How to pick a robust UK equity income trust

However, it has been almost two years since the sharp fall in sterling and the effect seems to be waning. Link says dividend growth in the final three months of 2017 was minimal as sterling was having a negative effect on this. It predicts dividend growth of 3.1 per cent in 2018, which would be 5 per cent without the negative effect of stronger sterling. "Lower special dividends and foreign exchange penalties on the stronger pound are likely to have an impact [on payout growth]," explains Link.

So with the UK dividend haul less certain and equity income growth possibly slowing, it's important to know which UK equity income funds could be hardest hit.

There are a variety of UK equity income open-ended investment companies (Oeics), unit trusts, and closed-ended investment trusts. Some investors prefer investment trusts for income because they believe their structure makes them better suited to providing this consistently. But such structures need to be analysed and properly understood, because if the dividend outlooks changes so can the security of income.

Tricks up their sleeves

According to broker Numis, UK equity income investment trusts increased their dividends by 5.6 per cent on average in 2017. But maintaining such a growth level in 2018 will be harder as the market's growth is set to fall below this level. So it is important to look at what a trust's source of income is and how its payout growth is likely to fare.

Investment trusts do not have to pass on 100 per cent of the income they receive each year to their investors, and can hold some back in reserves. For example, in 2017, only one investment trust – Lowland Investment Company (LWI) – paid out 100 per cent of the dividends it received, while Merchants Trust (MRCH) paid out slightly more. You can help to determine a trust's ability to pay income by looking at its dividend cover. This is calculated by dividing the revenue it receives from stocks by what it pays out to investors. A figure above one indicates that a trust has held some back and added to its reserves.

UK equity income trust dividend cover

Source: Numis (excludes trusts with a market cap smaller than £200m)

The table shows that most investment companies are prepared for a downturn in growth because they could grow their own dividends without using their reserves or taking income from capital, if their investment policies allow that. Diverse Income Trust (DIVI) has dividend cover of 1.34 and last year grew its payout to investors by 7 per cent, although the trust's income profile differs to some of its peers because it has exposure to smaller companies. Eight other investment trusts have a dividend cover above 1.1.

Another way to help determine the security of a trust's income is by looking at the level of its revenue reserve in relation to its most recent annual dividend. A dividend reserve figure indicates how long a trust can maintain an annual payout at the level it paid in its previous financial year without drawing on any revenue from the companies it holds. For example, a figure of 1 would mean one year.

UK equity income trust revenue reserves

Source: Numis (excludes trusts with a market cap smaller than £200m)

The table shows that most UK equity income trusts have built up relatively substantial reserves. The lowest is Finsbury Growth & Income Trust (FGT) at 0.42 as this trust is more focused on total returns than some of its peers. JPMorgan Claverhouse (JCH), by contrast, has enough reserves to cover 1.21 years' worth of the dividends it paid in its last financial year.

The figures imply that UK equity income investment trusts are generally well placed to withstand a reduction in dividend growth from UK companies, and most are secure enough to manage a fall in dividend income.

Sam Murphy, associate director at Numis, says: "The extent to which a trust's dividend is covered by its net income, known as dividend cover, remains strong, averaging 1.1 times across the peer group. This is in line with the prior year and illustrates that the dividend growth is well supported by earnings from the [trusts' holdings]. There may well be headwinds to trusts' revenue growth in light of sterling strength. However, we believe that the [sector] is well placed to weather any storm. A key benefit is the ability to build up a safety net of revenue reserves in good times to support dividends in lean years. This has led to the peer group building up average reserves of 0.72 years' worth of dividends."

Dividend track records

In addition to income security, Mr Murphy says investors must look at investment trusts' boards' records on protecting dividends. Many UK trusts have shown resilience when markets have taken a downward turn, suggesting their boards are good at planning and managing income. "Investors value the steady and predictable nature of the dividend stream provided by such funds so boards are keen to continue the impressive track records," says Mr Murphy.

Dividend growth

Source: Numis (excludes trusts with a market cap smaller than £200m)

A number of trusts have long-term unbroken records of increasing their dividends every year. Three UK trusts, City of London (CTY), JPMorgan Claverhouse and Murray Income (MUT) have increased their payouts every year for 40 years or more.

James Calder, research director at wealth manager City Asset Management, advises: "You should look for trusts with a progressive dividend policy, but where it doesn't back the board into a corner."

Dividend concentration

UK equity income investment trusts tend to focus on the largest and highest dividend-paying shares. But the proportion of dividends from the 10 UK shares that pay the most dividends is growing. This year, 59 per cent of all dividends from the FTSE 100 index are likely to come from only 10 companies, with Royal Dutch Shell (RDSB) accounting for 14 per cent, according to broker AJ Bell.

This means that the safest and highest-yielding, large cap-focused investment trusts could become more susceptible to capital loss and dividend cuts if any of the large dividend-paying companies fail to meet expectations. Sarah Godfrey, analyst at research company Edison, says some trusts that focus on the small-cap space, such as Diverse Income and Standard Life Equity Income Trust (SLET), would be less affected. Merchants, however, owns five of the top 10 dividend-paying companies, making it slightly more susceptible. Mr Calder says it is a symptom of what investors need from investment trusts, with most designed to own 'boring' companies and use their structure to give investors the income they desire.

"When looking at equity income funds, are you starting from the premise that you want to find the best one in terms of capital growth and whatever yield that comes with it?" he asks. "Or are you looking for market returns but with a yield you find attractive to fund your lifestyle? These are traditional, boring approaches to investing. But boring is good. You are taking equity risk here – there are no guarantees, but on a relative basis they are very attractive."

