Last year did not see the return to ‘normal’ markets that many investors were hoping for, as fears of a global economic slowdown were compounded by troubles in the eurozone.
Global equity markets ended the year more than 5% lower, in sterling terms and, if you look at individual regions or countries, it is easy to paint a far worse picture. So where should investors look in 2012 if they want real income from their investments?
A unique toolkit
The oft-ignored world of investment trusts is a good place to start. Granted, closed-end funds were no more immune from the woes of 2011 than any other investment, but nor should they be. Their remit is the same as most other mutual funds, but they have extra tools at their fingertips such as the use of gearing.
In particular, when investors want income, this is where investment trusts come into their own.
In 2011, the Morningstar Investment Trust All ex VCT Index saw its discount widen out by nearly two percentage points to end the year at more than 14%. While ‘discount’ is an emotive word and causes fear and angst to many, I would argue that discounts can bring opportunities, particularly when a fund is trading at a discount that is wider than has historically been the case, due to negative market sentiment, for example.
Smoothing the way
Contrary to our expectations, the use of investment trusts to smooth out a client’s income needs is still relatively muted. Yet these vehicles offer a great solution to this problem. The fact they can keep back income in the revenue reserve account is a huge plus and means that, in years when the bigger dividends are scarce – 2009 being one such example – they can dip into this account and make sure their shareholders still get that income cheque when they should. It makes for a far easier conversation with clients, rather than having to explain a 25% cut in a fund’s dividend.
Preparing for RDR
There are numerous reasons why financial advisers have been reluctant to embrace investment trusts, but when the Retail Distribution Review comes into force, any who want to retain the badge of independence must consider them.
Not only can investment trusts make use of their revenue reserve account, but as a sector they can offer up a number of alternative sources of income. Let us look specifically at the types of income-producing funds and how they fared last year.
It was a year in which we saw the launch of some income-targeting investment trusts: for example, Henderson International Income and Diverse Income Trust were two new equity funds that were brought to the market. Both started out trading at a premium to their NAV, and Henderson has sustained this (as at 5 Feb, 2012), while Diverse is now at a modest discount.
But it was not just equity funds that were launched last year. There was also Neuberger Berman’s Global Floating Rate Fund and Duet Real Estate Finance which specialises in commercial real estate debt. A change in tax rules in 2009 has made it far more conducive to run a fixed-income investment company and we are starting to see the benefits of this through new trusts coming to the market.
Both funds started out at a premium to their NAV, but in both cases this has reduced. Neuberger Berman is still at a modest premium, but Duet has slipped to a discount. With the latter yielding more than 4%, it is not a fund to be ignored.
Discount potential
There are some core UK equity funds that generate respectable levels of income in the investment trust sector. Furthermore, the pressure on UK equity markets has seen some of these trusts trade at wider-than-average discounts, thus presenting an interesting opportunity for the right investor.
Take Dunedin Income Growth, run by Jeremy Whitley and the Aberdeen pan-European team. This team uses a process in force across the majority of Aberdeen’s equity mandates; it is focused on quality and takes a long-term approach, so there will be times when it is out of favour. The fund’s 12-month average discount is in the region of 2.7% and, at the time of writing, had widened to nearly 4.5%.
This may not seem like much of an opportunity, but it is a fund that trades in a tight range around NAV, so any widening in the discount will potentially give rise to an increase in NAV as the discount tightens, as well as any uplift through market movement. The trust also has a yield of more than 4.5% and a solid track record in paying out that level of income.
Investors need not be wedded to the UK when searching for income. A global income fund is the latest must-have in an asset manager’s fund range.
Disciplined cash flow
In the investment trust sector, it is a long-standing concept. Funds such as British Assets and Scottish American have been around since the 19th century and both currently yield in the region of 4%. Such funds tend to trade in a fairly tight range around their NAV and quite often at a premium, in recognition of the value of that income predictability. But that does not mean opportunities do not arise to buy in at a discount. Sometimes, though, that assurance of income is worth paying extra for.
As well as global equity funds, the investment trust sector has several regional income funds, such as Aberdeen Asian Income and JPMorgan Global Emerging Markets Income. Then there are more specialist funds such as BlackRock Commodities Income.
While many might see these as contrarian ideas, I would argue they are just as viable as the mainstream funds, as long as they are used well. Others might argue they are high risk in nature, but the very fact emerging-market countries are seeing more companies pay dividends, means we are seeing more firms use their cash flow in a better and more disciplined way than was the case before. This in turn reduces the overall risk within the fund as the companies tend to be established with good if not outstanding corporate governance.
Olympic spirit
To end on a lighter note, I have one final contrarian idea to share and that is O Twelve Estates. This investment company was set up in 2006 to invest in property redevelopment as a result of London hosting the 2012 Olympics, which means this year is key. The fund currently trades at a discount to its NAV of more than 52%, on a fair value basis.
If you believe the Olympics will bring significant redevelopment and associated economic benefits, and that we can meet the looming deadlines for much of this work, then take a look at the fund.
Investment trusts undoubtedly have a strong role to play in portfolios. It remains to be seen how much advisers will embrace them, but the benefits are clear and the steady income cannot be ignored any more.
PA Summary
- Investment trusts were hit by the problems of 2011 as much as their open-ended peers, but are possibly better placed now the recovery is starting.
- For income investors, playing with the discount/premium to NAV can yield opportunities that mutual funds cannot.
- Gearing and the use of reserve cash accounts are among the specific advantages investment trusts have that investors can no longer ignore.
