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Seeking income from IT dividends

Our reader wants to retire in four years' time and needs to make up a shortfall in income via investment trust dividends. Our experts recommend that he diversify his portfolio further
October 22, 2014

Allan is 56 years old and wants to achieve a net monthly income of around £3,000 before he turns 60. This will enable him and his wife to retire.

He already had a pension from previous employment that provides net monthly income of £1,460. His cash Isas yield £480 a month but are all on fixed rates which end between 2015 and 2018. He wants to achieve the £1,060 shorfall in income via dividends from investment trusts.

He says: "I work full time and my wife works part-time. Our home is worth around £250,000 and the mortgage will be repaid at the end of 2016. My salary is sufficient to meet existing financial commitments and to enable regular savings via investment trusts.

"Past investments have shown that I can buy individual shares at a decent entry point but have struggled with a satisfactory exit strategy. As I have become older I am now more comfortable with collective investments where these decisions are made by others much more capable than myself. I prefer established and non-specialist investment trusts which provide a good mix of coverage and decent income levels. I try to analyse the portfolio from an income perspective rather capital value.

"We have just a slight hesitation, in terms of exposure to one investment house, that three of the investment trusts are managed by Invesco Perpetual."

Reader Portfolio
Allan 56
Description

Investment trust portfolio

Objectives

Income

ALLAN'S PORTFOLIO

Name of share or fundValue%
New City High Yield Fund (NCYF)£26,7387
City Merchants High Yield IT (CHY)£22,8016
Temple Bar Investment Trust (TMPL)£23,2896
Murray International Trust (MYI)£25,6296
City of London Investment Trust (CTY)£25,0296
Perpetual Income and Growth IT (PLI)£18,0205
Schroder Oriental Income IT (SOI)£13,9763
Aberdeen Asian Smaller Companies IT (AAS)£64,95417
Invesco Perpetual Enhanced Income IT (ILH)£4,3611
JPMorgan Global Emerging Markets Income IT (JEMI)£2,2941
Cash Isas£140,08036
Cash held in online easy access a/c£25,0006
Total£392,171100

ADDITIONAL INVESTMENTS:

Monthly saving plans: £900 per month split £400 JPMorgan Emerging Markets Income IT, £300 Perpetual Income & Growth IT and £200 Invesco Perpetual Enhanced Income IT.

Chris Dillow, Investors Chronicle's economist, says:

There are two big things to like here.

First, this portfolio should probably meet your objectives. To get an income of £3,000 per month, you will need an income of just over £1,000 from your equity holdings. If we assume a 5 per cent real return per year, and that you'll be able to generate an income of 5 per cent a year from dividends and share sales while keeping your capital intact, then with average luck you should get an income of around £1,250 a month (in today's prices) in three years' time. This, though, is only true if you invest as much as you plan to over the next three years.

I also like the fact that you have monthly savings plans. These have a double virtue. One is that they commit you to investing, by getting you into the habit of doing so. If, by contrast, you rely upon investing lump sums whenever you can, there's the danger that you'll find something else to do with the money instead.

The other virtue is that regular savings help you to buy on dips, because £900 buys you more when prices are low than when they are high. This means you benefit when the market overreacts to bad news, or when investors become more than usually risk averse. This benefit is perhaps especially great for investment trusts whose discounts tend to widen when prices are low; this means you can sometimes buy £10 worth of shares for £9.

The question, though, is: is this portfolio sufficiently well diversified?

You have big exposure to emerging markets. This includes not just your three emerging market funds, but also Murray International (MYI). It too has big emerging markets exposure - which might explain why, in the last four years, it has been very high correlated with your holding in JPMorgan Global Emerging Markets Income IT (JEMI). This matters, because - as we've been reminded in the last few weeks - emerging markets are correlated with UK equities. Losses on the former are usually accompanied by losses on the latter.

