Investors need to understand how income payments are made in the investment trust space, according to industry experts, as many companies are taking up the trend of enhancing their yields from capital reserves. 
Since 2012, investment companies have had the ability to distribute capital profits, subject to shareholder approval, and while using it to pay out an enhanced dividend is beneficial for an income investor, those focusing on total return may be caught out.
Charles Cade, head of investment company research at Numis Securities said: “On the face of it, the evidence in support of an enhanced yield is compelling. As a result, we expect more investment companies to adopt this strategy given the ongoing demand for yield.
“We believe that boosting yield is likely to broaden a fund’s potential investor base, and can help to differentiate it from its peers, including open-ended funds.
“However, it is not a one-stop solution for all funds. Simply adding a yield to a fund with a poor track record, or in an asset class that is out of favour, is unlikely to turn around investor sentiment.”
Investment trusts have long had the ability to utilise accumulated revenue reserves and charge a portion of fees and finance costs to capital. However, the line between income and capital is becoming increasingly blurred, Cade (pictured) says.
“The change has given them greater flexibility to pay dividends, and puts them on a more even footing with offshore funds (e.g. Guernsey-domiciled) that have fewer restrictions on distributing capital.
“During 2016, several funds announced plans to pay an enhanced yield, funded from a combination of income and revenue/capital reserves.”
As such, below FE Trustnet looks at some of the funds paying dividends out of capital and whether the market commentators believe this is a sustainable idea.
Kepler research analyst Alex Paget said: “Providing it’s done in a sensible and sustainable manner, I think it’s an attractive strategy for genuine income investors who don't mind sacrificing a degree of capital growth.
“However, if you are purely interested in total returns and want dividends reinvested, then backing a trust that pays out part of its dividend out of capital could mean you are being hit by an extra layer of charges by reinvesting yourself.”
The dominant area where investment trusts are using capital to pay enhanced dividends is in the private equity space with five of the 16 trusts currently employing the strategy from that sector.
Investment companies paying enhanced dividends out of capital
Source: The AIC
AJ Bell head of fund selection Ryan Hughes said: “The private equity ones don’t worry me too much because it makes perfect sense as I think it gives them the ability to vary where they pay their income from.
“If you’re investing in a boring portfolio of UK equities that pick off a yield you are going to get a pretty decent yield naturally and you’re going to pay that out of dividends.
“But if you are in the private equity space your total return is going to be made up of very different things: you might get some dividends but you equally are going to get some capital payouts through takeovers and flotations and so on and therefore your natural revenue is structured differently.”
Kepler’s Paget said: “It’s interesting to note that more and more trusts are taking such an approach and I think that is a reflection of the difficult environment we are in income-wise.”
Indeed, many of the above list, including JP Morgan Global Growth & Income, Lazard World Trust Fund and Baring Emerging Europe all announced policy changes last year.
“We’ve seen in the UK and elsewhere around the world’s equity markets that earnings per share has been falling while pay-out ratios have been increasing to meet the savage global demand for yield in this era of ultra-low interest rates, meaning levels of dividend cover have fallen dramatically,” Paget said.
“By paying part of your dividend out of capital, managers of trusts can avoid being forced to hold onto high yield stocks that might cut their dividends in the future to maintain their own pay-outs.
“As such, I think it’s clear that a growing number of managers are happy to limit potential capital returns over the short-term in order to help maintain their dividend growth going forward.”
However, this is not the only reason they may wish to do this, with marketing also playing a part.
Numis’ Cade added: “In most cases, the rationale behind enhancing the dividend by using capital reserves is that the higher yield will increase the appeal of the fund to a wider range of investors, and potentially narrow the discount.
“We believe that income investors are generally looking for a yield that is generated on a sustainable basis from the underlying portfolio, rather than a yield ‘manufactured’ by distributing from capital.
“This is supported by anecdotal evidence from private client wealth managers who state that they are reluctant to see funds distribute capital as income.
“On the other hand, there appears to have been a positive impact on the discount for some funds that have recently changed their dividend policies.”
Indeed, JPMorgan Global Growth & Income (formerly JPM Overseas), which we looked at in detail recently, is trading on a 5 per cent discount compared to 14 per cent prior to the announcement of an enhanced dividend.
Meanwhile, Invesco Perpetual UK Smaller Companies, which had been trading on an average discount of 16 per cent during the three years prior to the announcement that the board would start using capital reserves to bolster the dividend in March 2015, has traded on an average discount of 6 per cent since the announcement.
Invesco Perpetual UK Smaller Companies discount since 04 April 2010
Source: Kepler Partners
While Kepler’s Paget says this reasoning is “cynical” he adds that “existing shareholders have usually benefited from this sort of dividend policy change as the incessant hunt for income has meant higher yielding trusts have been in demand”.
However, the analyst says the big question is whether or not paying dividends out of capital is sustainable.
“Given that trusts were only allowed to take such an action in 2012 and most have only started doing it over the past 18 months or so, I think it is case of 'only time will tell',” he said.
“I would urge investors to keep an eye on how much of their capital a trust is using to maintain dividend growth though, as many of the trusts on the list have depleted their existing revenue reserves to fund their larger dividend payments.
“It comes back to the point that yield is only one part of the income puzzle, as capital performance is also vitally important. It is a naive and dangerous to buy into a high-yielding trust or fund and drawing income from it if it is losing money in capital terms.”