Before Deepwater Horizon, BP was one of the most generous, reliable distributors in the FTSE, deemed a stalwart holding in most income investors’ portfolios.
Then it cut its dividend, which should have seen investors receive roughly $10bn (£6bn) that year alone. Investors in open-ended funds were hit hard whereas investors favouring investment trusts (ITs) were shielded by the use of revenue reserves, seen as a key benefit to using investment trusts over Oeics or unit trusts.
David Smith, co-manager of the Henderson High Income Trust, cites this as one of their main advantages.
“You don’t have to pay out 100 per cent of the income [HMRC stipulates only 85 per cent must be distributed]. The ability to hold some of that income back, giving yourself a cash buffer to see you through the more difficult times and therefore a more sustainable income stream, is a huge benefit,” he says.
F&C Investments’ Peter Hewitt, manager of the Managed Portfolio Trust, cites the case of Investec’s Alastair Mundy, manager of the Temple Bar investment trust (as well as Investec’s Cautious Managed and Special Situations funds), who held BP across both structures pre-Deepwater disaster.
“Temple Bar was able to maintain its dividend simply through its ability to dip into its revenue reserves, whereas his Oeics cut theirs by 15 per cent and again the following year.”
The average yield on IMA UK Equity Income funds is currently 3.8 per cent, according to FE Analytics. This compares with 3.31 per cent for the comparable investment trust sector, so arguably yields are only marginally lower for ITs and for a small sacrifice you enjoy regularity of income. So how much does it cost?
Mr Hewitt says any investment with an above-average yield that is also quite sustainable will tend to trade either at a very narrow discount, par, or a small premium.
“I am a medium-to-long-term investor, so if I get the right manager who will grow the asset as well as the dividend, I’m not bothered about paying a 2 per cent premium. I wouldn’t pay 8-12 per cent as I think that’s probably a bit much, but you will find most of the equity income sector’s investment companies on discounts up to a 1-2 per cent premium.”
Nick Sketch, Investec Wealth & Investment senior investment director, suggests there is more to it than simply certainty of income. He explains: “The importance of smoothing dividends can be overstated and a long-term policy of turning capital into income at the margin is hardly tax-efficient. However, IT income reserves can mean that a manager can buy a stock that does not meet his income target this year, in the expectation that it will do well over three or four years.
“That extra flexibility can be useful, particularly if – as today – many equities with a yield of, say, 5 per cent look comparatively expensive in terms of expected total risk-adjusted return, compared with those yielding 3 per cent.”
