For some time it has been a feature of the investment company market that funds with above average dividend yields trade on tighter ratings than others. There are plenty of examples of this across all geographies and asset classes and, generally, it only falls down where investors are nervous about the sustainability of the income stream or the underlying assets.
From April, UK investment companies will be able to distribute realised capital gains as dividends – Laxey is calling for Alliance Trust to do this in the hope that this will narrow its discount. In a tax-neutral environment, rational investors ought to be looking at total returns and the premium ratings for higher yielding companies shouldn’t exist. Are income trusts mispriced and will any mispricing persist?
One of the easiest ways to look at the phenomenon is to compare two funds managed by the same team. Contrast Aberdeen Asian Income trust with Aberdeen New Dawn: both are Asian-focused funds with low to no exposure to Japan, both funds have Hugh Young as the named manager, they are both about the same size (Asian Income is larger with gross assets of £274 million versus. £239 million for New Dawn) but Asian Income yields 3.6% against 1.5% for New Dawn. Asian Income trades at a 5% premium and is regularly issuing new shares; New Dawn is on an 8.5% discount.
A daft situation you might think but, despite having a portfolio designed to generate an above average income, Asian Income is managing to outperform New Dawn on a capital basis as well.
Or how about Henderson High Income (4.2% premium) and Bankers (9.8% discount) – both managed by Alex Crooke at Henderson. Again, the income fund yields about twice that of the generalist (6.2% versus 3%). They are close, but not a perfect match – the income fund is mostly invested in the UK, while Bankers has a global portfolio, albeit with a distinct UK bias.
Again, the income fund has a better capital performance record. If we look at Schroder Asia Pacific versus Schroder Oriental Income, though (1.2% yield versus 3.8%, both are managed by Matthew Dobbs), again, the income fund has outperformed.
This makes me wonder if income funds are in vogue partly because over the past few years the investment environment has favoured more defensive, higher-yielding value plays. If this were the main reason for the disparity in ratings between income and growth funds it would suggest that using capital profits to boost distributions would not, by itself, improve a fund’s rating, you would need to change the investment approach as well.
I could also cite the example of Edinburgh Investment Trust. Distinctly unloved when it was a UK Growth fund managed by Fidelity, the rating improved dramatically when Invesco Perpetual took it on and it moved to the UK Growth & Income sector. Buy-backs stopped overnight. It now trades close to a 7% premium (and should be issuing shares to address this in my opinion). The objective did not change, the dividend has increased since but not dramatically – there was no step change in the payout ratio – the biggest change was in the investment style (which, looking at the relative performance of Edinburgh and Fidelity Special Values, could be said to have paid off).
The universe of investment companies includes all sorts of interesting vehicles and among them is Investors Capital, a unique fund that allows investors to choose between receiving dividends in the usual manner, the A shares, or rolling up the income as a capital gain, the B shares. (Perpetual Income & Growth went quite far down the road of issuing B shares in May/June 2010 but they pulled the issue citing ‘uncertain market conditions’).
Both A and B shares share the same underlying portfolio so, barring the effect of the dividend reinvestment the performance for both share classes, is the same. However, the dividend paying A shares sit on a 5% discount, while the B shares are on a premium. I can’t fathom a reason for this, except that the tax treatment for capital gains is more favourable than that for dividends.
If the difference in the tax treatment is important, it ought to make the use of capital profits to boost dividend yields even less attractive.
However, I think there is another factor at play here. In these days of absurdly low interest rates, investors are looking for alternatives to cash deposits. The natural next step is to opt for bond funds but I think some of the money is finding its way into equity income funds, which at least offer the prospect of an income that will grow in real terms.
So, in summary, I am not sure boosting yields by paying out capital would necessarily improve ratings. Though, as some brokers have pointed out, it does have the advantage that shareholders are getting their capital back at net asset value rather than at a discount (as is the case for buy-backs).
James Carthew is a former director of Advance UK Trust