You do, though, have some diversification against this in the form of your three trusts which hold higher-yielding bonds. Here, though, we must be careful. Although these trusts should hold up relatively well in normal times, when equities suffer minor falls in risk appetite or growth expectations, they might not do so well in truly bad times. In a financial crisis or deep recession, investors would fear increasing defaults upon bonds of even usually tolerable quality. In such an event, you could lose on all your trust holdings; this is especially the case because emerging markets are subject to crash risk - they do very badly in bad times. In this sense, you are taking on tail risk - the small chance of a big loss.

However, you have two cushions against this. One is your big cash holding. The other is that, with average luck, your income should exceed expectations, so that it's possible that you could suffer some shortfall without severe disappointment.

On the other hand, the fact that you plan to retire quite soon deprives you of the benefits of time diversification; if a financial crisis hits us in two to three years' time, you won't be able to benefit from the subsequent bounce back in share prices.

There are, though, ways of mitigating this risk. One is to reduce your emerging markets exposure. Another would be to consider postponing retirement if you need to - in effect, using your labour income to diversify crash risk in your trust holdings.

If the latter is an acceptable option, then - given that the risk is small anyway - there really isn't very much wrong with this portfolio.

Alan Steel, chairman of Alan Steel Asset Management, says:

It strikes me you don't actually have a problem achieving your aim of net income of £3,000 a month in about four years. You can achieve it now. All you have to do is stop the monthly contributions to investment trust savings plans. My calculations are that you have almost £2,700 per month made up of existing net pension plus monthly draw from cash Isas plus dividends from mainly income type investment trusts. Stop that £900 going out and Bob's your Uncle, leaving about £600 each month to squander on wee holidays and dinners out (life's a balance after all).

While I'm more at home with Oeics I fully get your faith in investment trusts. By and large you have chosen well, although if I were you I'd build exposure to small caps (UK or global) for the growth part. Gervais Williams of Diverse Income Trust (DIVI) is worth a look. You're underweight US equities so maybe add a technology fund, for the part of your portfolio with low yield. I find UK investors don't get the US story and vast potential with low energy costs and remarkable developments in manufacturing and technology.

You have selected some good managers too: Alastair Mundy, the troops at Invesco Perpetual including Paul Causer and Aberdeen's Bruce Stout all know what they're doing. I wouldn't worry about being overweight Invesco Perpetual.

By my reckoning out of about £200,000 (once you add other monies to the investment trusts) you have no more than 2.2 per cent exposed to Invesco Perpetual Enhanced Income (ILH). It's a high-yield bond fund managed by two of the UK's best and most experienced high-yield bond managers, Paul Causer and Paul Read.

City Merchants High Yield (CHY), under 12 per cent of your investment trust portfolio, is managed also by Mr Causer and Mr Read. But if The City Merchants board become dissatisfied with the manager’s performance they will act in shareholders' interests and replace them. I can't see any danger of that.

The Perpetual Income & Growth Trust (PLI), however, is a completely different animal, being invested in equities, and managed by Mark Barnett, a good long-term star at Invesco Perpetual and a safe pair of hands. On the same basis as above in percentage terms, only 7 per cent of your investment trust holdings is exposed.

What I don't get is the high exposure to cash Isas. You say you are comfortable with capital variances... it's income that matters. That being the case, you should look at the total return you have enjoyed from investment trusts and be brave. Over the last 40 years I've done this job give me patience together with income trusts any day. And I don't see interest rates rising much. You'll get a shock when you sees the replacement cash Isa rates when you come to the new terms. The high rates of inflation and interest rates of the 1970s to early 1990s I believe have gone for a very long time.

If I were you, when you come to the end of your cash Isa terms, don't reinvest into cash Isas. Convert them to stocks and shares Isas instead. I appreciate that this bull market for equities is now five and a half years old, but I believe this is an elongated positive period like the time from 1982 onwards. But I have to say this is the best portfolio I've looked at for Investors Chronicle and would congratulate you, while hoping that my comments help you be a bit more brave.