Acorn Income a hidden gem

Many investors have turned to and in their quest for more diversified sources of income, or they've paid steep prices for it in the UK. But it is still possible to buy a UK-focused investment trust with a decent yield and a cracking track record at a discount to net asset value - provided you look in the right place.

The Acorn Income Fund, a closed-ended investment company which seeks income from a portfolio of UK small caps and fixed-interest investments, is a good example. At just £24.8m, the fund is small, and it's not a member of the Association of Investment Companies (AIC) - which is probably why it is relatively unknown.

But it's been around since 1999 and its performance figures are telling. Over three and six months, one, three, five and 10 years, the fund has massively outperformed its peers in the AIC's UK Small-Cap income sector. Its net asset value (NAV) total return over ten years is close to 200 per cent, compared to 35 per cent for the Aberdeen Smaller Companies High Income trust and 115 per cent for the Small Companies Dividend Fund.

It's also beaten trusts in bigger sectors, outperforming every single fund in the AIC's UK Growth & Income and UK High Income sectors over three and six months, one, three, five and 10 years, and has substantially outperformed the FTSE Small-Cap index and the Hoare Govett Small Cap index since its launch.

The fund is split between two portfolios: a UK smaller companies portfolio with above-average yield, and a portfolio of fixed-interest securities.

The smaller companies portfolio makes up around 70 per cent of the fund's total assets and is managed by John McClure, the manager behind the successful Unicorn UK Income Fund. The fixed interest portfolio accounts for approximately 30 per cent of the fund and includes a spread of fixed interest securities such as corporate bonds, preference shares, Pibs and reverse convertible bonds. This part of the portfolio is managed by Paul Smith, who manages a number of fixed-income funds at Premier Asset Management, the investment adviser to the Acorn Income Fund.

The fund uses a conservative, low risk investment process to identify companies with an attractive dividend and low gearing. Dividend growth is also an important objective and the managers are alert to the dangers of buying high yielders where the dividend may be vulnerable. International diversification of income streams is another consideration; more than 50 per cent of the fund's income comes from outside of the UK.

The fund has significant gearing in the bond portfolio, allowing it to move around the sectors and take advantage of opportunities. While the interest rate on the loan facility is low, the fund has built in additional protection against the risk of rising interest rates by investing in floating-rate notes, index-linked bonds and convertible bonds.

The fund has a concentrated portfolio of shares but its turnover is low - some holdings have been with the fund since it launched. This means it saves significantly on dealing charges.

The fund pays quarterly dividends and has the benefit of a revenue reserve of more than £1.3m which can enable it to smooth income payments.

The discount to NAV used to be 17 per cent but has narrowed slightly. Even at 11 per cent, it's still cheaper than many bigger income trusts, which are trading at premiums to NAV. For a well diversified fund that's delivered strong growth and still sports an attractive yield, that discount doesn't look justified. Buy.

Key fund data:

Source: Thomson Reuters Datastream, *Morningstar

Notes: Performance figures as at 24 June 2011

Top ten holdings in smaller companies portfolio as at 30 April 2011

Sector Allocation