The ISAs have it: Finding income in investment trusts

F&C’s Mike Woodward looks at how income-seeking investors can find a range of attractive ISA opportunities within the investment trust sector.

With the deadline for using up the 2010/11 ISA allowance rapidly approaching, anecdotal evidence suggests investors are more keen than ever on investments that can generate an income.

The Holy Grail for many investors will be an investment that both produces a respectable yield and offers the potential for capital growth to outstrip inflation. Such opportunities rarely come without risk to capital, but as long as they are comfortable with this risk, income investors can find a wealth of ISA choices in the investment trust sector.

Income at home and abroad

Equity income funds abound in the open-ended space, with the five biggest funds alone in the IMA UK Equity Income sector accounting for some £28bn of assets. But while open-ended funds might be the default option (the assets of all the investment trusts in the AIC’s UK Growth & Income and UK High Income sectors added together do not even reach £7bn), research produced last year by Winterflood Securities suggests equity income investment trusts have consistently outperformed both their open-ended cousins and the FTSE All-Share over the long term.

And of course the UK is far from the only option for income seekers. Investment trusts have a long history of finding income from around the world – four of the six trusts in the Global Growth & Income sector are more than 100 years old. Many of the most recent launches also have an international income focus, with trusts coming to the market in 2010 aiming to capture an income from Latin America and global emerging markets.

Income is a very important element of the total return from equities. The latest edition of the Barclays Capital Equity Gilt Study shows that while the real (post-inflation) value of £100 invested in UK equities in 1899 without dividends reinvested would have been £180 at the end of 2010, the reinvestment of gross dividends would have boosted this to an astonishing £24,133. So for investors who do not have an ongoing need to take an income from their investments, a portfolio of higher-yielding equities could have considerable benefits.

Dividend cuts

The Barclays Capital study also looks at dividend growth trends, and shows a big fall in dividend growth between 2008 and 2010, leading to a five-year average dividend growth rate of just 1.3% in the UK. Since the onset of the financial crisis in 2007, income investors have been hit by dividend cuts first from the banks, and then in 2010 from BP as a result of the cost of the Gulf of Mexico oil spill.

In times of significant dividend cuts like these, some investment trusts are able to keep up payouts to their investors because they operate a revenue reserve. While open-ended funds are required to pass on dividends from holdings to their investors each year, investment trusts can choose to keep back some of the income they receive in the good years to bolster dividend payments in the bad. So while income returns from open-ended UK equity income funds fell sharply in 2010, many investment trusts were able to maintain their payouts by dipping into their revenue reserves.

ISA allowance

It would take a very public-spirited individual to volunteer to pay more tax than was necessary. But investors who hold assets elsewhere while not making full use of their ISA allowance may be doing just that. (Obviously in the case of pensions there is a trade-off between the upfront tax relief and the taxable eventual return, which may be more attractive if the investor is in a lower tax bracket post-retirement.)

With the introduction of a 50% tax bracket for the highest earners, the lowering of the threshold at which 40% tax is payable and the withdrawal of Child Benefit from families where either parent is a higher-rate taxpayer, the opportunity to claw something back from the taxman is not to be missed.

Investment trusts can even offer something extra for investors who have maxed out their ISA allowance for this year and next. Zero-dividend preference shares (ZDPs or zeros) pay no income during their lifetime and produce a capital return at maturity, which will be free of tax as long as the investor remains below the capital gains tax threshold for the year. And the innovative ‘B’ shares of Investors Capital Trust pay a capital distribution equal to the dividends on the trust’s ‘A’ shares, which again is taxable under the CGT regime, and only when the shares are eventually sold.