Steady income and performance to boost investment trusts’ popularity

AFTER a decade in the financial wilderness, investment trusts are emerging, blinking, back into the mainstream. Tainted by the split-cap scandal at the end of the Nineties, investors have favoured their open-ended cousins for the past decade.

Yet investment trusts have, on the whole, outperformed the FTSE All Share and the FTSE World ex UK indices over this period. They have also outperformed or done as well as OEICs in most major sectors apart from Japan, according to data from Winterfloods.

In spite of their better performance, there are almost six times as many assets invested in UK authorised unit trusts and open-ended investment companies (OEIC) than in investment trusts according to data from the Investment Management Association (IMA) and the Association of Investment Companies (AIC).

Over the next five to 10 years this imbalance is likely to be redressed for two main reasons. The first reason is their capacity to have revenue reserves, which help an investment trust to maintain its dividend payout even when the companies that it is invested in cut their dividends. Morningstar’s director of closed-end fund research Jackie Beard says: “Clients who really need income from their investments have struggled recently. Investment trusts offer a way of looking elsewhere for that income and meeting their needs. Their revenue reserves give more certainty of income payments and can avoid the need to draw on capital.”

Unlike open-ended funds, investment trusts only have to pay out 85 per cent of their dividend income. Although most pay out 90-95 per cent, this small percentage can build up over time to create significant reserves. Investment trusts have a long history – the first was set up in 1868 by F&C.

This has been reflected in their dividend performance relative to open-ended funds. For example, if you compare the dividend change for the Invesco High Income and the Edinburgh Investment Trust, the former has had to cut its dividend by 2.5 per cent this year whereas the trust increased it by 1 per cent. This is despite the fact that both are managed by Neil Woodford and hold approximately (although not exactly) the same stocks.

This also holds true for Investec Managed Distribution and Temple Bar – managed by Alastair Mundy – and for Karen Robertson’s Standard Life Equity Income and Standard Life Equity Income Investment Trust. “It’s an uphill struggle for unit trusts to maintain dividends,” says Peter Hewitt, manager of the F&C Managed Portfolio Trust – a trust that invests in other trusts.

The second major reason is the Retail Distribution Review (RDR), which is scheduled to come into force in December 2012. Since the commission bias will be removed from the system – investment trusts have almost exclusively never paid commission to financial advisers – this will level the playing field. The availability of trusts on platforms should also increase, improving the distribution channels and the take-up among private investors.

But these two factors are not the only advantages that investment trusts have. Their closed-end structure means that once the money has been raised, the fund manager is free to focus on running the money raised without worrying about potential or actual inflows or outflows of money. Since retail investors tend to buy high and sell low, an OEIC manager might find himself at the top of a bull market with a lot of money to invest. Equally, in a bear market as investors rush for the exit, he may have to sell at the trough.

Investment trusts are also structured as companies, which means that if a manager underperforms, the board can take corporate action and potentially replace him. Since they are listed companies, they also have to be transparent about their performance, which is not required of open-ended funds to the same extent. Finally, the average total expense ratio of investment trusts tends to be around 25 to 50 basis points cheaper than that of OEICs, says F&C’s Hewitt.

As the need for income continues and regulations change , trusts should become a more popular way of investing over the next decade. But given their superior performance track record, why wait for them to become popular to buy them?