Sails trimmed for growth: Unit trusts that have faced the recession could prosper, writes Christine Stopp

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WITH building society rates falling sharply, some investors are looking at equity income unit trusts as an alternative investment.

Average yields are around 5 per cent gross, so these trusts are beginning to look competitive. However, an income fund is designed to produce growth as well as return, and there are circumstances in which the fund manager may put growth first, thereby sacrificing pay-outs.

A large number of trusts have cut back on distributions during the recession because of dividend cuts made by the companies in their portfolio.

Peter Edwards, of the Bristol unit trust brokers Premier, publishes an annual income fund survey, which currently follows 185 funds. In 1981, during the last recession, 54 per cent of trusts cut dividends. In 1991 a fifth of funds saw cuts and in 1992 the figure rose to 40 per cent, though the figures suggest that these cuts may have peaked in the first quarter of this year. Between April and October about a third of funds made cuts - which is still tough, though it means that the majority of funds are still increasing dividends.

Though it may be bad news for the income investor, reducing distribution during a recessionary period is welcomed by fund analysts, since it suggests that the managers are prepared to protect the fund by reducing the pay-out rather than maintaining it at all costs. Maintaining dividends - a practice which has been championed by M&G - has become a 'virility symbol' according to Mr Edwards. While it may be impressive in the short-term, protecting pay-outs can be detrimental to the fund if it entails techniques that reduce capital growth.

A manager can, for instance, 'buy income' by repeatedly purchasing shares cum dividend. This reduces growth because the companies have been chosen purely on the basis of the dividend they pay and because of dealing costs. Second, putting more of the portfolio into 'high-yielding rubbish' - stocks which pay a high dividend but which are in a poor state - increases the risk associated with the fund.

A manager can also increase exposure to fixed-interest stock such as gilts, preference shares and convertibles. These offer a high, fixed return but not nearly so much potential capital growth as ordinary shares.

Fund Research, a company which analyses fund performance, is optimistic about prospects for dividend growth during 1993 among the funds whose managers 'have forsaken maximum income in order to optimise total return'.

Though the market may see many more dividend cuts before the recession is over, the best fund managers, says Peter Jeffreys of Fund Research, 'have already adjusted their portfolios to this reality and cut distributions accordingly'.

The table, which looks at some of the best-performing funds followed by Fund Research, shows that only one has been able to avoid making dividend cuts in the past two years.

Robert Shelton, the fund manager of Newton Income, is clear about its priorities. Capital maintenance comes before dividend 'because it is that capital block which is going to produce income for the future'.

If he feels a stock is overvalued he will sell it cum dividend and lose the payment. He also likes stocks with high dividend cover and a consequently lower yield. Mr Newton made a dividend cut early in the recession and feels that a further cut next year is unlikely.

Another fund which took a tough line early on is Buckmaster Income. Bill Mott, the fund's manager, took the view at the start of the recession that the UK economy was in for a hard time. His strategy was to divide the portfolio into a high- yielding block made up of convertibles and utilities and a lower-yielding section of growth stocks. The plan was so successful that the fund has not cut distributions and its last interim pay-out was up by a third.

While M&G will 'do its damnedest' not to cut distributions on income trusts, Save & Prosper has made cuts and does not rule out more in the future. Simon Walters, S&P's investment director, warns that recovery may be slow to affect the cyclical stocks, which are the traditional recourse of the income fund manager. Even if capital values go up, income growth could be slow to follow. The fund's annual management charge - a percentage of the growing capital value - must come out of its dividend income, which may stay the same or even be reduced. This will put further pressure on distributions.

On the whole, fund managers seem to expect stock market growth in 1993 but are wary of making exaggerated predictions. It is clear that there will be more distribution cuts, though they are unlikely among the better-managed funds. All managers made the point that a unit trust is not a good investment for money which may be needed quickly or for those who must have a dependable high income.