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High yield investment trusts

Investment trusts can now pay dividends out of their capital profits, potentially increasing payouts for shareholders
May 29, 2012

Earlier this year activist hedge fund Laxey Partners lobbied the UK's largest investment trust, Alliance Trust, to increase its dividends by dipping into its capital profits as well as its revenue (read more on this). Although Laxey's proposals on Alliance Trust were defeated at the annual general meeting (AGM) last month, the prospect of other investment trusts boosting dividends by dipping into their capital is a possibility following a legal change that came into effect on 6 April.

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 – Aberdeen Asian Income at 13 (read our profile). Ms Tepes also compares two funds run by the same fund manager, Schroder Asia Pacific and Schroder Oriental Income (read our tip). Although the growth fund has outperformed it currently trades at a discount of more than 8 per cent while the income trust is on a premium of 0.45 per cent.

"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.

Drawbacks

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 Phaunos Timber (read our sell note) and EcofinWater & Power Opportunities have grown their dividends but not tightened their discounts. These invest in esoteric and, in the case of Phaunos, illiquid assets. Some property trusts also offer high yields but still trade on discounts.

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

TrustYield (%)Discount/premium to NAV (%)3yr share price total return (%)Total expense ratio (%)
Carador Income Fund13.8-0.94476.232.52
Alpha Pyrenees Trust11.93-0.62-18.2527.96
Picton Property Income11.03-36.5971.135.93
IRP Property Investments10.95-13.4653.342.46
Schroder Real Estate Investment Trust10.41-31.8253.074.6
British & American Investment Trust10.14+16.4629.022.76
Greenwich Loan Income Fund9.66-2.91,108.7915.01
Isis Property Trust9.38-11.3865.742.71
Princess Private Equity7.93-34.52163.992.24
Axa Property Trust7.63-47.895.276.36
UK Commercial Property7.53-4.1140.171.36
Standard Life Investment Property Income Trust7.31-0.3675.323.19
Medicx Fund7.27+13.8744.113.24
Majedie Investments7.19-27.056.734.17
Shires Income6.84-2.1470.351.13
Small Companies Dividend Trust6.83-4.83118.122.46
Cambium Global Timberland6.82-32.91-293.14
New City High Yield6.73+6.1868.871.36
European Assets Investment Trust6.66-11.5639.811.59
City Merchants High Yield6.62+0.7373.034.36

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.