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Why investment trusts could be the answer for income seekers

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Written by: Paloma Kubiak
04/05/2017
In the low interest rate, rising inflation environment, income seekers are turning to the stock market for returns. Could investment trusts be the best option for UK equity income exposure?

With interest rates on savings accounts at record lows and inflation, which erodes the value of savers’ cash, set to increase, there are few places for income seekers to earn an inflation-beating return.

One option is investing in the stock market. If you decide to put your money in a fund, it may be worth considering a closed-ended investment trust structure.

Very briefly, investment trusts are a type of collective fund (i.e. many investors pool together money, which is then invested by a manager) with a fixed number of shares in issue at any one time. With an open-ended fund, there’s no limit to the number of units available and investors can move money in and out at any time.

Over the short-term, closed-ended and open-ended funds in the UK equity income sector have performed similarly, with the former returning 16.37% over one year (to 26 April), according to the Association of Investment Companies (AIC), and the latter returning 16.39% over the same period, according to the the Investment Association (IA).

However, over the longer-term, the average closed-ended UK equity income fund has outperformed, returning 75.16% over five years, versus 69.91% from the average open-ended version.

Here we list four other reasons why investors may want to opt for investment trusts for their UK equity income exposure:

Dividend payments in difficult times

A big draw of investment trusts for UK income seekers is they don’t have to distribute all of their income to shareholders, but can retain up to 15% of the income they receive each year from their investments and store it in their revenue reserves.

This is particularly useful during difficult periods because trusts can use these reserves to boost their dividend pay-outs.

The AIC – the investment trust trade body – says the ability to smooth dividends has helped investment trusts deliver long track records of dividend increases.

For example, The City of London Investment Trust has raised its dividend consecutively for 50 years. Meanwhile JPMorgan Claverhouse Investment Trust and Murray Income have increased dividends consecutively for the past 44 and 43 years respectively.

Alex Moore, a research analyst at Rathbones, says: “The relative appeal of investment trusts for equity income for some investors, therefore, will come when UK companies need to cut dividends, hence impacting some open-ended funds’ ability to maintain distributions, or when the appeal of some specialist forms of income – for example, property or infrastructure – subsides.”

Trading at a discount

Another advantage is the majority of UK equity income trusts are currently trading at a discount to net asset value (NAV) meaning investors can buy shares at a bargain price.

Investment trusts are companies listed on a stock market, therefore they have their own share price. If the share price of an investment trust is lower than the value of its underlying net assets, it’s said to be trading at a discount to NAV. If it’s higher, it’s trading at a premium.

According to the AIC, the average discount for the UK Equity Income sector at the end of March was -5%.

However, Laith Khalaf, senior analyst at Hargreaves Lansdown, says that investment trusts are often traded at a discount which is why it is important for investors to look wider at the trading patterns and discounts previously, such as over the past five years.

“If a company is trading at a 5% discount now, but it’s been at a 10% discount for most of the last five years, investors are paying over the odds. If you are looking at the discount, it’s important to compare it with the discount that it has historically pertained to trade at. This gives you a flavour of what you can sell it for in the future and how it will affect your returns,” he says.

Moore says he has strong conviction in the Murray Income Trust which is currently trading on a 6% discount, as well as Perpetual Income and Growth Investment Trust which is trading at an 8% discount. However he notes the two trusts have not always traded on discounts, with both having fluctuated from premium to discount over the last 10 years.

“Since 2008, Perpetual Income & Growth has seen its premium hit 7% and discount 11%, Murray 8% and -12% respectively. In the examples mentioned, the trusts would be more expensive than a year ago, but as also stated, looking at the historic discount rates is also important.”

Impact of cheap sterling on the market

A third benefit is the positive performance of the FTSE 100 in recent months, thanks mainly to the weakened pound since Brexit.

As a large proportion of FTSE 100 listed companies source their revenues from overseas, they benefit from a weaker sterling when translating their earnings back into sterling.

The blue-chip index climbed past 7,200 which was good news for investors and Khalaf explains why this has benefitted investment trusts.

He says: “UK equity income investment trusts trade in line with the UK stock market and things have been pretty good, partly because the economic picture has been better than expected. Despite the fall in sterling, this has increased the share prices of a lot of international firms in the FTSE 100, providing a knock-on effect on those companies.”

Further, as approximately two-fifths of UK dividends are denominated in dollars and euros, they’ve translated at more favourable exchange rates.

Borrow to invest

Investment trusts are able to borrow money in order to buy more investments – a practice which is known as gearing.

While this can lead to long-term performance as markets rise, the reverse is true if the performance of a company with gearing is weak.

Moore explains: “Gearing can help investment trusts generate higher returns in a positive returning market where any outperformance exceeds the interest costs of borrowing debt.

“But, in down markets gearing can exacerbate losses too. Leveraged investing in itself can increase return volatility to the end investor, but for a long-term investor who is comfortable to ride out this volatility, returns can be potentially higher compared with un-geared investing.”

Are investment trusts looking expensive?

The benefits of investment trusts are apparent, particularly for long-term investors. However Adam Carruthers, collectives analyst at Charles Stanley, says despite fees having reduced, they look expensive compared with their open-ended counterparts as the financial regulator’s come down hard on them in recent times.

He says: “One significant factor we’ve noticed is that fees are reducing in active open-ended (for example cheaper founder share classes on new launches) and passive open ended funds where a price war is in full swing.

“In the closed-ended space for example, we are pleased to see that Scottish Mortgage cuts its fees from 0.45% to 0.3% on its first £4bn of assets, and Monks from 0.45% to 0.33% on its first £750m of assets. Nine investment trusts in total have reduced fees this year.

“This is part of a longer game of post-Retail Distribution Review catch-up with open-ended vehicles, themselves being forced to lower charges. For example Kames Capital and Franklin Templeton, decided to reduce management fees on certain open-ended equity funds.

“Fees have been coming down more sharply in open-ended funds and some investment trusts now look expensive compared with open-ended competitors. But we believe that fee reductions in the closed-ended universe are set to continue, and at a greater rate than their open-ended counterparts.”

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