In the never-ending search for income, many people are drawn to investment trust dividends. They come in all shapes and sizes, though, and there are a few nooks and crannies dividend seekers should be aware of.
The 15% advantage
Perhaps the key thing to be aware of is that investment trusts have the ability to smooth their payouts over time.
Under tax law, in order to be an approved investment trust, a closed-end fund must pay out at least 85% of the income it receives (subject to a few exceptions).
To flip that around, an investment trust can keep up to 15% of its income each year, putting it into a revenue reserve to fund future dividend payments.
In the financial crisis, when many public companies cut their dividends in order to preserve cash, investment trusts were able to tap their revenue reserves to ease the suffering for their own shareholders.
Revenue reserves
The AIC website publishes revenue reserve figures, so this can give you an indication of how sustainable an investment trust’s dividend might be.
Many mainstream funds in the global and UK sectors have between one and two years’ worth of dividends in reserve. In other words, they have a fair bit of slack to play with.
Some trusts have substantially more leeway, however. Personal Assets has 8.4 years in reserve and Manchester & London boasts 18.2. Monks has 16.9 but that’s because its yield is just 0.2%.
Many newer investment trusts have very little in the way of revenue reserves. Some haven’t had the chance to build up much in reserves yet. Others are primarily set up to pay a high level of income and typically pay out everything they receive from their underlying investments.
Dividend Heroes
Many investment trusts have used the smoothing effect to generate spectacular records of consecutive dividend increases. Dubbed ‘Dividend Heroes’ by the AIC, some have even increased their dividends for more than 50 years.
The AIC’s list of trusts increasing their dividends for 20 years or more is normally published around March each year. Here is 2018’s. There are 21 Dividend Heroes at the moment out of a total of around 340 conventional investment trusts. It’s a rare accolade, therefore.
You’ll notice that a few Dividend Heroes have quite a low yield. Just because a dividend has increased a smidgen each year, their payout may still not be as high as other investment trusts.
The AIC has also published a list of next-generation dividend heroes, consisting of those with a 10+ year track record of increases. Somewhat surprisingly, there are only 22 names on this list, although that may reflect the fact that some 40% of investment trusts are less than 10 years old.
Sector by sector
There’s quite a wide variation of dividend yields by sector. The table below isn’t an exhaustive list as it ignores many of the smaller sectors. However, it should give you a flavour of where the higher and lower yielders tend to be found.
| Sector | Average yield as of 30 Sep 2018 |
|---|---|
| Global | 1.3% |
| Global equity income | 4.0% |
| UK all companies | 2.0% |
| UK equity income | 3.8% |
| UK smaller companies | 2.0% |
| UK equity and bond income | 5.7% |
| Europe | 1.8% |
| North America | 2.3% |
| Emerging markets | 2.4% |
| Flexible | 2.3% |
| Private equity | 4.6% |
| Property (direct) | 5.1% |
| Property (specialist) | 4.5% |
| Debt | 6.7% |
| Infrastructure | 4.8% |
| Renewables | 5.7% |
| Leasing | 7.4% |
Global yields are among the lowest, with these funds tending to hold US tech giants that often pay zero dividends.
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The UK is known for its high level of dividend payments but a great deal of UK-focused investment trusts pay out in the region of 2%. That’s just over half the current dividend level of the UK market, which is 3.8%.
There can be quite a wide variation within individual sectors as well. Private equity is the most striking, with a mixture of zero, low and very high yields (these tend to be in the process of winding down).
Europe is another odd sector. Its average dragged down by a couple of large funds with a low dividend yield.
How frequent are investment trust dividends?
I had to cobble together data from a few different sources for this section so the following table is just a rough estimate. It shows the split between various payment frequencies for investment trust dividends:
| Frequency | Proportion |
|---|---|
| Monthly | 3% |
| Quarterly | 39% |
| Half-yearly | 21% |
| Annually | 16% |
| Not a sausage | 21% |
Large numbers of income-orientated investment trusts have been launched in recent years. As a result, more investment trust dividends are now paid quarterly than are paid half-yearly and annually combined.
There’s even a handful of property and debt/leasing funds that pay dividends monthly. That seems a little ridiculous to me but each to their own!
A sizable proportion of investment trusts don’t pay any dividends. Some of these are new, so haven’t had the chance to make any payouts yet. They are still building their portfolios. But many country specialist funds and those in the private equity, flexible and hedge fund sectors don’t pay anything.
The capital/income shift
2012 was meant to be the year that the world ended. As far as a few people were concerned, something even worse happened! A change to UK tax law meant that investment trusts could pay dividends out of their capital reserves.
About two dozen investment trusts have taken advantage of this so far. There is a fairly recent list in this Money Observer article. They include a few that I hold myself, like RIT Capital Partners, JP Morgan Global Growth & Income and Princess Private Equity.
In the case of JP Morgan Global Growth & Income the decision to set a fixed dividend target of 4%, paid from capital if needed, seems to have helped eliminate its discount to net assets. A few other funds have had similar experiences, with double-digit discounts disappearing in less than a year.
We haven’t had a sustained bear market since this change was made, so you could say it’s yet to be battle-tested. Indeed, many investment trusts only changed their payout policy in the last two or three years.
You would hope that investment company boards have the sense to adjust course if needed. But UK investors love their dividends, so any radical downshift of a payout policy could hit a trust’s share price.
Taxing times
Investment trust dividends are taxed in the same way as other company dividends.
We all get a £2,000 tax-free dividend allowance for this tax year. Any dividends above this level are taxed on the basis of what income tax band you fall into:
| Tax band | Tax rate |
|---|---|
| Basic rate | 7.5% |
| Higher rate | 32.5% |
| Additional rate | 38.1% |
On the face of it, this seems fairly simple. But the sums get more complex if your dividends take you from one income tax band into another. The withdrawal of child benefit between incomes of £50,000 and £60,000 can add another complication.
The dividend allowance is a pretty new concept having been introduced in April 2016. It’s already been cut from £5,000 to £2,000, so the government obviously sees it as fair game for meddling with. Watch out for further changes in the Budget at the end of October 2018. And if a Labour government gets in, the tax rates could rise as well.
The simplest solution is to hold as much as your portfolio as possible in an ISA. Then, none of the above applies. That is until ISAs move into the taxman’s sights!
One last thing: property dividends can be tricksy
One final thing to watch out for is that certain property funds are classed as real estate investment trusts (REITs). These often pay two types of dividends: ordinary dividends and property income distributions (PIDs).
PIDs are classed as normal income, so you don’t get the benefit of any dividend allowance. You also pay income tax at your marginal rate (so usually either 20%, 40% or 45%). Again, this can be avoided if you hold these investments in an ISA.
May your dividends roll in for a long time to come!
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