The right to reserve

As the impacts on savers and investors of the Covid-19 pandemic continue to mount up, many of the arguments about the differences between open-ended funds and investment companies have never seemed more relevant. The debate about the merits of different fund structures and operating practices once seemed dry and academic; now it is really beginning to bite.

We’ve seen yet another example of this in recent days with the Investment Association’s announcement that it is suspending the yield rules for open-ended equity income funds. To be eligible for the equity income sector, open-ended funds must have a track record of paying at least a certain level of income, but with so many companies cancelling their dividends amid the Covid-19 crisis, the IA is understandably concerned that many funds could fall short. It is therefore dropping the usual yield eligibility criteria for 12 months to help funds through these remarkable times.

That seems perfectly sensible, but investors and their advisers should not lose sight of the implication here. It is that the IA expects many equity income funds to significantly reduce pay-outs because of the Covid-19 pandemic; for investors relying on this source of yield, that could be hugely problematic.

That brings us back to the conversation about fund structure. Investment companies surveying the fractured market landscape and fretting about maintaining income distributions have an inbuilt advantage here. Unlike open-ended funds, they have the right to build up dividend reserve funds, banking some of their dividends when times are good in order to sustain pay-outs to shareholders when the pickings are slimmer.

It is this structural difference that underpins the record of the investment company industry’s widely-admired dividend heroes; these funds have increased their dividends every year for decades – more than five decades in the case of the most enduring cases.

City of London, one of the best-known dividend heroes, has already said it will increase its dividend as usual in July. There is every reason to think most of its counterparts will follow suit, with Investec Securities analysis published earlier this month suggesting the dividend heroes all have enough in reserve to sustain higher pay-outs despite the collapse in dividend payments from the companies in their portfolios.

Investors have already taken note. There are around 10 investment companies that have increased their dividends every year for 40 years or more. All of them have moved to more expensive valuations in recent weeks, with their shares moving on to a premium to the value of their underlying assets or at least to a smaller discount.

Analysis published in recent days by Numis suggests these valuation shifts can be traced directly to the desire of investors to secure exposure to dependable sources of income during these uncertain times. No wonder: it expects “numerous investment trusts to be keen to continue their records of multi-decade years of consecutive dividend [increases]”. This, after all, is what the rainy-day cash squirrelled away in dividend reserve accounts is intended for.

None of which is to criticise open-ended funds now struggling to maintain their yields at traditional levels. It is simply an observation that fund structures really do matter. When the sun is shining – and we have seen a series of bumper years for dividend pay-outs in the UK and globally – it’s easy to lose sight of such technicalities. It’s when the bad weather set in that we count our blessings.