Divi Up!

Enhanced dividend strategies are growing in popularity, what do they offer investors?

Ryan Lightfoot-Aminoff Kepler

Disclaimer

This is not substantive investment research or a research recommendation, as it does not constitute substantive research or analysis. This material should be considered as general market commentary.

The growing prevalence of enhanced dividend strategies has been one of the investment trust industry’s low-key emerging trends in the past few years. Pioneered by European Assets (EAT) in 2001, this typically involves taking a contribution from the trust’s capital to top up the portfolio’s underlying revenue in order to boost the income paid out to shareholders. A tweak to the UK rules in 2012 has led to a steady increase of trusts adopting this approach, with over 20 now offering some level of enhanced dividend. With this approach growing in popularity, we look at what it offers boards and managers, how investors can benefit, and whether there are implications for a trust’s discount.

The case for an enhanced dividend

The enhanced dividend strategy works by using a portfolio’s capital reserves to supplement the underlying income a portfolio generates and then paying this combined amount out to investors. It’s important to note that neither capital nor revenue reserves are pots of cash, a point that is often misunderstood. What we are talking about is accounting identity. Portfolio income is, in an equity investment trust, typically reinvested in the portfolio, and an amount is added to the revenue account. When a dividend is to be paid, the manager will sell some investments to raise the actual cash to be paid out, and then write down the revenue account. It’s the same process when paying from capital, meaning investments are sold to raise funds, except there is no requirement for the cash to be ‘raised’, or debited, from the revenue account.

To provide clarity to investors, many trusts implementing an enhanced dividend policy will set out an income goal for the year, such as Invesco Asia (IAT) w adopted a policy in 2021 to pay out 2% of NAV every six months. In the years since its adoption, IAT’s dividend per share has been on average just over double the earnings per share, showing that investors are receiving an income of almost double what they would have if such a policy wasn’t in place.

Whilst the income benefits for shareholders may seem obvious, an enhanced dividend policy also provides some perks when it comes to capital returns. With the trust’s income effectively taken care of, the managers have more freedom to invest in what they believe are the best opportunities from a total return perspective, without being beholden to income targets. This helps reduce the conflict managers may find themselves in when deciding whether to invest in stocks with high future growth potential or those offering high yields today. This could help improve the overall performance of the trust in the long term, as managers are under less pressure to generate income in the near term which may come at the expense of future capital growth.

With several trusts now offering attractive yields, despite investing in asset classes that are not typically high-yielding, income hungry investors have a wider range of asset classes to choose from. This not only creates opportunities for better portfolio diversification but also means investors are less reliant on traditional income asset classes such as bonds or value equities. JPMorgan has been one of the biggest adopters of enhanced dividend policies, which have been implemented in five trusts in their range. This includes trusts investing in China and UK smaller companies, not areas famed for their income potential. However, the enhanced dividend strategy has meant that these trusts could be useful for income investors and enable them to create a more diverse portfolio.

Moreover, this could provide style diversification benefits too, as several trusts with enhanced dividend policies are run with a growth mindset, meaning their portfolios will consist of very different companies to the value-orientated ones typically in an income portfolio. One example is JPMorgan Global Growth & Income (JGGI). Through a series of mergers and strong performance, JGGI has grown to one of the largest trusts in the global sector and is managed with a strong growth bias. This has led to top ten holdings including Microsoft, Nvidia, and Meta, which are unlikely to populate income portfolios. Despite this, the trust’s enhanced dividend policy of paying out at least 4% of the NAV per annum has meant it could have appeal to both income and growth investors. It also means income investors can balance JGGI’s growth bias with more traditional income assets in a portfolio, whilst still generating a good income.

Some trusts, such as JPMorgan UK Small Cap Growth & Income (JUGI), use the NAV at the end of the previous financial year to set the amount for the next four quarterly dividends, meaning investors can be more certain of what they will receive in absolute terms, although as the NAV may rise or fall throughout the year. On the other hand, some trusts, such as IAT, will calculate the dividend amount based on the NAV at different points in the year, meaning the amounts can fluctuate.

CT Private Equity Trust (CTPE) has a slightly different approach, with dividends set through a strict formula which has been consistently applied since 2012. The dividend formula gives shareholders a highly predictable and secure income stream, with the annual dividend set at a rate equivalent to 4% of NAV, based on the average of the last four quarterly NAVs. However, if in any quarter this figure implies a reduction in the dividend, the quarterly dividend payable will be maintained. A result of this approach is that CTPE is now a ‘next-generation dividend hero’, having increased its dividend for ten or more years.

For trusts that follow any of these approaches, it is not hard to see that the dividend itself is not as reliant on the prevailing dividend environment, as is the case in more traditional income portfolios. This was best demonstrated in the early days of the COVID pandemic, when many companies suspended their dividends which put a strain on many income-focussed mandates, particularly in the open-ended space. However, almost all equity income investment trusts managed to maintain or grow their dividend. This was either by using revenue reserves or in the case of trusts with enhanced dividend policies, capital reserves. As such, enhanced dividend strategies can also support income resilience which may be particularly attractive during periods of market weakness.