Two of Kepler’s analysts discuss the growing trend for companies to pay an income out of capital…
Robbing Peter to pay Paul?
Thomas McMahon: Paying out of capital erodes one of the major advantages of the closed‐ended structure
The boards and managers of investment trusts rightly draw attention to the greater security of income which the closed‐ended structure can bring. Investment trusts can hold back current year income in a dividend reserve to use in future years; unlike open‐ended funds which are obliged to pass on lower dividends in any year where they receive lower income from their investments. Aware of how attractive this feature is, trust boards will go to significant lengths to maintain their dividend even through the lean years. I worry, however, that paying dividends out of capital is a step too far, and over the long run risks eroding one of the other key advantages the sector holds.
Investment trusts tend to outperform open‐ended funds on a total return basis. In my view, the main reason is that the managers can focus on buying and selling the investments they want to, without having to manage a cash balance in order to be prepared for potential or actual outflows. This means that cash drag is reduced, so net asset value (NAV) is a fairer and purer reflection of the manager’s stock picking. Furthermore, it means that managers can invest in more illiquid investments and reap the higher returns without having to worry that they will need to sell at a bad time; or that their illiquid weighting could increase if they have to sell more liquid stocks to fund redemptions.
As soon as a manager knows they might have to pay a dividend out of capital this advantage starts to be eroded; and they have to start thinking about what to sell and what their portfolio will look like afterwards. Any extended period of market drawdown could lead to a bunching of the portfolio in less liquid stocks (unless fewer are in the portfolio to start with). This is obviously likely to be a problem for managers who invest more into small caps and less liquid countries, such as the smaller emerging markets. But even for those managers investing in large caps, there will be at least some cash drag and some distraction of the manager from their main task.
Another issue which could emerge in a major drawdown is that the board might feel constrained to maintain a dividend by paying out of capital even after its reserves have been run down to zero. In this event, selling investments into a weak market would require potentially taking a bad price, thus eroding the capital base further. This would accelerate any decline in total return as well as increasing ongoing charges. A trust paying a natural income would have the automatic circuit breaker of its income account falling and revenue reserves running out, which would clearly necessitate a dividend cut. Unappealing as this might seem, it would arguably be the better policy in the circumstances. In my view, therefore, the more sensible policy for long‐term investors is to manage revenue reserves prudently.
William Heathcoat Amory: It is irrational to prefer one source of funds over the other
Money is money, wherever it comes from, and I have never yet been asked whether I want to pay a bill in capital gains or income. This seemingly facile point gets to the heart of the issue: other than on tax grounds, it is irrational to prefer income over capital gains or vice versa. [Note that while personal tax drivers are obviously important, they are beyond the scope of this discussion, so we’ll focus only on the underlying question.]
Taking capital gains as a dividend reduces the amount that you reinvest each year, and this will reduce your total return over the long run. However, the same is also true if you choose to take your dividend rather than reinvest it. So I don’t think this is a valid argument against taking dividends from capital. In fact, paying out of capital can have major advantages, chiefly with regard to diversification.
A manager who knows that a trust’s dividend can be paid out of capital has greater freedom when it comes to picking stocks. This means they are not constrained to high dividend‐paying stocks and sectors, which is a particular advantage given recent market dynamics. Traditionally the areas equity income managers focus on are by definition ‘value’ sectors – energy, materials and financials in particular. All have been under pressure in recent years, and there are good reasons to think this pressure will continue if not increase. The long‐term underperformance of value over growth is inextricably linked with the travails of these sectors. In the case of financials, the global economy seems incapable of coping with rates even at the 3% level which the US Federal Reserve has been forecasting would be the ‘new normal’ for years. In the case of energy and materials, the challenges of climate change mean that the long‐term viability of certain businesses is in question.
So a manager who has to rely on dividends from portfolio companies is stuck with a difficult choice. Either promise lower dividends, and maybe eat away at revenue reserves until they are gone, or invest in higher‐yielding sectors with potentially poorer long‐term prospects. In this light, the question about reducing total return potential becomes clearer: if the cost of not taking capital out to pay dividends is to remain invested in businesses with poor long‐term growth prospects, then paying out of capital seems wiser.
I am not saying that traditional equity income is dead: far from it. But I do think that using trusts which pay dividends from capital can add valuable diversification to an income portfolio. For example, International Biotechnology Trust (IBT) offers an income from a portfolio invested in high growth biotechnology stocks, which have strong long‐term secular trends behind them, along with minimal dividend yields. JPMorgan Asia Growth & Income (JAGI) pays a dividend largely out of capital and uses the freedom to invest heavily in technology and consumer discretionary stocks in Asia; some of which don’t pay dividends but have generated extremely attractive returns. JPMorgan Global Growth & Income (JGGI) is also unconstrained by yield requirements when it comes to stockpicking in the MSCI AC World Index. Last year Aberdeen Japan committed to raising its dividend significantly and paying out of capital when necessary. It thereby gains a considerable yield pickup even while investing in a traditionally low‐yielding market.
Another side‐benefit of paying dividends out of capital is that time and again it has proved to reduce both discounts and discount volatility; for some investors, in particular those who prefer to take an income, these factors can be a drawback of investing in trusts.
These views are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees