One of the themes of the investment trust sector over recent years has been the growing number of funds paying enhanced dividends by converting an element of capital returns into income. A tax change in 2012 made it possible for UK-domiciled investment trusts to distribute realised profits as dividends.
We estimate that there are now 10 UK investment trusts that are actively using these powers, with many introducing enhanced dividend policies in the last 12 months. Most recently, Aberdeen Emerging Markets announced at the end of July that it will pay a dividend funded by both income and capital. In addition, earlier this month the AIC started publishing information about whether its members’ dividends are paid from income or capital profits.
Funds are using these powers in a variety of ways and to different extents. For example, International Biotechnology and JPMorgan Global Growth & Income* are targeting dividends set each financial year equivalent to at least 4 per cent of the NAV as at the end of the preceding financial year, while Baring Emerging Europe and Standard Life Private Equity* have committed to using capital in order to increase the dividend from its previous level.
In addition it is worth remembering that offshore investment companies have no constraints in terms of distribution. Historically a number of the UK direct property investment companies domiciled in the Channel Islands have paid uncovered dividends, using capital to meet the shortfall from revenue.
A table of the equity-focused closed-ended funds that have announced changes to their distribution policies to allow them to pay capital out as income is set out below.
The increasing number of investment trusts using capital to boost their dividends can be viewed as a reaction to investors’ continued search for yield in the current low interest rate environment. This demand is reflected in the significant volume of issuance by income-focused investment trusts in recent months. Fourteen of the 16 IPOs so far this year are targeting a dividend yield of at least 4 per cent and secondary issuance has also been dominated by funds investing in income-producing asset classes, such as Property and Infrastructure.
While some commentators on the sector have been critical of the development of enhanced dividend policies, we believe that this is another advantage that the closed-ended fund structure provides. The ability to use revenue reserves to provide greater dividend certainty is well-established and appreciated by the market. It has allowed a number of investment trusts to develop impressive records of year-on-year dividend growth. The ability to convert capital into income takes this a stage further and allows funds investing in low or non-yielding assets the opportunity to pay regular dividends and can be a useful tool for smoothing out dividends, in the same way that revenue reserves have traditionally been used.
Having said this, we believe that each case needs to be judged on its own merits. For example, we remain more cautious regarding the dividend policy adopted by International Biotechnology Trust due to the lack of revenue generated by the portfolio combined with the relatively volatile nature of the biotechnology sector. The dividend will most likely be entirely paid from capital. Given the volatility of the biotechnology sector we believe that there is a risk of returning capital through dividends at troughs in the market and shareholders therefore missing out on subsequent rallies. Essentially the new policy creates market timing risk for investors. Nevertheless, the change in dividend policy has helped the fund be re-rated by the market, with its discount having narrowed substantially since it was announced in September last year.
The advantages of paying enhanced dividends are particularly apparent for funds attempting to differentiate themselves and attract retail buying interest. Attracting long-term retail investors is the Holy Grail for many funds in the sector. Enhanced dividends are not necessarily a silver bullet but, with demand for yield showing no signs of abating, we would expect more investment trusts to continue to adopt similar policies. In our view, a properly constructed and well-communicated enhanced dividend policy can be positive for a fund’s rating.
*Corporate broking client of Winterflood Securities
Emma Bird isnvestment companies research analyst at Winterflood Securities