Covid-19 provided the ultimate test of investment trusts’ ability to keep increasing dividends in tough times. The sector rose to the challenge with 85% of investment trusts that invest in equities and yield at least 1% increasing their dividends during 2020. That stands in stark contrasts to just 23% of comparable open-ended funds, according to an analysis by the Association of Investment Companies (AIC).
Unlike open-ended funds, which must pay out all their dividends each year, closed-ended investment trusts can hold back up to 15% of the income they generate to supplement distributions to shareholders during leaner times.
Canny use of investment trusts’ reserves has enabled 18 ‘dividend heroes’ to grow their annual payouts for at least 20 years in a row. A further 27 have grown their dividends for more than ten consecutive years. Most of them invest in equities but some invest in bonds, infrastructure and property.
Below, we take a closer look at three main ways in which investment trusts can turn on the income taps for investors.
Income from reserves
Traditional equity income trusts derive dividends from underlying holdings. Investors receive close to the natural yield on the underlying portfolio, but this can be topped up by revenue reserves. It is these reserves that have helped many trusts to forge a long history of growing their dividends.
Topping the table is City of London, a UK equity income trust in the Janus Henderson Investors’ stable, which has increased its dividends for 55 consecutive years.
“For many older trusts the reserves brought forward can be substantial, providing the ability to top up dividends paid out when underlying dividends fall short,” said David Liddell, a director of IpsoFacto Investor.
The average yield in the UK equity income sector is 4%, according to Winterflood Securities.
James Carthew, head of investment companies at QuotedData, said: “Factoring in capital growth too, they have made total returns of about 8.5-9% a year on average over the past 10 years.”
It could be worth looking beyond home turf, too. Global equity income trusts yield a little less, 3.5% on average, but have made more overall.
“The main reason why global funds have been doing so well has been the strength of the US market,” said Carthew. For example, North American Income Trust offers a yield of 3.6% and has made average annual returns of 12.7% over the past decade.
Income from capital
One global equity income trust that “stands out” for Carthew is JPMorgan Global Growth & Income. It yields 3.7% and has given an average total return of more than 15% per year over ten years.
It takes advantage of another tool available to investment trust managers – to pay income out of capital gains.
“Since company law allows capital reserves to be distributed, effectively any trust which has made capital gains can turn itself into an income-paying vehicle,” said Liddell.
“This has become an increasingly popular way for trusts to make themselves attractive in an era where low yield but high growth stocks – particularly the US internet and social media giants – have been such successful performers and high dividend ‘old economy’ value companies have been laggards.”
With this approach, an investment trust board announces a set percentage of the net asset value (NAV) to be paid out over the year with no regard to the value of underlying dividends.
JPMorgan Global Growth & Income has said it will pay 4% of its financial year-end NAV as a quarterly dividend from both capital and income, allowing the manager to invest in lower or even non-yielding names. In the year to 30 June 2021, the trust earned 5.5p from underlying dividends, but paid out 13.2p in dividends.
“The advantage of this approach is that it gives more flexibility to the fund manager to choose investments on their merit, regardless of the underlying dividend yield,” added Liddell. “The disadvantage is that capital is eroded and if markets suffer a sustained setback, the distribution will fall.
“On the whole we prefer trusts with a natural yield so that capital and income do not both fall together but this type of trusts can be useful in providing exposure not available through natural yield.”
One of the most recent JPMorgan trusts to change to this form of distribution is JPMorgan Japan Small Cap Growth & Income, which also pays out 4% of its NAV in quarterly distributions. Japanese small caps are not traditionally hunting grounds for income investors, and such an approach opens this market to income-seekers.
Income from alternative assets
Many investment trusts aim to produce a strong and rising income stream from alternatives assets – areas like infrastructure and property.
“Since the era of ultra-low interest rates we’ve seen explosive growth in investment companies investing in income-paying alternative assets, from renewable energy infrastructure and warehouses to shipping and song royalties,” said Annabel Brodie-Smith, communications director at the AIC.
“Many of these asset classes pay higher levels of income than mainstream equities or provide income that is not correlated with equity markets. In some cases, as with infrastructure, the income can be contractually linked to inflation, which looks set to make these companies even more attractive in an environment of rising prices.”
Liddell reckons such trusts can provide a “useful adjunct” to income portfolios. “They typically yield 5% or more but should be regarded purely as income assets, with the prospect of capital gain very limited.”
Among renewables trusts he likes JLEN Environmental Assets, which yields 6.6%, and for general infrastructure exposure he likes HICL Infrastructure, which yields 4.7%. Such has been the demand for income that most of these trusts are trading at a premium to NAV, making it important for investors to time their entry.
Property-focused trusts offer yields close to 5%. The best-performing of these over 10 years has been the Standard Life Investments Property Income Trust with an average annual return of 9.4%.
“It offers an interesting angle in that it is at the forefront of making its buildings more energy efficient,” added Carthew.