Finding a way of using your capital to provide a sustainable income, typically when you reach retirement, is becoming increasingly important. A growing number of retirees are opting for pension freedom, rather than buying an annuity or taking a company pension, and are looking to invest and draw down their lump sum. An investment trust portfolio that provides a regular income as well as potentially protecting the value of your capital could be a valuable part of the solution.
Many investors are understandably wary of investing in the stock market when they retire, because of the volatility of share prices, but company dividends usually follow a more predictable path and generally tend to increase over time as company profits grow.
The added advantage of investment trusts is that they can keep some of their dividend income in reserve, rather than paying it all out immediately as open-ended investment funds (Oeics) must do. This enables them to smooth out income payments to investors. A growing list of trusts is showing how it’s done by clocking up 10 or more years of consistently increasing dividend payments.
Another advantage for investment trusts, following a rule change in 2012, is that they are also allowed to dip into their capital gains to boost their dividends. This can provide income investors with a good way of gaining exposure to trusts which make most of their profits from capital growth, without having to cash in any shares themselves in order to generate the income they need.
Practising what we preach
To illustrate how an investment trust income portfolio can work in practice, Money Observer has put together a portfolio designed to deliver an annual income of £10,000 based on current yields. This year, we have calculated that the initial investment required to deliver this income is £254,500. It would be possible to achieve the same amount of income with a smaller lump sum, but this would mean investing in more specialist, higher-yielding trusts, or in trusts trading on higher premiums to net asset value, which could increase the risk of capital loss.
The portfolio we have suggested is more broadly based. It is not without risk, of course, and investors should be prepared for both capital and income fluctuations. This is the fourth year we have suggested such a portfolio and we have modified it slightly each year to make it relevant for new investors. Each year it has met its income target but in the first year – 2015 – there was a small capital loss in the portfolio. However, this reduction was more than made up by the growth the portfolio generated in 2016 and 2017.
Last year, the capital outlay of £257,500 for new investors in the income portfolio grew to £279,096. The income generated from the 11 trusts was nearly 10 per cent above our target, at £10,968.
So, for investors who backed this portfolio strategy last year, the enhanced capital sum at the end of the period should provide an income that more than beats inflation, which is one of the chief goals of this portfolio.
A tweak to our UK exposure
Around a third of the portfolio last year was held in four UK-focused equity income trusts, and this level of exposure will be maintained in 2018 to avoid taking too much currency risk. Though this aspect of overseas exposure can work in investors’ favour, as it has done in previous years when sterling has weakened, it cannot be guaranteed.
All four holdings paid out more income than we had estimated and their capital values also rose by varying degrees. City of London clocked up its 51st consecutive year of dividend increases and it still has money in reserve. The strongest performer on both the income and capital fronts was Diverse Income, which invests in small as well as large companies, including those listed on the Alternative Investment Market (Aim). Its capital value increased by 10 per cent and its income payout by over 20 per cent. This included a special dividend to reflect the special dividends that the trust received from many of the companies in its portfolio.
Perpetual Income & Growth also paid a special dividend, but this was slightly down on the special dividend it paid the year before, although its basic dividend increased. However, we have been disappointed by the performance of the trust over the past two years. Last year we reduced our holding in it, hoping that its performance would improve, as we still believe Mark Barnett is a good manager for the long term.
However, we are concerned that he may have taken his eye off the ball somewhat due to his role as head of UK equities at Invesco Perpetual. We have decided to replace this holding this year with Shires Income, which has the attraction of a higher yield. It invests principally in UK equities but also in fixed income securities. That mixed asset approach will help to give this part of the portfolio extra diversification, which may be useful in case of UK market volatility post-Brexit.
A replacement in the global category
All three of our global equity income holdings delivered capital growth and paid out as much or more than the expected amount of income in 2017. Murray International remains the portfolio’s largest holding. If anything, its high exposure to Asia and the emerging markets at just over 40 per cent of its portfolio now makes it an even more relevant holding for the coming year, with the outlook for these areas becoming increasingly attractive.
Scottish American, to which the allocation was increased last year, was the star global performer in capital terms, up 12 per cent, though the rise in its income payment was modest at less than 2 per cent. However, the good performance of this trust in recent years under manager Dominic Neary has resulted in the trust trading at significant premiums to net asset value.
Bearing this in mind, as well as the departure of Neary last August, we have decided to replace this holding with JPMorgan Global Growth & Income.
Among the attractions of JPMorgan Global Growth & Income are its higher yield and also the fact that it has a lower exposure to the UK than Scottish American. Its UK holdings are currently under 10 per cent of the portfolio. At the end of 2016, the trust’s shareholders agreed that future dividends could be funded using capital as well as income, and it was decided that a target dividend equivalent to at least 4 per cent of the net asset value (as at the end of the preceding financial year) would be paid.
As its investment approach is focused on growth and its NAV performance in recent years has been strong relative to its peers, we feel the risk of capital erosion from this dividend policy is minimal.
For added diversity, 30 per cent of our portfolio is invested in four specialist trusts to give exposure to higher-yielding options or those we believe have good prospects for growth. Performance here was mixed in 2017.
F&C Commercial Property delivered a steady monthly income but declined slightly in capital terms, mainly because the share price fell to a small discount to net asset value at the end of 2017, having been quoted on a premium for most of the year.
Schroder Oriental Income was one of our best performers in terms of increased income and capital growth, as Asian stock markets benefited from the recovery in global economic growth and the earnings of Asian companies rose, underpinning healthy dividend growth. This is a trend that we expect to continue.
Our overall star performer in capital growth terms was Princess Private Equity, which invests in a globally diversified portfolio of unquoted, mid-sized private companies. This was partly due to the strength of its underlying investments but also to a narrowing in the trust’s share price discount to net asset value over the year, from 13.1 per cent to zero. Private equity trusts were a popular choice among investors last year.
The portfolio’s least successful holding was Middlefield Canadian Income, which delivered slightly less income than we had expected and also saw a fall in its capital value. Although the trust still offers an attractive yield, we have decided for this year’s portfolio to switch to another trust with a higher yield which we believe has more potential.
The new trust is European Assets, which fixes its dividend at 6 per cent based on its net asset value on 31 December each year. The dividend is paid mainly out of capital reserves but what we like about this trust is that it invests in smaller companies across Europe and these companies do not tend to be high dividend payers because they are growth businesses.
It means that we can give the portfolio exposure to an area that is not typically present in income portfolios and which we believe has the potential to perform well this year.
Keep up to date with all the latest personal finance news and investment tips by signing up to our newsletter. Email subscribers will also receive a free print copy of Money Observer magazine.
Subscribe to Money Observer Magazine
Be the first to receive expert investment news and analysis of shares, funds, regions and strategies we expect to deliver top returns, plus free access to the digital issues on your desktop or via the Money Observer App.Subscribe now