Finding hidden income from funds

The uncertainties of recent years have at least made life much easier for income investors. They need not cast far and wide for juicy yields any more: equity income funds can pay out nicely, FTSE 100 stocks such as Legal & General (LGEN) offer forward yields of more than 7 per cent, regions such as Asia show plenty of promise and even government bonds are paying out a decent rate for now.

Share price weakness has also left many of the classic alternative income plays, such as infrastructure investment trusts, on high yields and wide discounts. As we wrote this week in our newly launched, free-to-read investment trust newsletter, plenty of trusts across different asset classes paid out handsomely in 2023 and continue to come with a good level of yield – if you're not already a subscriber to our newsletters, click here.

But what about the less conventional sources of income? It might be easy to pack a portfolio with equity income funds, bonds and a few alternatives, but dividends can also come from some unusual places. That much was illustrated by the fact that three trusts investing in UK smaller companies, Athelney (ATY), BlackRock Smaller Companies (BRSC) and Henderson Smaller Companies (HSL), have now all achieved a 20-year track record of increasing their dividends, landing them in the AIC's Dividend Heroes list. So, much as they aren't seen as natural income plays, they can play a role in such portfolios.

Small cap, big yield

Smaller companies are not an obvious source of yield for one main reason: they tend to focus on growth, and reinvesting in their business, as they try to scale up. But they can nevertheless throw off cash that feeds into dividends, something reflected in the findings of the Aim Dividend Index report. The most recent instalment found that Aim dividends had surged to a new record in 2022, with companies such as Fevertree Drinks (FEVR) and Serica Energy (SQZ) among the top payers for the year.

With small-cap and investment trust shares alike having sold off fiercely in the past 18 months, some of the dividend yields on offer do look enticing. As the table below shows, Aberforth Split Level Income (ASIT), a name we highlighted as a special situation last year as it approaches wind-down in the summer of 2024, comes with a share price dividend yield of 7 per cent, with Montanaro UK Smaller Companies (MTU) on 4.6 per cent and Aberforth Smaller Companies (ASL) on 6.3 per cent.

The three trusts with a long record of increasing their dividends (ATY, BRSC and HSL) come with yields of 5.5, 3 and 3.3 per cent, respectively. Open-ended funds have also come with some respectable trailing yields, from Aberforth UK Small Companies (GB00B2N9GS70) to M&G Smaller Companies (GB00B7N1NG56).

It's worth noting that these yields are partly a product of falls in the value of these portfolios, and should come down if the market strengthens. Still, small-cap funds could justify a small place in an income portfolio thanks to their ability to boost returns and add some diversification. Some UK income funds do also deliberately take a 'multi-cap' approach, holding blue-chip stocks but also delving further down the market cap spectrum for yield. They can provide a good level of diversification from a handful of big small-cap payers, although in most cases share price returns will have been poor in the short term given small and mid-cap shares' recent woes.

"I certainly think there is a place for UK smaller company exposure in most portfolios, and an income portfolio is no different," says Mick Gilligan, head of managed portfolios at Killik & Co. "Our favoured exposure for this right now is Diverse Income (DIVI) which, although it has an all-cap mandate, tends to favour mid and small caps. Our position size tends to be 1 to 2.5 per cent, depending on risk profile."

Diverse Income has certainly had a rough time in the past year, tending to trail its peer by total returns. But it has a good blend of exposure to companies across the market cap spectrum and should benefit if, and when, small and mid caps make a comeback. We will publish an IC Interviews podcast interview with Diverse Income manager Gervais Williams next week.

Rob Morgan, chief analyst at Charles Stanley, meanwhile, highlights Aberforth Smaller Companies as "a good trust that happens to have a decent yield to boot". Aberforth has a value investment style and a reasonably well-diversified portfolio, with 78 holdings. Positions in the fund include currency printer De La Rue (DLAR), business publishing and training company Wilmington (WIL) and Wincanton (WIN), the logistics company whose board agreed a takeover deal in January.

Share price total returns from the trust have been lacklustre in the past year, offering something of a contrast to some more generalist UK value funds, although investors can currently buy in at an 11 per cent discount to net asset value (NAV). As Gilligan highlights, such positions are likely to form only a small part of an income portfolio, given the volatility they can bring.

Can we trust private equity dividends?

Small-cap funds are not the only hidden source of income: last year HarbourVest Global Private Equity (HVPE) floated the idea of regularly distributing some of the cash generated from asset sales to its shareholders, a move that would put it in line with some of its peers. Various private equity trusts do distribute dividends, from Apax Global Alpha (APAX) to Princess Private Equity (PEY) and CT Private Equity (CTPE). And some of the yields look attractive.

Yet there is a catch: the private equity funds will pay income from capital, meaning distributions could fall or dry up completely if the investment team struggles to sell enough assets or other problems emerge. Princess Private Equity has had its share of woes on this front, with the trust suspending a dividend in late 2022 in response to losses related to currency fluctuations. As Morgan notes: "I'm a little skeptical of trusts that turn their growth into income, as it means that income stream could be cut if there is a period of poor performance."

Backing dividend-paying private equity trusts, or even trusts such as European Assets (EAT) and JPMorgan Global Growth & Income (JGGI) that buy listed shares but fund dividends partly from capital, can therefore be something of a leap of faith. But investors can check certain metrics. Daniel Lockyer, senior fund manager at Hawksmoor, points to the fact that investors can parse investment trust results to check their levels of dividend cover net of all costs including debt. A broad rule of thumb is that a dividend cover ratio of 2 or higher should be reassuring.

Investors may also have to put faith in boards, and their track record. Lockyer notes that CT Private Equity and ICG Enterprise (ICGT) have each delivered at least 10 consecutive years of dividend increases, while their boards have also confirmed "the dividend is sacrosanct".