Edinburgh Investment Trust, Lowland Investment Company and Aberdeen Asian Income are among the best closed-ended funds for investors looking for a “bullet-proof” level of income, according to Kepler Partners.
Trusts’ ability to “smooth” their dividend by retaining 15 per cent of their annual earnings gives them a big edge over their open-ended rivals. It means that they are able to lock away excess cash in particularly good years, so that their can maintain or grow their dividend in poor ones.
Kepler Partners, an advisory boutique that specialises in investment trusts and hedge funds, have recently released their quarterly Investment Trust Intelligence report which features a globally diversified model portfolio for those seeking a reliable income stream from investment trusts, named the Bulletproof Income Portfolio.
The groups uses an analytical ratio – the Kepler Income Ratio –to identify six investment trusts which together offer a sustainable combined yield ahead of the FTSE All Share and are resistant to the shocks which can occur in a volatile market.
Here, William Heathcoat Amory – founding partner at the group – talks FE Trustnet through the six trusts which have made the grade, explaining why they are such good choices for income investors.
First on the list is the Edinburgh Investment Trust, which had previously been managed by Neil Woodford and is now under the stewardship of Mark Barnett.
The trust has increased its dividend almost every year over the past four decades and has never cut it over the period. Due to the board’s commitment to its pay-out and Barnett’s enviable track record, Heathcoat Amory says it is good option for any income seeking investor.
Edinburgh, which currently yields 3.42 per cent, has increased its dividend per share from 12.15p in 2000 to 23.5p last year and Kepler believes this rate of growth is likely to continue.
“The trust has one of the highest revenue reserve cover figures in our portfolio. This gives us confidence that the board will be able to pay a sustained dividend for the foreseeable future,” Heathcoat Amory said.
Barnett has made a number of changes to Edinburgh’s portfolio since he took charge in January last year, making it less concentrated and cutting down its healthcare exposure.
He’s made a strong start, outperforming both the IT UK Equity Income sector and FTSE All Share since taking over in early 2014.
Performance of trust versus sector and index since Jan 2014
Source: FE Analytics
However, like many of its peers, Edinburgh’s discount has widened recently as a result concerns over valuations, rising interest rates and the upcoming UK general election.
Heathcoat Amory added: “The shares trade on a discount of 4.7 per cent. We believe the trust offers an attractive, highly liquid route to a comfortable dividend, which hasn’t been cut in 40 years, with an experienced, well-resourced management team who share our somewhat wary outlook for equities.”
The trust is geared at 10 per cent and has ongoing charges, excluding performance fee, of 0.68 per cent.
Another UK Equity Income trust, FE Alpha Manager James Henderson’s Lowland Investment Company offers greater exposure to dividend-paying UK small and mid-cap companies than Edinburgh.
While this means it can be volatile compared to many of its peers, Heathcoat Amory rates it not only as a strong grower of capital, but a very effective diversifier of dividends.
“While the trust’s emphasis on capital growth and the “always geared” positioning means that it is a higher-risk proposition, the manager’s long track record and consistent style gives us confidence that he will continue to deliver,” he said.
“Indeed, barring 2009 when the dividend was maintained but not grown, the trust’s unbroken record has in no way come at the expense of capital – it has performed very strongly relative to peers and the benchmark through many cycles.”
Kepler shows that it has also increased its dividend from 12.15p per share in 2000 to 23.5p in 2014.
According to FE Analytics, Lowland has been one of the sector’s best performers over 10 years with returns of 180.36 per cent, beating the FTSE All Share by close to 60 percentage points in the process.
Lowland’s discount has widened quite substantially to 8.6 per cent, thanks largely to the recent poor performance of small caps. This, combined with average NAV returns, means the trust has underperformed over the short-term. As recently as December 2014 it was on a premium.
Kepler thinks the widening discount has opened up a buying opportunity for one of the most established UK income trusts on the market. Lowland has a yield of 2.8 per cent, is geared at 15 per cent and has ongoing charges of 0.59 per cent minus a performance fee.
This trust also focuses on UK equities, but thanks to manager Alastair Mundy’s contrarian style, offers investors exposure to out-of-favour areas of the market. Top-10 holdings include the two oil majors, Lloyds and RBS, for example.
Mundy’s effective stockpicking, along with the board’s progressive dividend policy – it has increased its pay-out in each of the last 31 years – has led it to perform well relative to both its peers and benchmark since the manager took charge in October 2002.
