The income edge. Why have investment trusts increased in popularity?

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1 Material produced by Kepler Trust Intelligence should be considered a marketing communication, The income edge Last year saw investment trusts soar in popularity among both retail investors and wealth managers. We examine why this has happened, as well as the structural advantages of investment trusts for income-hungry investors... Update 5 August 208 Last year saw investment trusts soar in popularity among both retail investors and wealth managers. Statistics from the AIC show that during 207, independent financial advisors bought 990m-worth of investment trusts through platforms. That was 46% more than in 206, and 4% more than the previous record of 704m in 205. This increased demand has shown itself in the average discount across the investment trust universe, which has narrowed markedly, as shown in the chart below. Fig.: Increased Sentiment Towards Investment Trusts Source: Cazenove Why have investment trusts increased in popularity? Over the past few years, several pieces of research have documented the superior performance of investment trusts versus open-ended funds over time. Most recently, the Cass Business School released the first apples versus apples paper, comparing the performance of closed-ended funds versus open-ended funds. Professor Andrew Clare and Dr Simon Hayley discovered that over the 6 years to 206 closed-ended funds outperformed annually by 0.8% on average. When compounded over time, this equates to a large outperformance of closed-ended funds over open-ended equivalents. The long-term ability of investment trusts to outperform is not news, and isn t likely to be the key driver of demand. We believe advisors are increasingly recommending investment trusts to their clients due to a gradual recognition that the incomegenerating capabilities that can be engendered by the closed-ended structure are far

2 superior to those available to open-ended funds. This is particularly relevant now, following the gradual transition from defined-benefit pension plans to defined-contribution plans. So, with fewer retirees having a generous DB plan to rely on for consistent income through retirement, alternative sources of income are attracting more interest. In the past, bonds would have been considered the best option for an investor searching for a dependable source of income. However, as can be seen in the graph below, bond yields have gradually become more depressed over the past five years. Fig.2: UK Government 0Y Bonds Source: Trading economics It s the yield While bond yields and interest rates have been decreasing, the yields that investment companies are paying have been increasing. This has been driven by the huge growth in alternative income vehicles, across a wide range of asset classes such as infrastructure, renewable energy, peer-to-peer lending and aircraft leasing. The closed-ended structure offers advantages when investing in these illiquid assets. As the graph below shows, the yields on offer in the closed-ended infrastructure and direct property sectors are very much superior to those available on the equivalent open-ended fund sectors. Fig.3: Property And Infrastructure Aic Versus IA 5 AIC Property and Infrastructure yields vs IA Aside from the alternative income sectors, the investment trust structure offers advantages for pure equity strategies too, allowing them to deliver a higher and certainly more consistent income stream than equivalent open-ended funds. In this article, we review and discuss the various tools that investment trusts are able to use to deliver a higher and more consistent yield. Fixed size Due to having a fixed pool of capital, fund managers running an investment trust are able to take a long-term view on their investments and make investment decisions without worrying about the inflows and outflows of the fund. This is particularly important for those investing in more illiquid assets such as property. Typically, open-ended property funds have to hold a decent proportion of cash at all times in case they have outflows. Since the start of the year, the IA Property sector has on average held 7.7% net cash; however, this is lower than in previous years where the average was as high as 7.93% and 5.78% in 207 and 206 respectively. The fiasco in 206 showed the benefits of choosing investment trusts for property. Many asset managers running open-ended property funds, including the likes of Standard Life, Columbia Threadneedle, Janus Henderson, M&G and Aviva, had to suspended withdrawals, trapping billions of pounds of investors money, as there was a rush to withdraw money following the vote to leave the EU. In comparison, investment trusts like the UK Commercial Property REIT continued to pay an unchanged dividend over this difficult period. Aside from illiquid assets, this advantage applies to traditional equity trusts where open-ended funds will typically need to hold cash to meet possible short-term redemption requests, closed-ended funds can remain fully invested. In a world where cash on deposit earns practically nothing, this will have an impact on revenues earned. This can be seen below: in 204 in what was a bull market, AIC sectors were able to remain far more invested than the IA equivalents. 4 3 % 2 0 Infrastrcture Property Source: Morningstar and FE Analytics AIC IA Powered by Highcharts Cloud 2

