The definition of an income fund is one that consistently pays a dividend that is 120 per cent higher than the notional yield on the FTSE All Share index.
Today, in a low-inflation, low-yield environment this implies a fund that pays out 2.8 per cent or more. But income seekers want higher returns than this.
There are investment trusts that will meet this demand, albeit at some risk. Very high returns are now available, often over 8 per cent, with what are known as split- income trusts but only to investors who are prepared to some risks.
Originally, income investors were limited to conventional funds that invested in a mix of ordinary shares and gilts. Because investment trusts can borrow money to invest in the market, if the managers thought that prospects were good, called gearing, they could take a chance, raise funds and invest the proceeds to get a higher return.
As most trusts traded at a discount, this meant that the investor could get a higher income. "Let's assume an investment trust is on a 10 per cent discount, that is, its market price trades at 10 per cent below its net asset value," says Alex Gowans of Edinburgh Fund Managers, which recently launched a new split trust, the Edinburgh Income and Value Trust. "This means that if the underlying portfolio on average yields 3 per cent, the investor will get 3.3 per cent for his or her investment." But this level of dividend yield will not satisfy high income seekers. They want an immediate payback. So the split-capital trust was invented. This can be a complicated animal but at its simplest,will be a fund that has a finite life with the proceeds being distributed to its investors when it reaches the end of its term.
The holders of split-capital shares get no dividends, receive all the growth, assuming there has been some, while income holders benefit from a high yield during its lifetime and, hopefully, get their capital back.
"During the life of the trust, if the underlying portfolio can yield 3 per cent and the trust is split 50/50 between income and capital shares, with all the income going to the split-income share-holders, they will receive 6 per cent a year," explains Mr Gowans. "The growth in the value of assets will be used in the first place to return their capital and secondly to pay out the split-capital share-holders."
The Edinburgh Income & Value, for example, launched three months ago has a five-year life. It has several classes of shares and significant borrowings with gearing of 53 per cent. The pounds 58 million trust is largely invested in high-yielding ordinary shares of small and medium sized companies.
Their average yield is around 6 per cent, so the split-income holder will receive a highly competitive 9.6 per cent. Although early days, performance since launch has been good, the net asset value has risen to 126p per shares while the price in the market has gone up from the 96p launch price.
"Investment trusts, if they trade at a discount, will give the investor more assets for their money. Pick the right fund, where the discount will narrow, and this can be a big advantage over other types of managed investments," says Roddy Kohn, of Kohn Cougar, a Bristol-based firm of independent financial advisers (IFAs).
However, investors have to be aware there could be capital erosion if the manager doesn't perform."
Because investment trusts are traded on the stock market, they tend to be more volatile than unit trusts. "A safer way of generating a high income may be to invest in a fund such as Exeter High Income," says Kim North, of Pretty Financial, a London-based firm of IFAs. "This is a fund of funds, so you can leave it to the manager to choose the right investment trusts commensurate with risk."
Looking at conventional investment trusts, most advisers feel that high income seekers would be better off investing elsewhere. For example, Jason Hollands of BESt Investments, a firm which offers a free telephone-based independent advice service, says: "I have always liked City Merchants High Yield. It has shown good capital growth as well as yielding over 6.5 per cent today. But as it currently trades at a 10 per cent premium, that is above net asset value, there's better value elsewhere."
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YOUR CHOICE: THE PICK OF INVESTMENT OPPORTUNITIES
RODDY KOHN of Kohn Cougar, plumps for City of London, which has a small discount currently yielding about 2.5 per cent and boasts an unbrokenrecord of rising dividends since the 1960s; and Perpetual Income & Growth on an 8 per cent discount, for those after-total returns (income and growth). For split-income trusts, he likes Fleming Income & Growth, which closes in 2006, with a near 6.4 per cent yield.
Among conventional trusts, Kim North, of Pretty Financial,opts for City of London and Aberdeen High Income, currently yielding over 7 per cent. Of the split income, she chooses the Fleming trust, M&G Income Geared and Exeter High Income unit trust, which invests in split-investment trusts and which yields over 6.7 per cent.
Jason Hollands, of BESt Investments, feels that the best income trusts, such as City of London, are now overpriced. If forced to pick a split- income fund, he opts for "the cautiously managed" Murray Global Return. At present it yields over 8 per cent with a hurdle rate of around 3.5 per cent.
Ian Millward, of Chase de Vere, is another adviser loathe to recommend investment trusts to income seekers. Of the recent split-income launches, Henderson Geared Income & Growth and Framlington Second Dual trusts, both with yields in excess of 9 per cent and around 5 per cent hurdle rates, could be attractive prospects for sophisticated investors who understand the risks.
For details call Kohn Cougar on 0117-946 6384; Pretty Financial 0171- 377 5754; BESt Investments 0171-321 0100; Chase de Vere 01225-469 371Reuse content