Performance of trust versus index since Oct 2002
Source: FE Analytics
Performance has waned more recently, thanks largely to Mundy’s cautious outlook for UK equities. Cash and short-dated gilts currently make up 15 per cent of assets. Some poor stock selection calls and a widening discount, which currently stands at 5 per cent, hasn’t helped matters.
Heathcoat Amory says long-term income investors can afford to look past its bottom quartile returns over the past 12 months however, again seeing the discount as an opportunity.
“The trust has increased its dividend every year for more than three decades and, even at the height of the financial crisis, has been consistently well covered by its dividend reserves,” he said.
“Recent stock selection errors – the most glaring being the acquisition of Tesco last year – have given the trust a tough time and helped bring it down from its usual premium to a discount which we think makes the trust even more attractive.”
Temple Bar has a yield of 3.3 per cent and a dividend growth rate of 2.8 per cent over the last five years. It isn’t geared and has low ongoing charges of 0.48 per cent.
Schroder Income Growth has the ability to use covered-call options to boost income, in a similar way to the group’s open-ended Income Maximiser range.
Sue Noffke has steered the trust to the second quartile of the IA UK Equity Income sector since she took over in July 2011, though Schroder Income Growth’s returns of 61.45 per cent over that time are more than 20 percentage points greater than the gains of the FTSE All Share.
The trust, which is yielding 3.7 per cent, has increased its dividend from 13p in 2000 to 37p in 2014, and Heathcoat Amory says it is an ideal option for income investors who don’t want to take too much risk.
“The trust has produced a rising real income and has an unbroken record of raising its dividend every year since launch in 1995,” Heathcoat Amory said.
“We believe its rock-solid focus on income, backed up by a board which has demonstrated its commitment to maintaining the dividend in the most difficult market conditions, make it an ideal founding member of the Bulletproof Income Portfolio.”
The trust is trading on an 8.1 per cent discount to NAV, has gearing of 8 per cent and ongoing charges of 0.94 per cent minus a performance fee.
Scottish American, which is headed up by Baillie Gifford’s Dominic Neary, is a more esoteric portfolio than those mentioned so far.
“By comparison to many traditional Equity Income trusts, Scottish American is relatively differentiated: it invests globally in equities, but it also has the flexibility to invest in other areas such as bonds (currently 6 per cent) and directly held commercial property (currently 11 per cent), but also indirectly owns timberland and catastrophe bonds,” Heathcoat Amory said.
“Performance has not been particularly impressive of late, but we believe that this is a result of relative asset allocation decisions rather than anything more worrying.”
Scottish American has struggled from a total return perspective, relative to its FTSE All Share and FTSE All World 50/50 split composite benchmark, over one, three and five years.
However, Heathcoat Amory likes the portfolio for its diversification benefits and the fact that the board have increased the dividend in every calendar year since 2000.
“The trust is relatively highly geared compared to many peers, but as we examine, we believe that this isn’t as hair-raising or worrisome as may be apparent at first glance. The current discount of around 6 per cent offers an interesting opportunity to buy an attractive income stream with a tangible margin of safety.”
Scottish American has gearing of more than 20 per cent and ongoing charges of 0.9 per cent.
The final trust on the list gives the Kepler Bulletproof Income Portfolio exposure to higher growth areas of the market, according to Heathcoat Amory, who says manager Hugh Young’s focus on quality makes it a sensible option for income investors.
Young has a very strong long-term track record and launched his Aberdeen Asian Income trust in December 2005.
While the trust has outperformed its benchmark since launch, Aberdeen Asian Income has struggled more recently due to Young’s focus on quality, and his avoidance of markets such as China.
Performance of trust versus index since Dec 2005
Source: FE Analytics
Nevertheless, Heathcoat Amory is confident Young’s trust will replicate its past strong performance and, due to the board’s progressive dividend policy, says it a very attractive way to play Asian equities.
“Over a relatively short period, the board have built up revenue reserves that many trusts of a more ancient vintage might be envious of,” he said.
“Whilst there are clearly headwinds brewing in the form of a China slowdown and a strengthening dollar, we are confident that the dividend will at least be maintained for the foreseeable future.”
Aberdeen Asian Income yields 4.2 per cent and has increased its dividend per share from 4.5p in 2006 to 8p in 2014.
It is currently trading on a 3.4 per cent discount to NAV, is geared at 7 per cent and has relatively high ongoing charges of 1.24 per cent.