Investment Trust Dividends
It is well known that investment trusts (closed ended funds) have more flexibility than unit trusts (open ended funds) when it comes to paying income to shareholders via dividend payments. This is due to the fact that investment trusts have the ability to accrue revenue reserves of up to 15% of the portfolio income on an annual basis, which means that they have the potential to build up significant cash reserves over time. This allows investment trust Boards to grow, or at least maintain, dividend payments to shareholders even when there have been dividend cuts in the underlying portfolio holdings. In contrast, open ended funds have to pay out all of their income each year and have no ability to ‘smooth’ this payment, for example during market downturns or in periods of currency volatility.
The Association of Investment Companies (AIC) publishes a list of its ‘Dividend Heroes’ each year, consisting of those investment trusts that have increased their dividend consecutively each year for 20 years or more. Most notably, in 2018, there were four investment companies that had raised their dividend every year for more than 50 years – City of London Investment Trust, Bankers Investment Trust, Alliance Trust and Caledonia Investments – all well known to us at Speirs & Jeffrey.
Since a change in the tax rules in 2012, investment trusts have had the ability to pay income (i.e. dividends) out of capital profits. This has given an additional income advantage to investment trusts over unit trusts and, if a Board deems this to be an appropriate course of action (in order to meet shareholder demand for income in a low interest rate environment for example), the dividend policy can be amended subject to shareholder approval. In addition, it has allowed income focused investors to access exposure to sectors such as biotechnology and smaller companies which historically have been previously omitted from portfolios due to their very low or sometimes non-existent dividend yields. It can also lead to a narrowing in the trust’s discount in the short term due to increased demand from income seeking investors. There have been over 20 investment trusts that have taken advantage of this change in the rules, including some that are well known to us such as JPMorgan Global Growth & Income, Securities Trust of Scotland, European Assets, International Biotechnology and more recently Montanaro UK Smaller Companies Trust.
It is worth noting that some trusts are just using the capital profits to ‘top up’ the portfolio income received whereas others, such as those in the biotechnology or private equity sector, are often meeting the entire cost of the dividend in this way. In addition, some trusts pay out a fixed percentage of the Net Asset Value (NAV) every year, often determined by the NAV per share at the end of the trust’s financial year, whereas others use capital profits to help sustain a ‘progressive’ dividend policy. However, the disadvantage of paying income from capital profits is that it will, by definition, reduce the long term capital returns that a trust generates – hence this practice is often referred to as ‘robbing Peter to pay Paul’. Paying dividends out of capital can also be less attractive from a tax point of view given the higher rate of tax levied on income than capital gains when investments are not sheltered within ISA’s or SIPP’s.
It should also be noted that most of the trusts amending their dividend policies to take advantage of the change in the tax rules have done so during the reasonably supportive period for markets that has been in place since 2009. If the NAV is rising every financial year, paying out a fixed percentage leads to rising dividend payments. However, as is being demonstrated at present after the recent pullback in equity markets, dividend payments can also be reduced when the NAV has declined over the financial year. A recent example would be European Assets, which invests in smaller companies and pays out 6% of its year end NAV to shareholders in the following financial year. In 2017/18, it paid out 8.80 eurocents but in 2018/19 it will only pay out 6.84 eurocents primarily due to the NAV total return falling by 16% during the year to end October 2018.
In summary, at Speirs & Jeffrey we fully understand that careful analysis is needed of those trusts that are paying out more income than is generated by the underlying holdings, particularly for those clients that are more reliant on income. Please contact your investment manager if you have any queries on the issues raised in this blog.
Head of Research
13 February 2019