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How to extract income from growth

You can create an income by selling chunks of growth investments from time to time
How to extract income from growth
  • If you need income from your investments, as well as holding dividend and income-paying ones, you could sell chunks of growth investments
  • This can be more tax-efficient, result in better performance and enable your portfolio to keep growing
  • Taking income via this approach incurs many risks including depleting the capital value of your investments

Earlier this month, the government announced an increase in National Insurance and the dividend tax of 1.25 per cent to help fund social care. This does not apply to dividends from investments held within individual savings accounts (Isas), and the dividend allowance still enables you to receive dividends outside Isas worth up to £2,000 each year tax-free. However, tax on dividends outside tax wrappers above this allowance will increase.

 

Dividend tax rate changes
Tax bandCurrent rate (%)Rate from April 2022 (%)
Basic rate7.58.75
Higher rate32.533.75
Additional rate38.139.35
Source: AJ Bell

 

If your dividends from investments outside tax wrappers exceed £2,000 a year, you could consider a total return approach, whereby you hold growth investments and sell chunks of them to, in effect, create an income. Gains on the investments you sell can be offset against your annual capital gains tax allowance, which is currently £12,300.

There are other benefits to creating an income in this way. Companies that don’t pay out dividends can achieve better growth than ones that pay dividends so you might get a better overall return by holding these as well as income-paying investments. If you include both types, you have a wider universe of potential investments to choose from. And your portfolio should be better balanced as it is not all focused on one area of the market. This could be beneficial both for generating extra returns and possibly mitigating downside because when certain areas are falling your entire portfolio would not be exposed to them.

“If you choose between total return and income, you are choosing between investment styles,” says Craig Melling, head of investment at Progeny Asset Management. “Income stocks, for example, have almost been a play on value for the past few years. Taking a total return approach means that your portfolio could include a blend of investment styles rather than either value or growth.”

You can avoid being very exposed to overvalued stocks or funds just because they have an attractive dividend policy and target investments with a sustainable and rising income alongside growth investments.

Taking a total return approach with some of your investments could help your portfolio to continue growing if, for example, it has to last through a potentially long retirement.

“You can decide how much you want to take out each month so you are not as dependent on a third-party deciding what your income actually is,” adds Adrian Lowcock, independent investment analyst. “You also have greater control over when you take the money out and how often.”

This means that you can take it when you have the available tax allowances to offset it against.

 

Higher-octane approach

However, there are a number of risks you should try to avoid if you sell growth investments to create an income. If you sell investments in a falling market you will exacerbate the decline in the capital value of your portfolio, especially if markets fall for a long time and you continue to do this. You will be left with a smaller pool of capital so when markets go back up it will be harder for you to recoup your losses.

“Capital withdrawals need to be well-timed as 'these have a massive impact on the long-term performance of a portfolio,” says Lowcock. “For instance, a £5,000 withdrawal from a £100,000 portfolio is 5 per cent of its value, but only 4.1 per cent of a portfolio worth £120,000.”  

For this reason, taking a total return approach to income is probably more suitable for investors with larger and more diversified portfolios. If some areas of such a portfolio are falling there may be other holdings to turn to for capital or income. Melling suggests that income investors with smaller portfolios focus on income investments. And in any case, most or all payouts from portfolios with smaller values are likely to be covered by Isa and dividend allowances.

If you take a total return approach to getting income, you should be an experienced investor and prepared to take a hands-on approach to managing your investments. “Markets and investment styles, managers, investment opportunities and cycles change,” says John Moore, senior investment manager at Brewin Dolphin. “So it is important to review your approach and holdings regularly, and make sure that what you want to achieve is realistic against the backdrop of what is happening today.”

You need to be very careful that you don’t run down your capital while you still need it. “Each capital withdrawal reduces how much you have invested, putting greater pressure on delivering growth from the remaining investments,” explains Lowcock. “If your portfolio isn’t growing quickly enough you could start eating into your capital very quickly and potentially run out of money, for example later in life [if this is a retirement fund] just when you need it.”

