In an investment world where capital growth is scarce and total return of cash and gilts is negative, investors, and savers, look for income that beats inflation.  This has been happening for a while now and I think will continue to happen all the while the investment world is upside down.

Investment Trusts, and Closed-End Companies, have many favourable characteristics that enhance the ability to provide income.

Basic understanding of Investment Trusts

Investment Trusts are public companies with issued shares listed on the stock exchange, sometimes more than one class, and therefore they have a Board.  They are collectives as they invest in other assets that generally are direct equities but can also include, property, debt, private equity, corporate bonds etc.  The value of the underlying assets is called the Net Asset Value (after debt) and is quoted separately from the share price of the trust which is determined by supply and demand.  If the price is less than the Net Asset Value (NAV) then the trust is said to be trading at a discount.  In this scenario one can purchase a trust for less than it is worth.  If the trust becomes more popular then this discount could narrow (get closer to the NAV) and one can make a profit in addition to the movement of the NAV.  The opposite can of course occur and one can make a loss even if the NAV has not moved.  I find that this risk of a widening discount can be mostly ignored if, a) one is investing for the medium to long term, and b) one does not buy the trust when the discount is significantly above its normal level.  Due to the hunt for income many trusts are today at a premium, which is where the price is above its real value.  A 5% premium can become a 10% discount fairly quickly if market sentiment changes.

Purchasing at a discount can also enhance the income.  The yield is generally quoted in order to monitor income of a trust.  This is the dividend divided by the price, usually the mid-price.  Trusts trade on a spread, that is, there is a price for a purchase of shares (the offer price), one for the sale (the bid price), and the mid-price is the average of these two.  One must not forget that the income is a dividend which is quoted as a number of pence per share.  If you buy a trust at a discount you obtain more shares for your money than if it was at par (like a Unit Trust), therefore you will have a larger dividend payment and your yield is higher.  So, as a discount increases not only do you have the chance to accelerate a capital gain but the yield will increase too.

Investment Trusts can gear, or borrow money, thus accentuating any result, either capital growth or income.  This can work very well when times are good and become a major headache in a falling market.  Good fund managers use moderate gearing at the right times.  The market is more cautious now than it has been in the past!  The level of gearing is a factor in ascertaining the risk of a trust.

Earlier I alluded to there being the possibility of more than one share class.  These trusts are called Split Capital Trusts, for obvious reasons.  To use a common style as an example a trust could have Zero Preference shares (zeros) and Ordinary Income shares (ords.).  The holders of the Zeros have relinquished their rights to income and so the holders of the Ords. can receive this income in addition to their own direct rights.  In this way the yield can be much higher than normal “vanilla” trusts, or indeed direct equities.  This share structure however does produce a form of gearing as the Zeros are ahead in the queue for a fixed capital return, any extra growth will go to the ordinary shareholders.  They are therefore a higher risk than normal trusts.  A while back these Splits invested in each other and when things went wrong the result was dire.  It was made worse by advisers selling the Zeros as a safe bet, which of course they are not!  Today this spiral is not possible as any investment in other splits is capped and the market prefers not to see it at all.  Naturally a well-run Ord. share can be a useful part of an income portfolio.

The Revenue Reserve

Inflation is the dirge of income investing.  At simply 3% for 10 years one will lose a staggering 26% of the spending power of your money.  So not only should one look for the right level of income but this income should also be able to increase over time.  In investments this is called dividend growth.  I look for trusts that have a history of growing the dividend above the rate of inflation.  Investment Trusts are able to do this because they are allowed to put aside up to 15% of their income each year into a Revenue Reserve.  This allows a smoothing of dividend payments, the ability to control a regular dividend increase (there are many trusts with over 40 years of continuous increases), and most importantly not be at the whim of the boards of the underlying stocks.  When BP cut its dividend Unit Trusts and OEICs had to follow suit; Investment Trusts continued unaffected.

Trusts can still add to Reserves but new rules allowing the payment of dividends directly from capital has somewhat reduced this functionality.  Having a good reserve (about a year’s worth of dividend payments) shows a discipline.  Of course the Reserve was invested so in effect it is a payment from capital should it be dipped into only it is earmarked as income.

Gross Dividends

Some Investment Trusts are offshore and thus the dividends are paid gross.  This is of most use when in a Stocks and Shares ISA or SIPP/SASS.

Benefits of a Closed share structure

The main advantage is that the fund manager does not need to concern him/herself with the daily movements in sentiment towards the trust.  Conversely the manager of a Unit Trust will issue or destroy units as they are traded.  Although there is a buffer, the underlying holdings will have to be bought and sold in line with the market demand for the units.  This can be self-defeating when there is a run on the book and the manager is forced to sell down holdings under duress.  This is generally why Investment Trusts are the better vehicle for illiquid assets like property.  Although the nature of Investment Trusts also works well for ordinary assets too due to the other qualities of the vehicle mentioned above.  Also the manager of an open-ended trust may be swamped with cash and be forced to invest when he/she would rather not.

In conclusion

These factors have long been known and, I feel, ignored.  It was only the recent market collapse in 2007 and the BP dividend cut that made investors realise that these differences are important especially if investing for the long term.

I run two accounts of differing risk levels that tap into the income potential of Investment Trusts that currently produce a gross return of 6.7% p.a. or 5.5% p.a. with the potential for some capital gains as well.  If you are interested please get in touch using the website’s contact details.

Risk

Any equity investment is riskier than cash but one is paid, via the dividend, for taking that risk.  Some investments in equities are riskier than others and generally the higher the risk the larger the dividend.  Equally, the higher the dividend the less chance of capital growth.  You may get back less than you invested and dividends can be cut.