3 Fig.4: Relative Difference In Net Cash % Relative difference in net cash (AIC sectors vs the IA sectors) UK All Companies Source: Morningstar Average over 204 Global Europe Asia Pac Exc Japan Global Equity Income UK Equity Income Powered by Highcharts Cloud Illiquidity yield premium/ illiquid assets Investment trusts are able to invest in a multitude of different asset classes and types of asset, many of which are potentially extremely illiquid and (in practical terms) difficult to acquire. In some cases, they also require a sizeable initial investment. As such, they often attract what is known as an illiquidity premium a higher yield (or return) for the risk attached to holding these assets. Examples include property, loans or infrastructure, where the lot size often runs to tens of millions of pounds. Where retail investors alone may not be able to fund this investment, and in access to these higher yielding assets, through the pooled structure of investment trusts, they can access greater yields. A good example of this is Greencoat UK Wind, which now makes utility scale investments in operating wind farms (often buying from utilities themselves). Total assets of.6bn and a specialist management team enable the trust to make very large investments that other vehicles might struggle to pull off. UKW s most recent investment was for 63m, into it s 30th wind farm. The managers recently reaffirmed their confidence in being able to pay a dividend that rises in line with inflation. At the current share price, UKW s prospective yield is 5.4%, although it does trade on a premium of % currently. We recently reviewed TRIG, which also has scale with net assets of.2bn, but which invests in both solar and wind technologies, and offers a yield of 5.9%. It is more highly geared, which is reflected in its slightly more reasonable premium to NAV of 5.5%. Both of these trusts give investors the ability to invest in high yielding assets without needing expertise or capital. Revenue reserves Arguably, the most important characteristic of investment trusts for investors living off their investment income is that trusts can retain up to 5% of the revenue they receive from their underlying investments in a reserve. This can be built up over time and, should there be a subsequent cut in the income the company receives from its investments for any reason, the board can use the reserve to ensure that the dividend is maintained. This is known as dividend smoothing and helps investment trust shareholders be more assured of income continuity than with open-ended funds. An example of this was in 200, with the BP Deepwater Horizon disaster. BP suspended its dividend, dramatically hitting both open-ended funds and investment trust revenue accounts. However, in contrast to open-ended investment companies, most investment trusts were able to maintain a progressive dividend policy by dipping into their reserves. For some investors, this reliability and consistency is extremely important and so, in this regard, investment trusts have a decided advantage over openended funds. An example of the benefits of revenue reserves can be seen in Finsbury Growth & Income. In comparison to its open-ended counterpart, Lindsell Train UK Equity Fund, Finsbury Growth & Income has paid greater dividends, more smoothly and frequently. To do this, it has dipped into reserves for example last year, where the full dividend came from reserves. Fig.5: Dividend Comparison Lindsell Train OEIC vs Finsbury Growth and Income: Dividends Source: Lindsell Train LT UK Equity Fund First Interim FGT total Powered by Highcharts Cloud Another example is a member of our Bulletproof Income Portfolio, Scottish American Investment Company, which has had a return to form under its new managers. Whilst staying within the Baillie Gifford trust stable, the trust had a slight shift in strategy in 205. We understand 3

4 that part of this change was predicated on the dividend level potentially becoming unsustainable under the old strategy. Changing the trust s managers meant a lower portfolio yield in the short term, but increased hope that the trust could grow its yield under the new strategy. In the intervening two years, the board paid uncovered dividends from reserves, ensuring that shareholders didn t feel the change in terms of their income profiles. The last financial year saw the company paying a covered dividend once again, vindicating the change in manager and the board maintaining the dividend progression over the period of the change. Scottish American has been rewarded with a significant re-rating, coming in from a c.7% discount in 205 to the current premium of c.4%. Gearing It can also be seen as a discount-control mechanism. Where a board may have found it difficult to narrow a wide discount through changing the distribution strategy, the trust may see a re-rating. As can be seen below, we have included a few trusts that we have recently covered that pay income from capital. Examples include ICG Enterprise Trust and NB Private Equity Partners and, in our view, this has unarguably helped bring discounts in. An example of this having helped in the equity space is Invesco Perpetual UK Smaller Companies Investment Trust, where the board has adopted an enhanced dividend distribution strategy (aided by payments from capital), and which had a decisive and lasting impact on the discount. Fig.6: Recently Covered Companies That Pay Income From Capital Another, defining characteristic allowing investment trusts to provide a superior income is the ability to gear. Borrowing money allows managers to increase the amount they invest on behalf of shareholders and helps to leverage returns. This facility is not available to open-ended funds and can be a key selling point for investment trusts, although it clearly exacerbates the risks. Due to the size and status of investment companies, the manager can often negotiate borrowings at a reduced level and with far more flexible repayment terms than an individual could hope to achieve, enjoying the benefits of economies of scale for example, Scottish Mortgage recently secured 70m of borrowing at just 3% fixed for 30 years. For income investors, gearing can be an important tool. Whilst it does exacerbate risks, gearing can also either provide a yield boost (invest at 4% but borrow at only 3%) or allow the manager to invest in an income growing at (hypothetically) 0% a year, with fixed borrowing costs. Over time, such an asset could be a significant additive to income. At the time of writing, the average net gearing for the AIC investment trust sector is 8% (Source: Morningstar). Converting capital into income In 202 tax laws were changed, allowing boards to pay dividends out of capital reserves. As can be seen in the table, numerous trusts we cover pay their dividend partially (or entirely) from capital. With interest rates so low across the UK, this offers income-seeking investors huge diversification benefits, given the income is being generated from a non-income producing strategy (and thereby exhibiting a very different return profile to the usual income producing funds). Versatility of investment strategies Investment trust managers are able to use the closedended nature of their fund to ensure they can use the entire toolkit in trying to deliver their objectives for shareholders. One of these, not used particularly widely, is the ability to write options on the shares the company already holds. This is called a covered call option strategy and it helps to add an additional income stream. The options are sold by the manager of a trust for a premium and give the buyer the ability to acquire the shares at a higher price than the shares are currently being sold. Thus, the trust will receive an income from the premium, but runs the risk of limiting its potential growth. Alternatively, a trust can write puts on a stock again receiving a premium, but committing the manager to buy a stock at a price lower than they current trade at. BlackRock Commodities Income is a perfect example of a trust that uses option writing flexibly to help investors gain additional income. Option writing has historically been a profitable strategy for the trust given the highly volatile nature of the mining and energy sectors, and in 205 and 206, premium income 4

