The Big Theme
Earlier this year activist hedge fund Laxey Partners lobbied the UK's largest investment trust,
Prior to this investment trusts could only use their revenue reserves to pay dividends, so this could help trusts which do not have large reserves but want to pay higher dividends. If events equivalent to the cancellation of BP's and the banks' dividends happen again, investment trusts will not necessarily have to reduce their dividends just because they don’t have a reserve. And recently launched investment trusts that have not had years to build up a reserve may also be able to pay dividends.
Using capital could allow trusts to pay a stable dividend yield for long periods of time, and allow them to set a dividend yield target independent of the underlying portfolio revenue yield.
In contrast to a tender offer (an alternative way to return capital) there would be no transaction fees and the capital would be distributed at net asset value (NAV) rather than the small discount typical to most tender offers.
Investment trust managers will be less constrained because they will not have to rely so much on high yielding securities to meet dividend payments, giving them a greater choice of where they invest.
Some also argue that raising dividends could be a way to tighten discounts – the reason Laxey wanted Alliance Trust to increase dividends with capital. Higher yields can narrow and stabilise discounts and some including Laxey argue this is more effective than share buy backs, and in the case of Alliance would have cost less than the buy backs it has been making.
Recent research by broker Westhouse Securities finds that on average higher yielding investment trusts trade on higher ratings than those on lower yields or which do not yield. "The current low interest rate environment helps to justify the better rating of income funds," says Monica Tepes, analyst at Westhouse. "However, it is interesting to see that their higher rating has been persistent over the longer term, despite better total return performance from their non-income peers."
This doesn't seem to be down to performance: Ms Tepes says that over five years only one of the top 20 best performing funds in terms of NAV total return is an income fund –
"Going back to the supply/demand argument, an income fund will attract a larger pool of investors than a non-income fund," adds Ms Tepes. "Non-income investors will invest in both, as they are only concerned with total returns, whether they come in the form of capital gains alone, or capital gains and income. However, income investors, given their income requirement, will be restricted to income funds and will not form part of the demand for non-income funds."
Raising the dividend has already proved in some cases to narrow the discount. Last year Securities Trust of Scotland changed its investment objective to invest globally and boost its revenue to increase its dividend and it now trades on a premium of 2.7 per cent in contrast to its 12 month average, a discount of more than 2 per cent.
BlackRock World Mining (read our tip) more than doubled its most recent dividend and made changes to its charging policy to allow for higher dividends. Since then the trust's discount has fallen to 10.53 per cent in contrast to its 12 month average of 15.7 per cent.
So far only F&C Private Equity Trust (see box out below) is going to use its capital to pay dividends, but other trusts are said to be weighing up this option, particularly those which do not have sufficient revenue reserves to pay a higher income and global trusts which have been buying back shares to tighten their discounts.
However analysts have a number of concerns about the rule change. Ms Tepes says having an income requirement could detract from total returns over the longer term. A manager's investment style could be hindered if they have to sell stocks to realise capital gains to pay higher dividends, leading them to cut winners and run losers. One of the advantages an investment trust has over open-ended funds is that its managers are not forced to sell stocks to make redemptions, but this advantage could in effect be negated.
Generally, the bigger the fund size, the larger the potential investor base, the more liquid the shares and the lower the fund's total expense ratio (TER). Therefore there is a risk the assets are shrunk by paying dividends causing TERs to rise. Funds which do not make distributions have an advantage over those that do as it is easier for them to grow their portfolios and they benefit from the compounding effect of re-investing.
Ms Tepes adds that smaller fund sizes can reduce liquidity and increase discounts.
"Ultimately, a fund's rating, discount or premium, is a function of the demand and supply for its shares," she says. "There are many factors that influence both, with most of these out of the control or influence of boards – what can a board do if, for example, the market is experiencing a liquidity squeeze or a sector is out of favour at a given time?"
Trusts such as
Investment companies which are domiciled offshore were able to do buybacks prior to 6 April. These include a number of property investment trusts and European Assets Trust, but paying dividends from their capital has not in some cases tightened their discounts.