Generating the necessary growth might be a challenge in some years if your investments are falling or not rising as much as you need. This could be because they invest in areas that are not doing well or the funds are underperforming.

“Capital growth is less predictable than dividend payouts because most companies are determined to at least maintain – if not grow – their dividends and there is a link to earnings,” adds Jason Hollands, managing director at Bestinvest. “Share price gains are substantially driven by prevailing market conditions and are a lot more volatile than dividend payouts.”

For these reasons, you should hold easily accessible cash worth at least six months of your expenditure, or more if you are retired, so that you do not have to cash in investments when markets are falling.

If your portfolio is very focused on high-growth funds it could end up with a higher risk profile than you want because it will need more of a growth strategy. “As a consequence, you are likely to have less exposure to income-generating assets including bonds, property and equity income, which are lower-risk,” says Lowcock. “A growth portfolio is likely to have greater exposure to equities and be more exposed to short-term volatility in markets. A market rotation from growth to value could [result in your portfolio] not achieving the growth required to replace capital withdrawn. Also, growth stocks can suffer in different market conditions and may be harder to come by in a recession or different economic conditions.”

Melling suggests not just holding growth investments if you need income, but to have a mixture of equity income, growth, and small and mid-cap funds.

How much of your portfolio you allocate to growth investments for income depends on how much risk you are willing to take. “An investor taking the traditional income approach [of getting income from dividends and bond coupons] might settle for 25 per cent of the equity exposure in growth companies,” says Lowcock. “I would suggest no more than 75 per cent of equity invested in growth stocks [for either approach], and keeping exposure to other assets to ensure that the portfolio is diversified and has plenty of capital protection built into it.”

Selling chunks of investments could also incur trading costs.

 

Funds for a total return approach

Funds for getting income via a total return approach should be growth-focused. “This could be a mixture of pure growth such as the Baillie Gifford approach, or a focus on quality stocks as favoured by the likes of Lindsell Train and Fundsmith,” says Lowcock. “Smaller companies offer more potential for growth and you could consider certain regions that offer exposure to growth sectors, for example. the US for technology stocks.”

Scottish Mortgage Investment Trust (SMT), managed by James Anderson, Tom Slater and Lawrence Burns at Baillie Gifford, has delivered high growth. The trust has an outstanding performance record but is a higher-risk option. Its investments include unquoted companies, it takes big bets on some investments and it has substantial allocations to what are considered to be more volatile sectors such as technology.

Fundsmith Equity (GB00B41YBW71), by contrast, is a concentrated portfolio of high-quality, large, global multinationals and nearly 39 per cent of its assets were in consumer companies at the end of August. The fund's manager, Terry Smith, favours companies that are resilient to change with attributes such as the ability to sustain a high return on operating capital, advantages that are difficult to replicate, strong growth potential from reinvestment of cash flows at high rates of return and not needing significant leverage. Although Fundsmith Equity is a global fund, it had 71.8 per cent of its assets in the US at the end of August.

Lowcock suggests LF Lindsell Train UK Equity (GB00BJFLM156) which is managed by Nick Train, and aims for both capital and income growth. It has a very strong record of beating the FTSE All-Share index and other UK equity funds, although Train’s focus on quality and relatively defensive style mean that it can underperform the market and other funds when they are rising sharply, such as over the past 12 months.

Moore suggests Finsbury Growth & Income Trust (FGT), also run by Train. This is classified as a UK equity income investment trust and aims to maintain or increase its total dividend each year. This fund has a relatively low yield but has made outstanding long-term total returns so could work well as part of a total return income approach.

