such as Royal Dutch Shell, BP and GlaxoSmithKline. It pays a fully covered dividend, and has built up revenue reserves equivalent to 1.18 years' dividends, the highest of its peer group. Finally, research group Kepler has devised a top-20 list of trusts for those looking for income and growth, made up of funds that have "generated sound solid returns while delivering a high and rising income to investors". To make the list, funds must yield 3% and have grown their dividend by 3% on average over the past five years. Top of the list is JPMorgan European Income (LSE: JETI), which yields 4.4%. The fund screens the top 30% of the MSCI Europe ex-UK Index by yield and then avoids firms whose dividends could be threatened. Next is Schroder Oriental Income (LSE: SOI). It invests across Asia Pacific and yields 4.2%.
Sarah is MoneyWeek's investment editor. She graduated from the University of Southampton with a BA in English and History, before going on to complete a graduate diploma in law at the College of Law in Guildford. She joined MoneyWeek in 2014 and writes on funds, personal finance, pensions and property.
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