20 of the highest yielding investment trusts
Source: Morningstar as at 24 May
Raising the dividend is also not necessarily a replacement for share buybacks. "It has been stated that buy backs benefit a few, namely the sellers, while dividends are for everyone, but this argument is not strictly true," comment analysts at Winterflood. "Buy backs, assuming they are made at a discount, will lead to incremental uplifts to the NAV for remaining shareholders. In the case of the big global funds such as Foreign & Colonial Investment Trust and Witan, the buy back programmes have been one of the few factors that have consistently added to the NAVs."
Buybacks also help balance supply and demand.
Because dividends from capital rely on the markets at times of stock market falls trusts may decide not to further erode their capital base by paying dividends from capital. Because paying dividends from capital shrinks the trust's capital base when the portfolio's value falls this could be problematic, especially if the trust is significantly indebted or has commitments to finance such as in the private equity sector.
To buy or not to buy?
There is no straight answer as to whether you should buy or avoid an investment trust dipping into its capital. You need to look at each trust on a case-by-case basis and understand what the managers are doing. "It is very important that you have an idea of where a trust's dividends are coming from and to what extent they are covered (out of its revenue) or not," says Simon Elliott, head of research at Winterflood Securities. "Generating dividends from capital is not necessarily a bad thing, but look before you buy."
You should also consider what the trust invests in. "For example, higher yielding funds in the private equity or commodities sectors will not perform in the same way that a traditional UK Income Growth fund does," he adds.
Other things to look at are the trust’s distribution policy which you can find in its reports.
But Iain Scouller, head of the funds team at Oriel Securities, argues in favour of trusts that can pay a covered, growing and sustainable dividend, with capital being retained for future growth. "Be wary of substantially uncovered ones," he says.
For investors wanting to incur capital gains tax at 18 or 28 per cent rather than income tax, a dividend heavy investment trust might not be a good idea for you unless you hold it in a tax efficient wrapper such as an individual savings account (Isa) or pension.
If you are seeking growth from your investments it might be better to look elsewhere though you could reinvest the dividends.
F&C Private Equity
F&C Private Equity Investment Trust is implementing a new dividend policy which aims to return 4 per cent of its NAV per annum to ordinary shareholders by dipping into its capital. Currently the trust yields only around 0.5 per cent and high yields are not usual in this sector. F&C Private Equity hopes the new policy will help tighten its discount of more than 34 per cent. It says this will provide ordinary shareholders with greater and predictable dividend payments.
"Under the new policy, the company will aim to return 4 per cent of its NAV per annum to ordinary shareholders, paid through two semi-annual dividends. This represents a dividend yield of 6.6 per cent based on the ordinary share price of 150.5p as at 30 March 2012," explained Mark Tennant, chairman of F&C Private Equity.
Monica Tepes, analyst at Westhouse Securities, says using capital to pay dividends could be a good idea because while F&C Private Equity performs well it still trades at a wide discount.
But Iain Scouller, head of the funds team at Oriel Securities, is concerned because the trust has outstanding commitments to fund. "The revenue earnings per share in the year to December 2011 was 0.78p, which suggests to deliver the new dividend policy, there will effectively be a reduction in the NAV per share of around 9p a year," he says. "We think by their very nature that private equity funds are much more suited to generating capital growth than income. We also think there is a risk that high dividend payouts may not be reliable at times of market weakness and falling NAVs, when boards may have to consider the financing of commitments and leverage ratios. F&C Private Equity is currently leveraged at 22 per cent of NAV and in our view it appears that the proposed uncovered dividend could result in an increase in leverage, assuming there is no net cash inflow in the reporting period. The trust's expenses (£2.6m), plus finance costs (£3.9m) are already significant, equivalent to c.9p per share and we think the additional payment of a dividend is likely to result in a significant drag on capital or NAV performance."
But Hamish Mair, manager of F&C Private Equity, says: "The new distribution policy reflects our confidence in the company's ability to generate cash which is more than sufficient to meet draw downs, repay in due course the zero dividend preference shares and, importantly, to fund an ongoing programme of selective new investments."
Source: Morningstar, F&C.
Performance data as at 14 May 2012
Top 10 holdings as at 31 December 2012
|August Equity Partners II||4.6%|
|Candover 2005 Fund||3.7%|
|Warburg Puncus IX||3.6%|
|Procuritas Capital IV||3.6%|
|August Equity Partners I||3.4%|
|Chequers Capital XV||3.4%|
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