Investment trusts have performed very well in the recent rising market, which has meant that many of them are now either trading on premiums or on much tighter discounts than they have done in the past.However, due to the ultra-low interest rate and currently high prices of bonds, the majority of closed-ended equity income funds have become extremely expensive compared with their historic averages.
Henderson says that given that equity valuations are now looking toppy without strong earnings growth, investors would be better off using open-ended income funds because they would be buying them at NAV and would therefore not be taking discount risk.
“I would definitely say that if I were buying for myself right now, I would buy the open-ended fund,” Henderson said.
When the manager spoke to FE Trustnet, the trust was trading on a 7 per cent premium, a figure that has come in slightly to 4.7 per cent over the last few days.
Lowland Investment Company and Henderson UK Equity Income & Growth are very similar portfolios as the manager looks for companies that are in a position to consistently increase their dividend.
For example, the likes of Senior Group, Hiscox, GlaxoSmithKline and GKN feature in both of their top-10 holdings.
However, due to factors such as a narrowing discount and the closed-ended fund’s ability to gear up, or borrow, Lowland has massively outperformed the open-ended vehicle over recent years.
Henderson has managed the Henderson UK Equity Income & Growth fund since January 2005. It has beaten the FTSE All Share over that time with returns of 133.53 per cent.
Over that same period, his trust has outperformed by close to 75 percentage points.
Performance of funds vs trust and index since Jan 2005
Source: FE Analytics
This outperformance isn’t just limited to Henderson’s portfolios either.
According to FE Analytics, the average closed-ended UK equity income fund has beaten the average open-ended UK equity income fund over one, three, five and 10 years.
Henderson says this shouldn’t come as any real surprise as the structure of investment trusts does help them to outperform over the long-term and in strongly rising markets.
However, he says that the price paid for an investment is one of the biggest drivers of returns and at the current valuations of trusts, the odds are now stacked against you.
“They will go back to discounts one day, they always do. I love investment trusts dearly, but they are expensive,” Henderson said.
The manager also points out that the new charging structure of open-ended funds, after RDR, makes them more attractive than they have been in the past.
“The other thing to say on that is that in the past when people would say that Lowland was better than Equity Income, this was when Lowland’s charges were much lower than the fund's. However, under the new I-class which we are selling now, the fund’s charges are the same as Lowland’s.”
“The charges are the same and so the major difference is that Lowland has gearing, it is currently geared at 12 per cent, so in a rising market that will give it a bit more. However, those premiums on investment trusts won’t last,” he added.
There are a number of advantages with using income-producing investment trusts over an equity income OEIC or unit trust.
One of the main benefits is that trusts have the ability to “smooth” their dividend, as the manager or board only has to pay out 85 per cent of their earnings each year, while open-ended vehicles have to pay out everything.
That means that trusts can hold back up to 15 per cent of their earnings each year to cover the dividend in falling markets.
It has helped some trusts, such as Bankers IT and City of London IT, to raise their dividend in each of the last 47 years.
Lowland has delivered 38 years of dividend growth, though it did freeze it in 2009.
While the yield is only 2.4 per cent, it has delivered 6.3 per cent dividend growth over the last five years, according to the AIC.
The manager's Henderson UK Equity Income & Growth fund – which yields 3.2 per cent – has increased its net distribution in each of the last three years.
Charles Cade, head of research at Numis Securities, rates Henderson as a manager.
While he thinks that Lowland will perform well over the long-term, he agrees that investors are taking a big discount risk if they buy it now.
“I would agree. The risk is only one way in a sense, it is trading at something like a 6 per cent premium and even if it were to move back to asset value, that is a significant hit. The bigger risk is that it goes out to discount,” he said.
“James is a very good manager but he does have a bias towards small and mid caps. If there were to be a set-back in the market, they are the sort of areas likely to be the worst hit.”
“If you were taking a long-term view, then small movements in the discount won’t have too much of an effect on the overall return.”
“However, anything shorter than that, then I would certainly say that the open-ended fund is a more attractive proposition,” he added.
Lowland has ongoing charges, including a performance fee, of 0.9 per cent.
Henderson UK Equity Income & Growth has an ongoing charges figure (OCF) of 1.75 per cent and requires a minimum investment of £1,000.
