Income you can trust

Getting the right balance of yield and dividend growth is tricky, but buying off-the-shelf portfolios in the form of investment trusts can offer an excellent solution. You'll need to watch out, though, because the corporate structure that allows trusts to pay uncovered dividends when times are tough can make hunting for the best yields a treacherous business. To make it easy, we've screened more than 300 trusts to find the three best bets for high and fast-growing yields.

The key advantage to seeking income through investment trust shares is that they provide their shareholders with diversity through their portfolios, as well as the research muscle and expertise of the fund management company charged with taking the investment decisions. The corporate structure of trusts also gives them a technical advantage when it comes to generating steadily increasing income streams thanks to the use of their so-called revenue reserves (a rule change earlier this year means they will also be able to pay dividends out of booked capital gains in the future to much the same effect).

The revenue reserve is principally an accounting phenomenon, which keeps track of the income a trust has received over the years but has not paid out to shareholders. While in reality this money is likely to be invested rather than kept on call, the existence of such reserves means a trust is legally allowed to pay dividends that are not covered by running the reserve down when its current income (known as revenue EPS) falls short. The actual cash paid out to shareholders that is reflected in the fall in the reserve will normally come from the sale of assets, which affects net asset value (NAV) performance. Payment of an uncovered dividend is not an option for open-ended funds.

When it comes to selecting trusts, the tricky bit is that the performance of fund managers varies a lot, and not all trusts are what they seem from their surface track record. Indeed, while revenue reserves are great to use as an emergency measure, as many trusts did following the credit crunch, they can also be used to mask more fundamental problems, which will ultimately result in serious disappointment.

In the long term, the key to an investment trust sustaining and growing a dividend is growth in its 'revenue EPS'. This is income a trust receives - usually in the form of dividends from the shares it holds - which is available to pay out to shareholders. To confuse matters, movements in the value of a trust's assets are also reflected in the overall earnings per share (EPS), so analysis of the statutory EPS figures is not much help in working out the veracity of a trust's dividend record. However, we've crunched the numbers to find the dividend growth stars that have fundamentals that are as good as their dividend track records suggest.

Finding our dividend growth stars

We've put more than 300 investment trusts through a number of gruelling tests aimed not only at finding trusts with excellent long-term track records of dividend growth, but also those trusts that have grown dividends consistently and on the back of genuine growth in revenue EPS.

We've also assessed trusts on the basis of their likely yield over a five-year holding period, basing our forecast for dividend growth on a blend of average annual growth over the last three- and five-year periods. To try to take account of the timing of payments over the five-year period we've used a discount rate based on the 1.49 per cent being paid by a 10-year UK government bond (the risk-free alternative) to work out the so-called 'net present value' of the average yield that can be expected over the period. Only three of the trusts (see below) we looked at - less than 1 per cent of the total – boasted an average five-year discounted yield of more than 3 per cent and passed the following tests:

Dividend growth

■ Average annual dividend growth over the last three, five and 10-year periods must be 5 per cent or more.

■ No dividend cuts in any of the previous 10 years and growth of 5 per cent or more in at least two of the last three years.

Consistency

■ A standard deviation of dividend growth over the past five years of 0.1 or less. Standard deviation is a measure of how consistent dividend growth has been with a lower number representing more consistency.

Revenue EPS growth and cover

■ Revenue EPS greater than dividend per share.

■ Revenue EPS growth equal to or more than 75 per cent of dividend growth over both three and five years.

THREE DIVIDEND STARS

Murray International

When it comes to assessing trusts based solely on our screen's criteria, Murray International is the out-and-out winner. Of the three funds that have passed the test, it is the only one that has actually grown revenue EPS by more than dividend per share over both three and five years. In addition to this, dividend growth over the past five years has been the most consistent out of the three trusts and the projected discounted payout over five years is the highest.

Unsurprisingly, the trust is extremely popular among both investors and advisers and it has taken advantage of the strong demand for shares by regularly issuing new equity at a premium to net asset value (NAV). For existing holders, this has the advantageous effect of enhancing NAV and reducing fund management costs. While this is a nice bonus, the true allure of the trust is its investment success under the stewardship of Aberdeen Asset Management's Bruce Stout.

Murray International's approach is to tap into growth in Asian and Emerging markets. Indeed, Mr Stout's view on the prospect of the West is downbeat to say the least and at the time of the trust's recent half-year results he predicted that "the heavily indebted, mature, consumption-based economies of the US, the UK, Europe and Japan" face "low growth, periods of recession, stagnant labour markets plus contracting overall incomes and living standards for the foreseeable future".

Unlike funds that are explicitly marketed as investing in these emerging market regions, Mr Stout is not constrained by steadfast asset-allocation rules. He is also a fan of companies based in the West but with significant exposure to emerging markets, such as his largest holding, British American Tobacco. The trust has also recently been reducing its exposure to bonds, which Mr Stout says look expensive. At the end of July, the fixed-income component of the portfolio stood at just 6.4 per cent of the total.

Murray International (MYI)

Perpetual Income & Growth

Perpetual Income & Growth is managed by Invesco, home of equity-income legend Neil Woodford. However, it is Mr Woodford's colleague Mark Barnett who actually manages the trust in question. In practice, Perpetual Income & Growth has much in common with the funds run by Mr Woodford and the team's world view is clearly evident in the portfolio - take Mr Barnett's decision not to hold any banks and big sector bets on tobacco and pharmaceuticals.

The trust shares a similar gloomy view of the world to Murray International and Mr Barnett has spent the last two years positioning it ready for several very challenging years for the global economy. This has meant focusing on high-quality, larger companies that have sound balance sheets and diverse geographic exposure.

Mr Barnett believes the sombre outlook has resulted in some good value emerging, though, and he hopes the type of stocks he holds - ones with predictable, non-cyclical earnings and inflation-beating dividend growth - could soon start to re-rate as "de-risking" by institutions abates.

An interesting aspect of the trust is that it has a relatively high level of gearing. This increases the potential upside of good investment decisions but also increases the risks if things go wrong. The defensive nature of the portfolio helps balance this out to an extent, though.

While the trust is chiefly UK-focused, 13 per cent of the portfolio is invested in international equities. It has recently gained approval to take advantage of its premium rating by issuing new shares. If issued at a premium these shares, equivalent to 10 per cent of the existing shares in issue, will help nudge up NAV as well as reducing the running costs per share of the trust and boosting liquidity.

Perpetual Income & Growth (PLI)

British Empire Securities & General

British Empire has a very particular bent on investment and, despite its impressive dividend record, the prime focus is not income generation. Indeed, the trust is interested in buying companies and funds that are valued at a significant discount to its own estimate of their sum of the parts.

Unfortunately this approach, and particularly the fund's focus on Europe where many such opportunities exist, has produced dismal performance over recent years. However, the long-term track record of the trust is impressive and the respected manager, John Pennink, believes there is significant value on offer at the moment.

Indeed, the trust currently estimates that the average discount that its holdings trade at relative to their NAV is a whopping 35 per cent. What's more, the period of underperformance recently suffered by the trust has led to the discount on its own shares widening, especially following heavy selling recently by major shareholder Caledonia.

This means there is a lot of potential value to unlock if the trust's strategy ultimately pays off, as it has for patient investors in the past. But the trials of recent years also makes it the highest risk of our three income-growth trusts.

As well as the dividend that we've based our performance analysis on, British Empire is in the habit of paying special dividends with some regularity and it paid out 2p in 2011. As far as our analysis of the shares goes this is really just a welcome bonus.

British Empire Securities & General (BTEM)

Dividend growth stars