5 contributed more than 50% of the trust s underlying income generation. The contribution from option writing has come down of late, reflecting the calmer state of equity markets and lower implied volatilities. At any one point, around 7%- 0% of the portfolio will have options over it. The managers participate in option writing (covered calls and writing puts) tactically and on individual stocks, but not as a blanket programme. Option writing in this manner can add a useful extra layer of returns that (given all of the options are originally written out of the money) constitute as income. Board oversight Investment trusts are overseen by an independent board that acts on behalf of the investors. It means that shareholders have somebody on their side who is able to ensure that investor interests are at the forefront of the manager s mind unlike open-ended investment companies, where the fund manager doesn t have an independent entity to answer to. The board is responsible for affirming the parameters within which the manager is allowed to operate, as well as taking responsibility for the investment objective of the trust. The board is vital for some of the income-impacting aspects previously mentioned, including setting the gearing range and the amount of the income that is added to reserves, as well as having ultimate responsibility for what level of dividend is paid. This means that (in contrast to open-ended investment companies, where the dividend level is set by the administrator), the board s reputation is at stake when deciding the appropriate dividend level. Boards have an entrenched interest in making sure that it is proportionate and sustainable, as well as supporting a credible belief that the dividend will (hopefully) continue in the future. Proof in the pudding: AIC dividend heroes Each year the Associate of Investment Companies (AIC) publish a list of its dividend heroes, the trusts that have increased their dividend for over 20 years consecutively or more. This is no mean feat and illustrates perfectly the advantage that investment trusts can have in providing predictable incomes over the very long term. Currently, 2 trusts sit on the dividend heroes list. We profile below three dividend hero trusts that we have recently updated our research on, all of which offer attractive propositions for investors, with long dividend track records: Alliance Trust The past 50 years have seen Alliance Trust change its investment strategy greatly. The trust now adopts a multimanager approach with eight sub-managers, each tasked with managing a highly concentrated portfolio. Stock selection from the managers is the key driver of returns, but weightings relative to country and sector are managed so that they are broadly in line with the MSCI AC World Index benchmark. With just over a year in this new form, shareholders have seen an improved performance, especially on a riskadjusted basis. The discount narrowed significantly on the announcement of the change in strategy in January 207, and has remained close to 5% since then. JPMorgan Claverhouse Investment Trust Described by co-manager William Meadon as a get rich slow fund, JPMorgan Claverhouse Investment Trust invests in income-generating UK companies with a focus on those that provide consistent and growing dividends. The managers have a high conviction focus, and ensure that they are running their winners. William looks for companies trading at low valuations with strong balance sheets and high cashflow generation. The portfolio of 66 stocks is built through a bottom up, stock picking approach with macro and economic views having little influence over investment decisions. Being a stock picker, William believes that the current volatility across global markets can be of benefit to shareholders, enabling him to pick up more of the shares he likes at lower prices. UK companies in particular have faced a huge amount of pessimism, and William points to numerous political events causing this uncertainty, with Brexit s constant presence as a major feature. Witan Investment Trust Similar to Alliance Trust, Witan Investment Trust has an established multi-manager approach run by Willis Towers Watson. Using third party managers, the trust is made up of multiple concentrated portfolios, together offering a globally diversified and actively managed portfolio. Since Andrew Bell took over as CEO in 200 the trust has performed well, outperforming the board s customised benchmark on a NAV basis over one-, three-, five- and ten-year periods. Witnessing something of a de-rating during 206, the last few months have seen the discount significantly narrow and it currently stands at only 2%. Witan Investment Trust represents a very low maintenance but actively-managed exposure to global equity markets, albeit at a slightly higher cost than average. 5

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