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Investment Trusts: Ultimate Cash-Generators

A little thing called a “revenue reserve account” allows investment trusts to ensure they pay stable dividends to shareholders

Jackie Beard, FCSI, 19 July, 2012 | 10:30AM

Investment trusts are excellent vehicles for investors seeking income because they have revenue reserve accounts that allow them to be more flexible in paying dividends compared to traditional open-end funds.

The revenue reserve allows the fund’s board to keep back up to 15% of the portfolio’s dividend income and to transfer it into the revenue reserve account. They can then dip into this ‘buffer’ in lean years, when dividend income from the underlying investments is lower than expected.

Investment Trusts Unfazed by BP Dividend Cut
A good example of this was in 2010 when BP cancelled its first-quarter dividend and said no dividend would be declared for the second and third quarters. This was because of the major oil spill in the Gulf of Mexico. Along with Shell, those two companies accounted for 25% of the dividends paid in the UK in 2009, so it was a stock that was widely held at the time in investment funds—and equity income funds in particular—for this very reason. While numerous open-end funds slashed their yields in reaction to BP’s news, investment trusts weathered this storm well. Indeed, boards were able to honour policies of progressive dividend growth by dipping into their revenue reserves to bolster that year’s income payment to shareholders. This move allowed many investment trusts to maintain multi-decade records of increasing dividends year on year.

But it’s not just UK equity investment trusts that pay decent levels of income using the investment trust structure; it’s becoming a global phenomenon and we have seen a number of more specialist income funds launched.  Below is an outline of the different kinds of dividend-paying investment trusts available, plus an analysis that shows investors are becoming more willing to pay up for dependable dividends:

The Traditional: UK Growth & Income
There are 22 funds listed by the Association of Investment Companies (AIC) under the UK Growth & Income category that have at least three years of history. Only three funds have an average three-year discount that’s actually a premium, indicating their popularity amongst investors: there is the Gold-rated City of London (CTY),the Gold-rated Edinburgh Investment Trust (EDIN) and F&C Capital & Income (FCI). Roll forward to just the last six months and the number of funds which had an average premium was 10. That’s more than a three-fold increase and that suggests that investors are prepared to pay extra for a predictable income stream.

The Traditional: Global Growth & Income
In the AIC Global Growth & Income category, there are nine funds with at least three years of history. Just two have an average three-year discount that’s actually a premium: the Gold-rated Murray International (MYI) and F&C Managed Portfolio (FMPI). Fast-forward to the last six months and there are now five funds which have a six-month average premium.

The Modern
BlackRock launched a commodities income investment trust (BRCI) in 2005, and it’s rated Bronze by Morningstar. It’s a niche investment but if you want commodities exposure with relatively muted risk, this fund has a yield that’s above 5% and an Average Morningstar Risk rating. The Silver-rated Schroder Oriental Income fund (SOI) is run by Matthew Dobbs and yields around 4%. Then there is the Bronze-rated JPMorgan GEM Income (JEMI) and Aberdeen’s Latin American Income fund (ALAI). This shows the diverse nature of income-generating funds that are using the closed-end structure to benefit their shareholders in these times of low return and low interest rates.

The Premium Problem
With a number of funds now trading with sustained premiums, what does this mean for the average investor? Be wary when buying a fund at a premium: it means you’re paying more than what the underlying assets are worth. There is the risk that the premium could erode over time and the fund could move back to trading at a discount. This is certainly a risk investors should be aware of before making an investment.

See related video:
Investment Trusts for Income A look at which specific investment trusts could be suitable for income seekers.

This article was originally published during Morningstar's "Seeking Income Week" in July 2012. 

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.