Manager's view: A less imperfect solution - investment trusts and income

Aberdeen’s Charles Luke explains how in a low-interest rate world, the structure of investment trusts means they can take a much more flexible approach to generating income.

Those seeking an income from their investments have had little choice but to turn to the stock market in recent years, as the interest on savings accounts and bonds has dwindled. Company dividends have offered a compelling mix of an income that grows over time – increasingly important in a reflationary environment - plus greater opportunity for capital gains. However, while most income-hunters access this type of investment through equity income funds, these remain an imperfect solution to generating the high and stable income that most people are seeking.

Homogeneity risk

The first problem is that the UK stock market is relatively concentrated in the type of stocks that pay dividends. The top five dividend payers comprised 38 per cent of the UK’s total dividend payouts in 2016, up from one third in 2015. Shell alone distributed 12 per cent more last year than the entire UK mid-cap index, and accounted for £1 in every £8 of UK dividends.

As a result, UK income funds can look homogeneous. Blue-chip companies in the financials, healthcare, oil & gas and consumer goods sectors typically make up a significant proportion of their holdings. This is a particular problem for the largest funds, which – for reasons of liquidity and practicality – have less choice in the type of stocks they hold. This is fine when things are going well, but can leave investors exposed to weakness in individual sectors. Perhaps the most glaring example of this was the rout in the banking sector following the financial crisis.

Equally, the aggregate picture for dividends is not as rosy as it may initially appear. While UK dividends ended 2016 with a grand hurrah, up 11.7 per cent in the last three months of the year alone, the lion’s share of this (£4.8 billion of £5.2 billion) came from the pound’s weakness (1). Without the fall in the pound, dividends would have been just 0.6 per cent higher. Special dividends added another £3.3 billion to the total. Without these or the changes in currency, dividends were actually 3.7 per cent lower year on year. In other words, dividend growth has been patchy, reliant on currency and one-off dividends, rather than being supported by improving profits from companies.

This is not to say that there aren’t plenty of opportunities to find companies growing their dividends, it’s just that investors aren’t going to find them accidentally, and they need to be selective. Of the 39 sectors analysed in the most recent Capita Asset Services Dividend Monitor, 26 sectors paid out more in 2016 than in 2015. This is fewer than normal, but suggests there are plenty of companies growing their dividends. However, investors may need to look beyond the traditional income-paying sectors to other industries with potentially stronger growth.

This selectivity is particularly important because payouts from FTSE 100 companies have been conspicuously weak: 2016 marked the third consecutive year that the UK’s largest companies have seen slower growth than their mid-250 peers. Top 100 dividends rose just 2.2 per cent in 2016 in spite of the hefty boost from the weak pound, while mid-caps rose 5 per cent, riding higher on stronger profit growth. The point is also illustrated by the gap between cyclical and defensive sectors. The weakness of certain, previously reliable, defensive sectors has been a feature of 2016 – payouts from aerospace and defence companies were down 17 per cent in 2016 over 2015, while those from food and drug retailers were down 22 per cent. This may continue in 2017, with dividend cuts from Rolls-Royce and Rio Tinto yet to wash through the figures.

In contrast, cyclical companies have been looking far stronger. Media companies, for example, raised their dividends by 23 per cent, travel and leisure by 75 per cent, chemicals by 87 per cent. There are exceptions on both sides, of course, but the figures illustrate the problem of sticking rigidly with a certain type of stock. It is important to have the capacity to be flexible through the business cycle.

This is not to make a point, necessarily, about large cap versus mid cap or cyclical versus defensive, but simply to show that an equity income strategy of itself is not enough to ensure a stable and growing income. Trying to generate an income from an undifferentiated basket of income stocks is unlikely to o¬ffer the protection or the consistency that investors need.

Another problem is dividend cover. At almost 3.5 per cent (2), the yield from the FTSE All-Share appears attractive, but dividend cover – the extent to which a company’s dividends is covered by profits – is falling. It is currently down 10 per cent on a year ago and half its level of two years ago. For the FTSE 100 as a whole, earnings only just cover dividend payouts.

Dividends under pressure

This suggests the overall level of dividends in the market could come under pressure. A survey by AJ Bell at the start of the year (3) showed 26 FTSE 100 firms forecast to have dividend cover of 1.5 times or less.

The report warned: ‘Divided cover of below 1.0 should ring alarm bells because it means the company is paying out more to shareholders than it makes in that year. This means it has to dip into cash reserves, sell assets or borrow money to maintain the payment. This is unlikely to be sustainable over the long term.

‘Dividend cover of around 1.5 is less than ideal because it means a company has less room for manoeuvre if profits fall in one year. It will then need to decide whether to reduce its dividend, stop reinvesting in the business or take on more debt.’ In other words, there are a number of major companies that look vulnerable to dividend cuts. Even the largest companies have not proved immune and again, this argues for selectivity.

However, before getting too gloomy, the problem is solvable. There are plenty of firms growing their dividends, with the cash ow and earnings to sustain growth in their dividends. Fund managers just need the flexibility to be able to find them.

To our mind, the greater flexibility available to investment trust managers provides a solution to some of these problems. Investment trusts have a fixed pool of capital, which means the manager does not have to buy and sell holdings to meet investor inflows and outflows (as is the case for open-ended funds). This allows them to be more active than managers of open-ended funds, as they are not as constrained by the liquidity of individual stocks. Investment trust managers can invest as and when they see compelling opportunities, for both income and growth.

A number of other elements of the investment trust structure also afford investment trust managers more flexibility. For example, investment trusts have the ability to reserve income in ‘feast’ years, to pay out in ‘famine’ years. It means they are not condemned to invest in the highest-yielding companies regardless of their growth prospects, simply to support the annual dividend payout.

The definition of equity income by the Association of Investment Companies is also more flexible than it is for open-ended funds. UK equity income investment trusts have to demonstrate that they are aiming to achieve a total return to shareholders from capital and dividend growth and there is no specific yield target. In contrast, the Investment Association definition has a specific yield target and funds have historically been ejected from the sector for failing to meet it. The yield target has recently been reduced in recognition that it did not give managers sufficient flexibility, but investment trusts still have the edge.

We would also argue that investment trusts compare favourably to ‘enhanced income’ funds, which have been considered a solution to some of the difficulties of paying a high dividend yield for investors. These funds sell options on existing holdings to boost the income. The problem is that this limits the potential growth: a recent Hargreaves Lansdown report (4) found that the higher income has in some cases come at the cost of capital growth, with some funds even experiencing capital losses.

Investment trusts can employ option-writing to boost the overall income yield, but they have alternatives, such as leverage, available to sustain a higher income. This allows for a more nuanced approach to generating income. Options can be employed when pricing looks attractive, but there is no necessity to write options if it doesn’t.

Investment trusts may not be a perfect solution to the income dilemma and, of course, investors must still be selective, but trusts do have some natural advantages. As such, we believe they are a less imperfect option.

Find out more at:

(1)Capita Dividend Monitor, www.capitaassetservices. com/sites/default/files/SS15723%20Dividend%20 Monitor%20Jan%202017-v6.pdf.
(2)Morningstar, 10 April
(4) Hargreaves Lansdown UK Equity Income Report, March 2017

Risk warning

The value of investments and the income from them can fall and investors may get back less than the amount invested.

Please remember that past performance is not a guide to future results.
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