Investment Guide: Investment Trusts
Now you need to see which funds offer you a high level of income growth while still protecting your capital.
Thanks to some of their unique features and the way they operate, investment companies are excellently placed to deliver income for shareholders – so all you need to do now is wait for your investment trust to start delivering a healthy return on your money.
Income from investment companies gets paid in the form of dividends. How often they get paid varies from company to company but the majority pays them either twice a year or quarterly. Some investment companies aim to produce a high level of immediate income or try to grow it over time, while others offer a mixture of both capital and income growth.
When you consider retirees have had a difficult time achieving a decent income in recent years – thanks to record low interest rates - it's clear why investment companies represent an attractive option for those who are willing to accept the risk that comes with any form of long-term investment.
According to recent research from the Association of Investment Companies (AIC), nearly half of active investors (46%) feel that investment companies are the most likely to deliver a consistent, high or growing income in retirement. So how do investment trusts make such a success of growing income?
Unlike open-ended unit trusts that have to distribute all their income to investors each year, investment companies are able to hold some of their income back from investors when their holdings have been performing well.
This may sound unfair but this crucial process, known as 'dividend smoothing', means investment companies are able to maintain or even increase their dividends to shareholders even during tough periods, when their holdings are underperforming and paying reduced dividends – or none at all.
On top of this, investment companies have the ability to pay dividends not just from the income they receive but also from their capital profits, too. This is used sparingly as it reduces the profit the firm makes but can be useful for companies also looking to maintain and increase dividends in difficult times.
This flexibility has helped the sector gain a reputation for delivering consistent and long-term dividend increases - even if the market isn't performing as hoped.
The AIC's latest 'Dividend Heroes' research highlights a number of trusts that have performed remarkably well for investors over half a century.
City of London, Bankers Investment and Alliance Trust, for example, have all recorded an incredible 48 years of consecutive dividend increases since they were founded, while another seven firms have delivered increases for 40 consecutive years or more.
The AIC's communications director Annabel Brodie-Smith said: "There's nothing more reassuring to investors than a company with a solid history of dividend increases, and the investment company sector's track record here is second to none.
"Through the good times and the bad, many investment companies have been able to increase their dividend every year for decades because they have the unique ability to save some of the income they receive each year for tougher times."
Investment companies invest in a wide range of investments – giving them the best opportunity to generate higher incomes – in contrast to open- ended funds that are restricted into investing in certain types of shares and securities.
Alternative assets sectors such as commercial property, infrastructure and renewable energy can all offer higher levels of income and because they are illiquid assets, they are particularly suitable to being held in closed-ended trusts, as fund managers can take a long-term view without being pressured into sell stock to meet redemptions.
Investment companies' ability to borrow money to make additional investments via a process called gearing can also boost investors' returns if the stock performs well – though it should be noted that gearing can amplify losses, too.
With all these benefits in mind, should you still be wary of investing in these vehicles to generate an income?
In short, many of the drawbacks of putting your money in an investment company are the same as investing in general. If you need a guaranteed income or if you cannot afford to lose any of your capital, then you shouldn't consider investing in an investment company. They are not a substitute for cash deposit accounts that may not offer much in the way of income growth but do guarantee your capital.
Similarly, remember all investments are intended to be long term. You should be prepared to invest for at least five, or preferably 10 years or longer, in order to maximise your chances of seeing a healthy return on your capital.
If you are unclear about which way to go, then speak to an independent financial adviser (IFA) about your options and whether investing for now for your retirement would be a worthwhile course to take.
Investment trusts are companies that invest money in other companies and whose shares are listed on the London Stock Exchange. As with unit trusts, private investors buying shares in an investment trust are buying into a diversified portfolio of assets (to reduce risk), which is managed by a professional fund manager. Investment trusts differ from unit trusts in two important ways: they are listed on the stockmarket and so are owned by their shareholders and are closed-ended funds with a finite number of shares in issue. This means the share price of investment trusts might not reflect the true value of the assets in the company (known as the net asset value, or NAV) and if the NAV value of a share is £1 and the share price in the market is 90p, the trust is said to be running a discount of 10% to NAV. But this means the investor is paying 90p to gain exposure to £1 of assets. Investment trusts can also borrow money and use this money to buy investments. This is known as gearing and a geared trust is thought to be more of an investment risk than an ungeared one.
A financial adviser who is not tied to any financial services company (such as a bank or insurance company) and is authorised by the Financial Services Authority (FSA). They can advise on financial products to suit your circumstances. All IFAs have to give consumers the choice of paying by fees or commission and have to explain which would best suit the customer in that particular instance. Also, if commission is paid either by the client or the financial service provider recommended by the IFA, the IFA must disclose what that commission is.
Investors who borrow money they use for investment and use the securities they buy as collateral for the loan are said to be “gearing up” the portfolio (in the US, gearing is referred to as “leveraging”) and widely used by investment trusts. The greater the gearing as a proportion of the overall portfolio, the greater the potential for profit or loss. If markets rise in value, the investor can pay back the loan and retain the profit but if markets fall, the investor may not be able to cover the borrowing and interest costs, and will make a loss. Also used to describe the ratio of a company’s borrowing in relation to its market capitalisation and the gearing ratio measures the extent to which a company is funded by debt. A company with high gearing is more vulnerable to downturns in the business cycle because the company must continue to service its debt regardless of how bad sales are.
If you own shares in a company, you’re entitled to a slice of the profits and these are paid as dividends on top of any capital growth in the shares’ value. The amount of the dividend is down to the board of directors (who can decide not to pay a dividend and reinvest any profits in the company) and they will be paid twice yearly (announced at the AGM and six months later as an interim). Dividends are always declared as a sum of money rather than a percentage of the share’s price. Although dividends automatically receive a 10% tax credit from HM Revenue & Customs (HMRC), which takes the company having already paid corporation tax on its profits into account. Dividends are classed as income and, as such, are liable for personal taxation and so shareholders have to declare them to HMRC.