Pay out now, or later?

Anyone seeking to analyse investment trends in recent times runs the risk of sounding like a stuck record. Since the Bank of England cut the base rate to 0.5 per cent more than eight years ago (and then to 0.25 per cent last year), there has only been one game in town: the search for yield remains the dominant theme in our financial markets.

So it continues to prove in the investment companies universe. All four major investment company IPOs during the first quarter of this year were aimed at investors seeking income, offering exposure to alternative asset classes such as debt and property, where yield is available. Amongst existing investment companies raising new money meanwhile, income-focused funds also dominated – both equity income vehicles and more of the alternative assets specialists.

In fact, advisers increasingly understand that investment companies are a good place to be during an income drought. Their longstanding ability to maintain reserve funds, holding back earned income in better years to finance payments in leaner times, provides investors with a smooth flow of dividends that other collective investment vehicles struggle to match.

Moreover, since a change in the rules in the sector a few years back, investment companies have also had the right to fund dividend payments by realising capital gains on their underlying portfolios – this has proved popular, with many funds beginning to operate this way.

It was interesting, therefore, to note a Citywire column this week warning investors to tread carefully with such investment companies. Ian Cowie, the widely-respected financial journalist, pointed out that “this new feature of the closed-end fund managers’ tool box has not yet been tested by a sharp and sustained downturn in prices”.

He’s right, of course. Clearly, by paying income out of capital gains, investment funds are depriving shareholders of an element of long-term return. The effect may be relatively mild during periods when the portfolio continues growing and provides compensation for what has been withdrawn, but will be significantly more marked when the fund is losing value.

Nevertheless, there are certainly advantages in allowing investment companies to operate in this way. The fact is that investors want and need income – and as more people move into drawdown arrangements with their pension savings, that demand will only increase. Moreover, fund managers argue, being allowed to use capital gains to finance income means they don’t have to focus their portfolios on high-yielding assets, many of which may be over-priced, precisely because the hunt for yield has been so strong.

Such arguments have merit (and Cowie acknowledges them). The debate, then, is really about the extent to which advisers and investors are buying into investment companies paying enhanced yields with their eyes open. Do they understand how the yield is being financed and have they thought about the potential implications in different market conditions?

Investment companies themselves must take some responsibility here. They must be completely transparent about how they’re paying yields and boards should be keeping such practices under regular review. For advisers, meanwhile, the responsibility is to weigh up the potential risks and rewards of enhanced dividends – while there will be many investors for whom this approach is suitable, some will want to steer clear.