Special Report on Investment Trusts (5): Careful selection can pay dividends: As interest rates fall, cash deposits earn less. Rupert Bruce looks at the high income trusts

MANY of the investment trusts launched during the industry's renaissance of the last few years have performed dismally. But now, some analysts expect the best of them to pick up, at least in the short-term, and beat the stock market.

Most of the trusts launched in recent times have had a stated objective of high income. But during the recession they have, almost by definition, had poor capital performance. That is because many of the high income shares they have bought have been those that were likely to cut their dividends. And, when a dividend is cut, the share price tends to fall.

Now Jerry Evans, UK equity strategist at NatWest Securities, thinks the prospects for the best of the high income investment trusts may be about to improve. 'If you have a good fund manager I think the high yield investment trusts can be some of the best performers in 1993,' said Mr Evans.

His faith in these high income investment trusts goes hand in hand with expectations of a sustained economic recovery. If this is the case, many of the high income shares should do well because, with the exception of utilities, they tend to be the most sensitive to economic conditions.

He expects a further boost to performance because some shares have higher income yields than those earned by putting cash on deposit. That should encourage investors to buy these shares and push up their capital value.

'The main proviso I would make is that the fund managers have to be selective and make sure they buy the shares that will definitely not cut their dividend,' he said.

The poor performance of Merchants Trust, managed by Kleinwort Benson, is representative of many high income trusts during 1992, according to Robin Angus, a senior investment trust analyst at NatWest Securities. It has an income yield of just over 6 per cent, but its capital value climbed by only 11 per cent in 1992. Meanwhile the FTA All-Share broad stock market index rose by 14.8 per cent. The trust's annual report and accounts published in January 1992 revealed that its largest holding was British Petroleum. A few months later the oil giant cut its dividend and the share price fell sharply.

But, while some of the straightforward high income investment trusts may be about to perform well, problems are far from over for many recently launched split capital investment trusts. Like the normal high income trusts, they need to invest in shares with a high income. Unlike them, however, any poor capital performance is exaggerated by the capital structure of these trusts.

The simplest of these trusts have two classes of capital. The zero dividend preference share should steadily appreciate in capital value each year until it reaches a predetermined level on a predetermined date. The so-called ordinary income share gets all the income from the trust's portfolio, but only has rights to capital once the zero has been paid off in full. A few years of disappointing dividends and poor capital performance have created, in the very worst cases, doubt over whether the zeros can be paid fully. In many more cases, however, surprised income share investors are sitting on hefty capital losses.

Michael Woodward, investment director at Ivory & Sime, believes that if straightforward high income trusts do have a period of outperformance, it will be short term. He said: 'At the end of the day we firmly believe that it is dividend growth that drives investment performance in the long term. And dividend growth does not come from high yielding stocks . . .

'I would think that the investment trust industry will think again before going on such a binge in these things.'