When it comes to generating a high and growing income, investment trusts have a couple of superpowers.
First, and unlike open-ended funds, they are allowed to hold back some of the income they receive from their investments in good years and store it in what are known as revenue reserves.
When times are tougher, they can dip into those reserves to keep dividends flowing.
For investors, this can be an incredibly useful feature. Instead of income jumping around from year to year depending on market conditions, like we saw during the pandemic most recently, investment trusts can smooth the payments they make to shareholders.
And for anyone investing through an Isa, that income stability can be even more appealing.
Any dividends received inside an Isa are completely tax-free, meaning a growing stream of income doesn’t come with an unexpected tax bill.
Powerful: When it comes to generating a high and growing income, investment trusts have a couple of superpowers
Trusts with attractive dividend growth records
This ability has helped some investment trusts deliver not just an attractive yield today, but also an impressive record of dividend growth for investors over time.
In fact, the investment trust sector is home to a special group that the industry trade body, the AIC, has dubbed the ‘Dividend Heroes’ – trusts that have increased their dividend every year for at least 20 years.
The pre-eminent Dividend Hero is City of London Investment Trust (CTY). CTY currently yields around 3.8 per cent, slightly ahead of the wider UK market, but the real attraction is its consistency, having raised its dividend for almost 60 consecutive years.
By investing in established UK companies that steadily grow their payouts, and its prudent management and use of revenue reserves, CTY has kept those annual increases coming year after year, through multiple market cycles including the global financial crisis in 2008 and the Covid-19 pandemic.
For investors seeking a higher starting income, there are also trusts offering more generous yields today.
Aberdeen Equity Income (AEI) currently yields around 5.6 per cent, supported by a portfolio of companies with strong cash flows capable of delivering high, growing and sustainable dividends.
Its yield is among the highest in the UK Equity Income sector, and it also boasts 25 years of consecutive dividend growth, earning it too a place on the AIC Dividend Heroes list.
Income from further afield
Income opportunities are not limited to the UK either. For investors looking to diversify their portfolios, markets further afield can offer attractive sources of income, sometimes in places where dividends have traditionally been less common.
That can help broaden income sources beyond more traditional dividend markets such as the UK.
A good example is CC Japan Income & Growth (CCJI). Japan has not traditionally been known as a strong dividend market and for decades
Japanese companies preferred to sit on large piles of cash rather than return it to shareholders.
But that culture is now changing. Companies are facing growing pressure to put that cash to work, including increasing dividends.
Diversify: For investors looking to diversify their portfolios, markets further afield can offer attractive sources of income
This shift has created a new opportunity for income investors. Whilst CCJI was launched to capture the growth potential of Japanese companies, it has also tapped into Japan’s evolving dividend culture.
The trust has increased its dividend every year since launch and is now approaching a decade of consecutive rises, the first among today’s Japan-focussed trusts. It also offers one of the highest yields in its sector at 2.5 per cent, compared with 2 per cent for the wider Japanese market.
For Isa investors looking to build a portfolio that delivers both a high and growing income, these types of trusts can play an important role.
Their ability to invest with a long-term mindset and smooth dividends through reserves means investors may enjoy a steadier, and often rising, income stream, even when markets are less predictable.
Leveraging profits to pay dividends
But the story doesn’t end there. Investment trusts have a second superpower when it comes to dividends – the ability to pay dividends from their capital profits.
This means that investment trusts that own shares in companies that themselves don’t pay a dividend are still able to do so.
There are many reasons why companies may not pay a dividend, but as a broad generalisation those with higher growth prospects may favour reinvesting excess profits in their business over paying a dividend.
And it’s also a matter of culture, as in some markets investors may prefer companies to return excess profits through share buybacks.
The US is a good example. Being such a broad market, it is certainly possible to find many companies that do pay consistent dividends.
The North American Income Trust (NAIT), managed by Janus Henderson, specialises in these types of companies and generates a yield similar to some of the UK trusts mentioned above, but many US companies are much more focused on growth, or prefer share buybacks.
BlackRock American Income (BRAI) is one trust that invests across the US market, and pays a dividend equivalent to 6 per cent of net asset value, funded by a mixture of traditional income and capital profits.
And this raises an important point about these types of dividends. Normal market practice is to pay a dividend equivalent to a percentage of the net asset value, calculated at the start of each financial year.
This means if the trust’s net asset value rises significantly over a year, then next year’s dividend is likely to rise significantly too.
But the opposite is also true, and when investors who want to build a portfolio of different trusts for income, they should be cognisant of which ones use this approach and decide what mix of traditional and capital dividends suits them.
Another good example is Europe. Although like the US it is certainly possible to find companies that pay traditional dividends, there are also many companies that don’t, and although Europe might not be the first place investors think of to invest for ‘growth’, in fact this region has many world-class technology, pharmaceutical and engineering businesses that have been growing fast over the last few years.
A great way to access some of the less well-known companies in Europe is the European Smaller Companies Trust (ESCT).
This trust has a 5 per cent dividend payout, calculated in the manner described above, but gives investors access to a portfolio of many of Europe’s best businesses across a variety of sectors and countries.
Further up the size scale, JPMorgan European Growth and Income (JEGI) invests mostly in Europe’s larger companies but again can provide access to growth businesses while at the same time paying out a dividend set at 4 per cent of net asset value.
And Emerging Markets, a traditional hunting ground for growth investors who like the combination of strong economic growth and fast-growing companies, is also a good place for an investment trust to use the same approach to paying dividends.
JPMorgan Emerging Markets Dividend Income (JEMI) is a great way for investors to access that growth potential while at the same time taking a 4 per cent dividend payout.
And although Japan, as we looked already, has begun to offer plenty of opportunities for a more traditional dividend strategy, Schroder Japan (SJG) follows a value approach rather than focusing on income, investing in high-quality undervalued companies across the market-cap spectrum and using the trust’s dividend superpower – its ability to distribute capital – to pay a 4 per cent dividend each year.
Overall, investment trusts have a lot to offer income investors. Those who prefer the more traditional dividend policies, powered by underlying company payouts, are very well catered for, and the label ‘dividend hero’ is highly prized in the investment trust sector.
But investors who feel drawn to other markets or sectors can also find plenty of investment trusts that pay a dividend without compromising on their pursuit of capital growth.
Wrapping either up in an Isa means investors don’t have to worry about the different tax treatment of capital and income and can just enjoy the diversification and growth benefits that these two superpowers help create.
Alan Ray and Josef Licsauer are investment trust research analysts at Kepler Partners.
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