In simple terms, this allows funds to set aside earned income in good years, in order to maintain or grow its dividend to shareholders in years when income falls short.
A good tax change
This year has seen a change in the tax rules for investment trusts. Going forward, onshore investment trusts will be allowed to distribute capital to shareholders. This brings them into line with offshore domiciled trusts that can already do this. Investors who have enjoyed the high level of dividend income from many of the listed property funds will have received dividends that in many cases have been essentially funded from capital gains.
The situation presents a number of interesting opportunities for investment trusts, but also challenges for those looking to invest in the sector.
The main opportunity is for more esoteric asset classes. Take for instance, private equity. Many of these trusts do not pay any dividends, given the majority of their returns are earned through revaluations, sales or public listing of their underlying companies. This is treated as being a capital gain, and has not been available to be distributed to shareholders.
Under the new rules, capital gains could be distributed. This could be doubly beneficial to investors in the private equity sector, where many companies trade on significant discounts.
With yield being a big requirement for many investors today, the change in regulation could allow private equity funds to pay a ‘capital’ dividend. If this was accompanied by some kind of statement announcing the intention to return capital to investors in the event of successful asset sales, the companies could see the wide discounts to Net Asset Value at which they trade narrow sharply.
Revenue reserve
This could be particularly useful for trusts such as Electra, which has performed excellently in recent years, made some very well timed asset purchases and sales, but still languishes on a 26% discount to its NAV. Electra’s slightly complicated balance sheet could preclude significant distributions of its capital gains but we think the potential is there for it and a number of its peers to narrow their discount through sharing their gains with shareholders.
A revenue reserve is not a pot of cash, it is an accounting concept. Use of one is a distribution of capital, irrespective of what the accounts say. Investors should still look unfavourably on mainstream equity trusts that pay income out of capital on a persistent basis. The income cart should not be put before the investment process horse, in our opinion.
Any number of academic studies demonstrates that long-term investment returns are mainly earned through the reinvestment of earned income, a point lost in much of the current rash of income-oriented fund and trust launches.
The best trust managers such as Mark Barnett (Invesco Perpetual) or Bruce Stout (Aberdeen Asset Management) have produced strong dividend growth records without distributing capital gains, and their track record demonstrates their long-term quality.
For private client portfolios, we think it presents an interesting opportunity. Ultimately the focus should be on buying long-term quality assets, but trusts such as Alliance Trust or 3i, both in the news at the moment, could be seen as being ripe for a large dividend distribution in order to assuage large dissatisfied shareholders.
And for clients for whom turning capital into income is a necessity or at least helpful, onshore and offshore investment companies meet that need quite nicely.
