There are plenty of reasons why genuine income investors should use investment trusts, especially as they are often told that a growing dividend stream is vital to a long-term portfolio. 
The reason why closed-ended funds are such a good fit in that respect is due to their structure. While features such as discount volatility and gearing (or their ability to borrow to potentially enhance returns) can lead to larger losses in a falling market, investment trusts have the benefit of ‘smoothing’ their dividend by withholding up to 15 per cent of their earnings in good years so that they can pay out in the bad ones.
Open-ended funds such as unit trusts and OEICs, on the other hand, don’t have this luxury and have to pay out all their earnings annually.
Of course, just because managers and boards of investment trusts have this advantage it doesn’t mean every closed-ended fund has been able to increase its dividend year-in-year-out.
In fact, there are just a handful of trusts that have upped their pay-out in every year over the ultra-long-term – the so-called ‘dividend heroes’. One of which is Simon Gergel’s The Merchants Trust, which has increased its income in each of the last 33 years.
Over the last 10 years, for example, The Merchants Trust has delivered dividend growth of more than 27 per cent as its dividend per share has consistently increased from 18.6p in 2006 to 23.8p in 2015.
The Merchant Trust’s dividend history over 10yrs
Source: The Merchants Trust
Gergel, who also runs a number of open-ended funds at Allianz Global Investors, has headed up the trust since April 2006. He says there are a number of reasons why the closed-ended fund has been so successful in that respect.
“It comes from two or three things. First is the underlying portfolio, as we tend to invest in higher yielding stocks. Each company we buy has to have a yield in line with the market or above, either today or within 18 months,” Gergel (pictured) said.
“There are exceptions, but generally that’s true.”
The second point, according to Gergel, is that his trust’s ability to gear enhances its distributable income. That is because the income the portfolio is generating on the investments is more than the cost of debt.
He says the third reason comes back to a trust’s ability to ‘smooth’ dividends.
“We have reserves which equal to about a year’s dividend and that tides you through very tough years. 2010 and 2011 were difficult years so we built up reserves in the good years and dipped into them in the bad ones. That’s helped smooth the process.”
Gergel points out that he is now currently broadly covering the dividend, following a couple of years where he has had to dip into his reserves.
However, while dividend growth is an important aspect, it is only one part of the income puzzle.
That is because while receiving higher dividends in each year may be satisfying, it could be the case that the absolute level of income an investor is receiving isn’t that high.
The Merchants Trust, though, has a starting yield of 5 per cent which is some 1.4 percentage points higher than the dividend yield of the FTSE All Share.
Gergel says he tends to invest in companies with high dividend yields anyway, but the recent underperformance of international facing large-caps relative to more domestic-orientated mid-caps has increased the current yield of the portfolio.
The Merchants Trust is predominantly invested in FTSE 100 companies, while many of its peers have significant exposure to the FTSE 250.
Performance of indices over 5yrs
Source: FE Analytics, total return in sterling, data to 15 September 2015. Past performance is not a reliable indicator of future results.
“The dangers of going down to mid-caps are the valuations, as they have outperformed large-caps dramatically and so one of the reasons mega-caps yield so much is because they have underperformed – which is a good reason for buying them and not for selling them.”
One of the major concerns surrounding some of the UK largest dividend paying companies (which also account for a very high proportion of the overall income produced by the FTSE All Share) is that there is a risk they may have to cut their pay-outs in the coming years.
Those fears have been directed towards the likes of BP, Royal Dutch Shell, GlaxoSmithKline and Vodafone, which have faced various issues ranging from the dramatic fall in the oil price to large-scale capital expenditure (capex).
Given that dividend cover on the FTSE 100 as a whole has fallen to 1.5 times and a number of large-caps have already had to cut over the last 12 months, those concerns seem to be valid.
However, Gergel says that he isn’t invested in any ‘value-traps’ and therefore his current high yield shouldn’t rule out any further increases to his dividend.
“There is always the risk of dividend cuts so you have to do your homework and analyse it,” he said.
“We will, occasionally, have a company which will cut its dividend but I don’t foresee wholesale dividend cuts across the big stocks. Just look at the ‘big four’* we own. We are confident BP* and Shell* can manage that dividend through the cycle by cutting costs and cutting capex, in order to cover the dividend.”
“GlaxoSmithKline* have very publically committed to their dividend for the next three years and we think HSBC is very solid.”
In fact, Gergel thinks now is a very good time for income investors to look at the largest companies in the UK equity market.
“You’ve got to be careful of looking at yield as a guide to value or whether you are going to get dividend cuts,” he said.
“If you don’t get a dividend cut and a stock is yielding 7 or 8 per cent, you can make a very good return. We think there are starting to be some really interesting high yielding companies which will make very good returns.”
According to FE Analytics, The Merchants Trust has returned 49.92 per cent since Gergel took charge in April 2006. While those gains are slightly lower than the IT UK Equity Income sector average, the trust has beaten its FTSE 100 benchmark over that time.
Performance of trust versus sector and index under Gergel
Source: FE Analytics, bid-to-bid total return in sterling, data to 15 September 2015. Past performance is not a reliable indicator of future results.
It is also beating the index over one, three, five and 10 years having outperformed in six out of the last 10 calendar years.
The trust, which has ongoing charges of 0.62 per cent and is geared at 20 per cent, is trading on a discount to NAV of 3.2 per cent as at 15 September 2015.
(*) This is no recommendation or solicitation to buy or sell any particular security. Any security mentioned above will not necessarily be comprised in the portfolio by the time this document is disclosed or at any other subsequent date.
Investing involves risk. The value of an investment and the income from it may fall as well as rise and investors may not get back the full amount invested.
Past performance is not a reliable indicator of future returns. You should not makeany assumptions on the future on the basis of performance information. The views and opinions expressed herein, which are subject to change without notice, are those of the issuer and/or its affiliated companies at the time of publication. The data usedis derived from various sources, and assumed to be correct and reliable, but it has not been independently verified; its accuracyor completeness is not guaranteed and no liability is assumed for any direct or consequential losses arising from its use, unlesscaused by gross negligence or wilful misconduct. This is a marketing communication issued by Allianz Global Investors GmbH,an investment company with limited liability, incorporated in Germany, with its registered office at Bockenheimer Landstrasse42-44, 60323 Frankfurt/M, registered with the local court Frankfurt/M under HRB 9340, authorised by Bundesanstalt fürFinanzdienstleistungsaufsicht (www.bafin.de). Allianz Global Investors GmbH has established a branch in the United Kingdom, Allianz Global Investors GmbH, UK branch, 199 Bishopsgate, London, EC2M 3TY, which is subject to limited regulation by the Financial Conduct Authority (www.fca.org.uk). Details about the extent of our regulation by the Financial Conduct Authority are available from us on request. The duplication, publication, or transmission of the contents, irrespective of the form, is not permitted.
The Merchants Trust PLC is incorporated in England and Wales. (Company registration no. 28276). Registered Office: 199 Bishopsgate, London, EC2M 3TY. The Company is a member of the Association of Investment Companies - Category: UK Equity Income.