FOOL'S EYE VIEW
Investing for Income

By James Carlisle
March 1, 2002

The Motley Fool, amongst others, is frequently pointing out that the stock market is the best place to grow your money over the long term. That's how it's worked out in history and there's no reason to suppose it'll change. So you grow your money in the stock market and then, one day (or over a period of a few years), you reach retirement and reckon that you need your investments to produce some income for you to live on.

The conventional approach is to increase the level of gilts or corporate bonds in your portfolio, but there are a couple of problems with this. With corporate bonds there's a risk of the companies going bust, so you really need a spread of them and, for most people, that means a fund of sorts. Funds mean charges and that tends to wipe out the extra income that you were aiming for. If you stick with gilts, then you're also stuck with a fixed long-term yield of 5%. Ten or twenty years down the line, that income might not be worth very much.

So, if we're hoping for a long retirement and we want a long-term income that can grow along with inflation and economic growth, then we're back to shares. Unfortunately, though, some of the traditional approaches aren't too good at producing an income. The FTSE All Share index yields just 3% (a couple of years ago it was more like 2.3%) and, if you take a typical index tracker's charges of 0.5% away from this, you're not left with much of an income. The same goes for a portfolio of directly-held shares, assuming they're spread across the market.

Of course, the reason that these investments yield just 3% today is that investors expect them to produce capital (and income) growth so, on that basis, you could supplement your income by selling a small chunk of your portfolio each year. That, however is a dangerous game to play. It's the opposite of 'pound cost averaging': just as regularly adding capital to your portfolio reduces risk, regularly removing capital from your portfolio increases risk. In bad years, taking out the same amount as before puts a bigger hole in the portfolio.

High yield portfolio

One solution to this is to use a long-term portfolio of 'high-yield' shares. The theory goes that they should have lower long-term growth prospects to compensate (though some would dispute that). On the whole, though, they can at least be expected to grow along with the economy. The trick is probably not to be too greedy. If you see a dividend yield that's much above the yield on long-dated gilts (currently 5%), then it's an indication that the market expects the dividend to be cut.

A suggestion for a long-term income portfolio is to focus your thoughts entirely on the income that the shares, and the overall portfolio generate. Instead of being concerned if a share price has been sliding over the last year, be concerned if there's reason to suppose that its dividend might not grow. Instead of being concerned if your portfolio's value falls over a year, be concerned if there's reason to suppose that the overall dividend income might not increase. Instead of being concerned that a particular share is accounting for a large percentage of the capital value of your portfolio, be concerned if it starts to account for too much of its income.

Stephen Bland, aka TMFPyad, has set up a hypothetical high-yield portfolio as a basis for discussion of this type of approach and the latest article about it is here. The discussion takes place on the sensibly-named High-Yield Portfolio discussion board.

Investment trusts

Many people, however, are not keen on investing in direct shares. A solution for them may be investment trusts. These have several advantages over unit trusts, mostly relating back to the fact that they are actually companies and have to do things for the long-term benefit of their shareholders (that's you by the way, if you invest in an investment trust). This means that they can't advertise and cost savings from this and elsewhere has meant that they've typically outperformed unit trusts over the years.

It gets better still for the really big (generally long-standing) investment trusts. Again because they're companies, they're obliged to pass to their shareholders the benefits of any economies of scale in the costs of managing them. So, the bigger they get, the smaller their charges tend to get as a percentage of your money. The largest investment trusts therefore tend to have 'total expense ratios' well below 1%, comparing favourably even with index trackers.

For income, however, investment trusts have a further string to their bow, and that comes from their 'discount'. Take an investment trust that has investments (less debts) of £500m (called its net asset value or NAV) and 500m shares. That would give it NAV per share of 100p. However, the shares might typically trade at 95p. That would give the trust a 'discount' of 5%.

As far as the capital value of your investment is concerned, you should probably ignore the discount. You might buy your investments for a discount of 5%, but you should probably also work on the basis that the discount of 5% will still be there when the time comes to sell. Overall, that would have no effect on your expected rate of return.

Imagine, however, a basket of shares, worth £10,000, that provides a dividend yield of 5%. You could by the shares directly yourself, paying £10,000, and collect your £500 per year income. Alternatively, you could buy the same basket of shares in an investment trust, at a discount of 5%. So you pay up £9,500, but still get your £500 income (we're ignoring costs for the time being). That amounts to a dividend yield of 5.26% - a useful improvement on buying the shares directly.

Of course, you then have to knock off the charges. On the whole, these will be greater than the 0.26% advantage that you get because of the discount. However, the fact that the discount at least wipes out a part of your (already low) charges might sneak them ahead of index trackers on the charges front and they're providing you with that nice yield that you wanted.

Choosing high yield investment trusts

To get the benefit of all this, then, you want an investment trust that:

(a) has a nice dividend yield (but not too nice because, as with shares, much more than 5% would be an indication that the market doesn't think it's sustainable);

(b) is nice and big, so that it has a low total expense ratio; and

(c) has a decent discount.

The place to start for this information is the Association of Investment Trust Companies (AITC) Monthly Information Service, available on its website. The sectors to look at are Global Growth and Income, Global High Income, UK Growth & Income and UK High Income sectors (although for the global funds, you should also think about the geographical weightings).

I would tend to stick to the 'conventional and packaged units' segments for each sector, ignoring the 'packaged units'. These are created by combining the different segments of split capital trusts. To me, they lack transparency and you'd expect them to have higher charges anyway. The AITC doesn't give figures for the total expense ratios, but you can get these from the FT Fund Ratings service. The trawl I did came up with the following:

Trust              Total  Dividend  Discount    Total
                  Assets     Yield         %  Expense
                     £'m         %              Ratio
                                                    %
British Assets       662       3.9       6.1     0.80
City of London       543       3.5       5.5     0.47
Merchants            536       4.3       4.9     0.62

I should stress that these aren't recommendations, just the funds that seem to fit the criteria. Before investing in an investment trust, just as with any company, you'd want to look at the annual accounts to see how it spends its (your) money and check that you're happy with the investment philosophy. You could also see the largest holdings and see that you're happy with them (the information is on Trustnet as well as the annual accounts). For the above three trusts, the largest shareholdings are as follows:

    British Assets       City of London            Merchants
GlaxoS'Kline  5.1%   GlaxoS'Kline  6.1%   BP            7.5%
BP            4.7%   BP            6.0%   Shell         5.0%
Vodafone      4.5%   Shell         5.2%   GlaxoS'Kline  4.6%
Shell         2.9%   HSBC          5.0%   RBOS          3.6%
Barclays      2.7%   Vodafone      4.7%   BT            3.5%
HSBC          2.6%   AstraZeneca   3.6%   Lloyds TSB    2.9%
Lloyds TSB    2.4%   RBOS          3.6%   HSBC          2.8%
AstraZeneca   2.3%   Barclays      3.1%   Imp Tobacco   2.5%
CGNU          1.4%   Lloyds TSB    2.8%   Bank of Scot. 2.4%
RBOS          1.4%   CGNU          2.7%   S&S Energy    2.1%

You can see from this that there's not much difference in the way that these funds invest your money but, if you're worried about picking a dud, there's no harm in going for several of them (so long as you're careful not to let it increase your costs). If you bought equal amounts of the above three investment trusts, you'd end up with a yield of 3.9% from a widely diversified pool of assets, with low charges and very good prospects for your income to increase at least alongside inflation and economic growth. Of course, there's no reason not to combine this investment trust approach with the direct shares approach mentioned above.