As we near a new financial year, Ian Cowie explores the advantages of investment companies when it comes to paying income.
Investment company shareholders seeking rising and sustainable income enjoy important advantages over those in every other form of pooled funds. Dividends - or the income paid by shares - delivered most of the real returns from the stock market over the last century, so investment trusts’ income advantages are very valuable.
This is a good time to consider them as we near the end of the financial year, at midnight on April 5, when annual tax allowances for individual savings accounts (ISAs) and pensions will expire. It really is a case of use these allowances or lose them.
The main income advantage that investment companies have over all other pooled funds is the ability to smooth out some of the shocks of the stock market, such as the risk that share prices may fall and dividends can be cut or cancelled. Investment companies are allowed to retain or hold back up to 15% of returns in good years to top up payouts to shareholders in bad years.
This ability to sustain dividend distributions during difficult times is very important to people who may be relying on income from their investments to pay for the cost of living, such as pensioners. That’s a big advantage in practice; there is nothing theoretical about this.
No fewer than 20 investment companies have raised their dividends for more than 20 consecutive years. So these companies kept increasing the income they paid to shareholders throughout stock market setbacks that included the dotcom crash of 2000, the FTSE 100 index of Britain’s biggest shares losing nearly 50% of its value in 2003, and the global credit crisis that began in 2008.
Even more remarkably, four investment companies have raised their dividends for 50 consecutive years or more. So their shareholders enjoyed rising income throughout a half-century that included a couple of oil crises, the three-day week when industrial disputes forced Britain to work part-time and, more recently, wars in the Falklands and Iraq.
You can find a complete list of these dividend heroes, plus another 21 investment companies that have increased dividends for more than a decade but less than 20 years - sometimes called the next generation of dividend heroes - at the Association of Investment Companies’ website; theaic.co.uk
That’s also where you can see other important information for income-seekers. For example, if you click on ‘Find and compare investment companies’ and then select an AIC sector, the column on the far right of the table will show you each company’s dividend yield - or the income it pays expressed as a percentage of its current share price.
The next column along to the left, headed ‘5 year dividend growth (%) p.a.’ will show you how much these payouts have grown during that period. While the past is not necessarily a guide to the future, this may be useful to people considering whether there is a history of rising income.
If you click on the name of an individual investment company, you will see more information about income payments. The table headed ‘Dividends’ will show you the dates and cash value of recent distributions, which might be important for people seeking quarterly rather than half-yearly income.
This table also tells you how these dividends were funded - for example, whether they were generated by income or capital gains. Investment companies can boost income payments from capital growth in their underlying portfolio but it is important to understand that these enhanced dividends will reduce capital growth and may reduce total returns.
You can also see ‘Dividend cover (years)’ and ‘Revenue reserves (m)’. The latter shows the cash value of reserves - or returns being retained to smooth distributions in future - and the former shows how many years dividends at the current rate could be sustained from those reserves.
I find this free information invaluable when making my annual Isa selection and allocating assets within my self-invested personal pension (SIPP). The discipline of dividends or keeping an eye on income can help investors cope with the inherent volatility of stock markets. Share prices may fall without warning but decent dividends or - better still - a rising stream of income can pay us to be patient.