The Easy Way To Equity Income: Revisited

Investment trusts pay dividends for lazy investors.

In an article just over a year ago, I set out a simple, minimum-effort income strategy, designed as an alternative to an annuity for those prepared to accept the risks of equity investment.

One year on, it seems an appropriate time to revisit the strategy and see how the sample portfolio I used to demonstrate the idea has performed.

Investment trusts

The strategy uses investment trusts, which are stock market-listed companies that invest in other companies and assets.

One of the characteristics of investment trusts is that they are not obliged to distribute all their annual income to shareholders. Many run a 'revenue reserve', which they add to in times of abundance and draw on in times of famine. This prudent policy is designed to enable them to pay out a growing dividend to their shareholders through thick and thin.

The strategy

Using investment trusts for income was not a new idea, but most of the discussion I'd seen on the topic revolved around trying to identify a few superior specimens.

I suggested a slightly different approach. Pick a broad basket of trusts with the following unexceptional characteristics: reasonable size (market capitalisation), yield, dividend growth and revenue reserve; and the stated objective of increasing dividends in the future.

This broad-basket approach simply taps the income-generating capacity of the generality of fairly large and boring investment trusts, rather than attempting to cherrypick a few 'top performers'.

An added benefit is that if a freak 'Black Swan' event completely wiped out one trust it wouldn't be the end of the world for the income stream.

The portfolio

I selected a portfolio of 10 investment trusts, by way of demonstrating what I considered to be suitable candidates, acknowledging there were others that might have fitted the bill equally well.

The core of the portfolio came from the UK Growth & Income sector. I also threw in a UK Growth trust that was on a reasonable yield and a couple of trusts with a global mandate, just for variety.

In the table below, the final column shows the dividend growth in the year to 9 March 2011 (the exact anniversary of my original article). The other columns show annual dividend growth in the preceding three years on a like basis.

^{* Estimated RPI inflation, based on 11 months to January 2011}

As the table shows, the investment trusts continued to grow their dividends through the 2008/09 recession, a time when many income investors in individual blue chips were reporting falls in excess of 30% in the income of their portfolios.

In the three years to 9 March 2010, the investment trusts averaged annual dividend growth comfortably ahead of RPI inflation. In the latest year, average growth continued positive in absolute terms but slightly undershot inflation.

I strongly suspect this period of sub-inflation growth will be short term and will be reversed when the pick-up in individual company dividends feeds through to investment trust shareholders.

Year to year

At 9 March 2010 the portfolio's trailing 12-month dividend yield was 4.5% (FTSE All-Share 3.2%). An investment of, say, £75,000 at that date would have delivered, after costs and with 3% growth, an income of about £3,500 in the year to 9 March 2011.

After an average 10.5% capital growth over that period, the trailing 12-month yield of the portfolio stood at a still-quite-reasonable 4.2% (FTSE All-share 2.9%).

The share prices and trailing yields of the individual constituents at 9 March 2010 and one year on are shown in the table below.

After the market turmoil of the last week, share prices are now somewhat lower, making the current yields slightly more attractive, though still at a level below last year's average.

Research

As I mentioned earlier, there are other candidates beyond these ten, which could also merit consideration. The AIC website is a good place to begin research.

In addition, there has been a considerable amount of discussion about baskets of investment trusts on our Investing for Income community board over the past six months. In particular, regular contributor Luniversal has produced a remarkable body of historical data and analysis for many trusts; and, latterly, a handy bibliography of his posts on the topic.

In light of the interest in this strategy, I'll continue to monitor my original 10-trust demo portfolio and report on its progress again next year. The main thing I'll be looking for is whether the trusts have returned to delivering income growth ahead of inflation.

> G A Chester holds shares in Bankers, City of London and JP Morgan Claverhouse.

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