Putting your trust in dividend income is risky

Fed up with the paltry returns from your savings account?

It could be time to consider investment trusts, according to Ian Overgage, of the Association of Investment Companies. He is, of course, paid to promote such trusts, but there are figures to support his argument that income from investment trusts, paid out through annual dividends, is a real alternative while interest rates remain at record lows. The most impressive statistic is that some 15 investment trusts have increased their annual dividend payout every year for the past 26 years. The City of London Investment Trust has even increased dividends every year since 1966. That sounds ideal for those wanting a regular, rising income.

Meanwhile, research from Foreign & Colonial Investment Trust – which has increased dividends for the past 40 years – shows that annual returns have averaged out at about 6 per cent over the past 12 years, which is not too shabby. "There is no doubt, in a downturn, that the revenue reserves of some established trusts will be a benefit," says Peter Hewitt, the manager of the F&C Managed Portfolio Trust. "Most trusts have avoided having to cut dividends, either by having strong reserves or a big overseas component to their income. The result is a pretty secure dividend, or even dividend increases in some cases."

But before rushing to sign up, you must understand the risks of investment trusts, which can be high. The trusts are actually companies which have shares traded on the stock market and, like all shares, they can slump in value. The trusts actually invest in other shares or assets, just like unit trusts. But they have one key difference: the amount the trust managers have to invest is fixed, according to how much cash was raised in the initial share issue. With unit trusts, if there are more investors keen to join the party,the trust can simply issue new units. Does that make investment trusts better? Not really, says Nick McBreen, of Worldwide Financial Planning. "You are trying to compare apples and pears," he says. "But it is quite remarkable that if you look at the returns from the income and growth from investment trusts, it is an extraordinary dislocation between them and unit trusts."

He points to a study from Winterflood Securities which shows that investment trusts outperformed unit trusts over the past decade. "The group compared eight investment trust sectors with their equivalent fund sectors over 10 years, and investment trusts came out on top every time, except for the Japan sector," says McBreen.

The report suggests investment trusts tend to outperform in rising markets because they make better use of currency, have more flexibility with gearing and because they can offer the opportunity to get in at a discount to the company's net asset value.

"But investors need to understand what the risks are with investment trusts," warns McBreen. "Gearing, for instance, is a major issue, but so is the fact that many trusts trade at a discount to their value." To explain, trading at a discount is when the share price of an investment trust is less than the assets it holds. That can be a problem when you come to sell, so it is important to understand the concept, or what it means when trusts trade at a premium, which is currently the case with Fidelity's popular China Special Situations fund, the highest-profile investment trust to launch this year.

Gearing is when investment companies borrow money. That is perfectly acceptable, but the more highly geared a trust is, the more it will have to meet interest repayments out of its funds, which can hit dividends. Despite that, the dividend story is interesting. How can trusts increase dividends for decades? "The structure of investment companies allows them to build up a revenue reserve from the dividends they receive from their underlying holdings," says Overgage. "This can be very attractive to investors who are searching for regular income, particularly when economic times are tough. Even though underlying interest rates are low, investment companies still have the ability to sustain their dividends."

*You can find out a lot more about investment trusts at www.theaic.co.uk.