Investing part 1

Investment trusts offer a world of opportunities to tap into but how can investors sort the wheat from the chaff ? In our Investing Analyst column, experts run the rule over what’s on offer.

In this column, Thomas McMahon, Head of Investment Companies Research, at Kepler Partners, looks at how to get really get trusts to deliver on dividends.

The activism of Saba Capital, which I discussed in my last column, has created a challenge for all boards of investment trusts and we are already seeing its effect.

It certainly seems possible that this was behind the series of measures announced by abrdn Asian Income Fund (AAIF) recently.

The trust will now hold a continuation vote every three years, and has also decided to massively boost the dividend it pays out, which should rise to c. 7 per cent on an annualised basis, when accounting for the current discount.

These measures had an instant impact on the share price, which saw a decent bounce in the following days. I’m pretty sure it will have been the dividend policy that has led to this reaction, judging by past such announcements.

What the board has decided is that they will pay out a fixed percentage of the net asset value (NAV), which is essentially the value of the underlying holdings.

This is to be 1.5625 per cent of NAV each quarter, which equates to 6.25 per cent annualised. As the trust’s shares are on a discount, the implied yield on the share price is higher, at c. 7 per cent at the time of writing.

This is almost 2.5 percentage points higher than the 10 year gilt yield, and from a portfolio which has the growth potential of Asian equities to offer too.

This sort of manufactured or enhanced yield has become increasingly popular in recent years. It is one of the features of the investment trust structure that can’t be replicated in the open-ended or ETF world.

Assuming they have first received the right shareholder permissions under company law, boards can essentially decide what dividend they want to pay out without any regard to what income they have earned.

In the jargon, this is described as ‘paying from capital’. I think this jargon misleads some people though. it gives the impression that there is a separate pool of capital and one of income, but really these are just accounting fictions.

Trusts can invest the dividends they receive, and then sell their holdings when they have to pay a dividend. There is no requirement to keep income in cash for distribution.

This is a mistake people often make when considering another feature of income-paying trusts: revenue reserves. This refers to past year’s income which can be held back by a trust for distribution in future years.

While we talk about it as being placed in reserve, all that really means is that an account is written up on a virtual ledger, while the money is invested back into the portfolio. When trusts pay from revenue reserves or from capital, they don’t have to keep cash on hand through the year but can simply sell some assets and pay the cash out.

These features of investment trusts thus offer incredible flexibility to boards and really underline the credentials of the investment trust structure as the preeminent one for income-seekers. Boards can draw up a dividend policy without worrying about the income received from the portfolio changing from year to year.