Lowcock also suggests Jupiter UK Smaller Companies (GB00B1XG9599), which aims for growth. The fund’s manager, Dan Nickols, has recently tilted the fund to more cheaply rated value stocks at the expense of more richly valued growth stocks, following under performance in late 2020 and early 2021 due to a focus on growth stocks. He now aims to have a balance between disruptive structural growth stocks on valuations that can be rationalised and more economically sensitive companies. His changes have included starting new positions in TI Fluid Systems (TIFS), Kier (KIE) and Wickes (WIX), and selling more expensively rated positions in AJ Bell (AJB) and Team17 (TM17).

The fund’s largest sector exposures at the end of July were consumer discretionary and industrials stocks, which each accounted for around a quarter of its assets.

Longer term, Jupiter UK Smaller Companies has a good record of outperforming Numis Smaller Companies excluding Investment Companies index and other UK smaller companies funds.

Lowcock highlights T. Rowe Price US Blue Chip Equity (LU1028172069), which typically holds 100 to 140 US large and mid-caps. Its manager, Larry Puglia, aims to invest in growth stocks that can deliver sustainable returns through different market cycles. He likes companies that have strong growth in earnings and free cash flow on a durable basis, and leading market positions in growth areas. He and his team also assess valuations and aim to avoid overpaying for growth.

The fund was overweight tech and communication services stocks relative to the S&P 500 index at the end of July, in which it had 40 per cent and 27 per cent of its assets, respectively. The fund's largest holdings included tech stocks such as Alphabet (US:GOOGL), Amazon (US:AMZN) and Microsoft (US:MSFT). It didn’t have any exposure to sectors including consumer staples and energy. The fund has a good record of beating the S&P 500 index and other North America funds.

Melling highlights Allianz Continental European (GB00B3Q8YX99). This focuses on larger companies and has substantial exposure to industrial and technology stocks, which accounted for over half of its assets at the end of August. The fund’s largest holdings included semiconductor company ASML (NET:ASML) and transport and logistics provider DSV Panalpina (DEN:DSV).

Moore also suggests specialist funds that aim to achieve higher-than-average returns by focusing their portfolio, style and overall investment approach, and maybe invest in a specific area or theme. Options include Worldwide Healthcare Trust (WWH), which invests in both the healthcare and higher-return, higher-risk biotechnology sector. Its managers, Sven Borho and Trevor Polischuk at OrbiMed, try to identify companies that could outperform in areas such as therapeutics.

The trust is well-diversified across various healthcare sub-sectors and at the end of July had 29 per cent of its assets in biotechnology, 26.5 per cent in pharmaceutical, 18 per cent in provider and services, and 17 per cent in equipment and supplies companies. It had 70 per cent of its assets in North America.

The trust can invest up to 10 per cent of its assets in unquoted companies in which it had 7 per cent at the end of July.

 

Fund performance – cumulative total returns
Fund/benchmark1yr (%)3yr (%)5yr (%)10yr (%)
Scottish Mortgage Investment Trust share price46.60159.19365.261051.94
Fundsmith Equity 22.9360.75128.83527.03
MSCI World index23.3943.5591.58280.18
IA Global sector average23.9843.5686.02224.47
LF Lindsell Train UK Equity 12.2122.1360.83274.90
Finsbury Growth & Income Trust share price7.7016.9554.92267.21
FTSE All Share index25.1312.7534.27117.70
IA UK All Companies sector average31.6519.0442.20144.29
Jupiter UK Smaller Companies42.5036.65101.63378.04
Numis Smaller Companies Excluding Investment Companies index47.8128.0958.72219.21
IA UK Smaller Companies sector average53.9044.31101.06288.01
T. Rowe Price US Blue Chip Equity 21.6170.00179.02588.41
S&P 500 index23.4645.4999.99334.39
IA North America sector average25.7848.50106.46346.93
Allianz Continental European31.4168.78119.81355.73
FTSE Europe ex UK index19.3932.9165.58183.95
IA Europe Excluding UK sector average21.6132.9665.99216.34
Worldwide Healthcare Trust share price7.7933.9188.65492.68
MSCI World/Health Care index14.3339.7479.02355.74
Source: FE Analytics, 13 September 2021