An ace up the sleeve

When is an income fund not an income fund? The answer, in the investment company world at least, is when that fund is paying income from its capital reserves, rather than the income it is generating on its investments.

Investment companies are unique amongst collective funds in having the option, subject to shareholder approval, of paying dividends financed from capital rather than income. The result is that many funds operating in this way, and therefore offering attractive levels of yield, reside outside of sectors classified as being for income funds. In some cases, you’ll even find such funds in sectors where funds have not traditionally paid any income at all – several private equity funds, for example, now offer investors an income paid for out of capital reserves.

In an article published by FT Adviser this week, several investment company analysts debate the merits of reclassifying all such investment companies as income funds. “Should investment companies paying yield be reclassified as income funds?”, as Sam Murphy, Charles Cade and Ewan Lovett-Turner put it.

Such a reclassification might well be attractive to investment companies themselves. In this ongoing environment of low interest rates, income funds have never been in such demand; as a result, almost all the funds in the investment company income sectors are sitting on very favourable valuations, with their shares generally trading at very small discounts to the value of the underlying assets or, in many cases, at premiums.

You can also see the appeal for advisers and investors. Wouldn’t it be simpler and easier if all investment companies offering yield as their pitch to investors were to be found in the same place? Right now, investors must scour a broad range of investment company sectors to ensure they’re getting the widest possible choice of high-yielding funds.

There are some counter arguments, however. One important point is that funds electing to pay income out of capital in one year may not choose to do so in future years. In which case, they would presumably have to yo-yo from one sector to another according to their most recent distribution policy.

A more fundamental issue is transparency. Clearly, it’s important that investors in these funds understand where their income is coming from. Drawing down capital reserves must have an impact on longer-term returns, which is fine if investors have weighed up that idea and decided that the price is worth paying, but less so if the idea hasn’t occurred to them. By lumping all funds that produce an income together, the implication might be that the income is all being generated in the same way.

In the end, of course, this is a debate that cuts to the very heart of the merits of paying income out of capital. Right now, in markets on an uptrend, and where income is in short supply, this strategy is hugely appealing, since it provides an alternative source of yield that doesn’t appear to have a cost, courtesy of the rising tide that floats all boats. In less upbeat markets, however, investors may end up feeling much less comfortable – and investment companies themselves may decide to row back on the policy.

The debate about classification will no doubt continue. But we can agree on one thing – there is real value in the very fact that investment companies have this option. Where investors understand the pros and cons of paying income from capital, they very often find such facilities invaluable.