Structural differences

Although many investment trusts have a long track record and a structure that enables greater security of income, few professional investors are convinced by them. Many professional investors use open-ended funds because they have simpler structures and suit their investing needs better. For example, trusts can be more difficult for them to buy in the large volumes they need, aren't always available on the investment platforms they use and aren't as cost-efficient when continuously investing.

While these factors are less relevant for private investors, especially if they buy investment trust shares and hold them for the long term, they can affect trusts' share prices, and discounts or premiums to net asset value (NAV). According to the Association of Investment Companies (AIC), the average discount on UK equity income trusts is 3.6 per cent. This is partly due to lack of demand from professional investors and not likely to shift dramatically in the near future.

However, the average figure is skewed by a few trusts in the sector, with the more popular and successful trusts persistently trading at premiums to NAV. So when a trust with an attractive income profile does move to a discount it can present an opportunity.

"In a lot of cases you're buying large-cap blue-chip companies at reasonable discounts to their net asset values [via the trust’s discount]," says Mr Calder. "If we get a more challenging equity environment, the discount will widen, but if you take the view that you’re holding this for a substantial period of time, the short-term volatility in the share price is something you should wear."

It is also important to be certain that the discount to NAV is not because of a valid reason, for example persistent underperformance or a problem with the trust which means it is not likely to come in. But if it seems that it is there because of, for example, over pessimistic market sentiment towards the sector the trust invests in or lack of demand from institutional investors because the trust is small, then there is a chance it may tighten if the trust goes on to deliver good performance and an attractive dividend stream.

Investment trusts also tend to be more expensive on average. FE Analytics says the average ongoing charge for a trust in the AIC UK Equity Income sector is 1.1 per cent, versus 0.92 per cent for open-ended funds in the Investment Association (IA) UK Equity Income sector. But again, this is an average and there are exceptions among both types of funds. For example, one of the cheapest of all active funds in any sector is City of London Investment Trust with an ongoing charge of 0.42 per cent, while Temple Bar Investment Trust (TMPL) is not much more expensive at 0.49 per cent and Edinburgh Investment Trust (EDIN) comes in at 0.6 per cent. 

And among open-ended funds you can purchase Franklin UK Equity Income (GB00B7MKLS14) from platforms for as little as 0.52 per cent, while JO Hambro UK Equity Income (GB00B95FCK64), GAM UK Equity Income (GB00BF09N571), Royal London UK Equity Income (GB00B3M9JJ78) and Fidelity Moneybuilder Dividend (GB00B3LNGT95) all come in at 0.67 per cent.

And there are many other funds and investment trusts with ongoing charges cheaper than their sector averages. So when it comes to costs, rather than looking at average figures for sectors, look at what each individual fund or trust charges – as well as what your investment platform charges for holding it. 

And while the investment trust structure can offer some advantages in terms of providing a secure income, ultimately it relies on the ability of the managers to pick the right investments to generate the revenue and build up reserves. If they fail to do this, having structural advantages will not compensate, so an open-ended fund with competent managers is a better option than a badly run investment trust.  

So before you invest in any fund, make sure you thorough research on it.

Secure equity income trusts

There are fewer than 30 UK equity income investment trusts, compared with more than 80 equivalent open-ended funds, but there are still some good options.

Merchants Trust is one of the highest yielding UK equity income trusts with a yield of 5.3 per cent. Merchants' managers run it via a fairly defensive income strategy, taking low risks in large well-established companies. However, this means performance is never the highest, and at the moment it is on a discount to NAV of around 4.6 per cent, which is one of the tighter levels it has been at in recent years. But the trust has ample revenue reserves which it drew on in 2017, with running cover of 0.99 for 2017 and 1 in 2016. Its top 10 holdings include Royal Dutch Shell, GlaxoSmithKline (GSK), BP (BP.) and HSBC (HSBC).

City of London Investment Trust has increased its dividend every year for 50 years, and last year grew it by 5 per cent. The trust's manager, Job Curtis, invests in secure income-paying companies such as Royal Dutch Shell, British American Tobacco (BATS) and Diageo (DGE). Its dividend growth is stronger than Merchants Trust's, as is its reserve cover. In terms of its total returns, it has beaten the FTSE All-Share index over five years. The trust yields around 4.3 per cent and typically trades at a premium to NAV because of its reliable and attractive income stream. 

Standard Life Equity Income Trust has been run by rising star Thomas Moore since 2011. It has an attractive yield of about 4 per cent and is on a 0.6 per cent discount to NAV. The trust has a bias to mid- and small-cap stocks, while including some big dividend payers such as Royal Dutch Shell, Aviva (AV) and HSBC.

Its total returns are among the strongest in its peer group, ahead of its peer group average and the FTSE All-Share index over one, three and five years. Its dividend growth in 2017 was 11 per cent, and its cover and reserves are both strong.

If you do not like discount volatility Troy Income & Growth Trust (TIGT) operates a zero discount policy by buying back shares at a tight discount and issuing them on a small premium, typically when they hit a premium or discount of 2 per cent. The trust holds large-cap companies such as Royal Dutch Shell, Unilever (ULVR) and Lloyds Banking Group (LLOY) and has a yield of 3.5 per cent which it pays out via quarterly dividends. Last year it underperformed the FTSE All-Share index, but over the longer term it has beaten this benchmark.

Performance

Source: Winterflood as at 20 March 2018. *AIC