Dividend income versus total return is an endless debate but if you have weighed up the arguments and decided to invest all or part of your portfolio with the aim of producing an inflation-beating income then it would be unwise to ignore the strengths of Income Investment Trusts.
Previous posts examined the pros and cons of dividend investing in general and the advantages of Investment Trusts in providing inflation-beating retirement income:-
I accept many of the arguments against “living off dividends”  but I am certain that for some UK retirees an Income Investment Trust portfolio can form a useful part of their income strategy.   I have around a third of my retirement income portfolio invested in what is basically the  8 Investment Trust Portfolio .   I will be reviewing the performance of the portfolio in my next post in a few week’s time but from an income perspective, things look reasonable with income slightly ahead of 2020 despite the Covid dividend crisis.

 

It´s pretty Well Impossible to Have a Passive Dividend Income Strategy

If you are looking to produce an increasing stream of dividend income then passive/index investing historically fails to meet this objective. Yes, there are various index-type income products such as the Dividend Aristocrats and high dividend yield indices that can be accessed via ETFs or funds.  However, none of these produce income stability – just look at the decline in dividends of the income funds post-March 2020.  Of course, you can create your own cash buffer and in the worst case sell some of the holdings but this implies far more investor activity than many retirees would welcome.
My view is that the best option is to leave the problem of stabilizing income to someone else and Investment Trusts perform this role very efficiently. The ability of the trust´s manager to retain up to 15% of earnings during good times allows smoothing out of dividend payments which is a significant advantage over funds and ETfs.

You Have to Actively Manage an Investment Trust Income Portfolio

The need to actively manage an Investment Trust portfolio is probably the greatest drawback of this income strategy.  In the latter years of retirement, a retiree may not have the desire or mental ability to deal with investment issues. So an Investment Trust income approach may be most appropriate for the first decade or so of retirement.
Why is Active Portfolio Management Essential?  Investment trusts change managers, managers change philosophies (remember Invesco´s Woodford/Barnet), investment strategies fall out of favour, trusts are taken over or merged (e.g. Temple Bar) whole sectors underperform (UK property, the UK market …) so the investor must undertake a periodic review – perhaps not annually but certainly every 2 to 3 years to check that the constituents of the portfolio are performing acceptably and that there have not been nor are there planned any changes in the objectives of the trust.
 

The AIC Investment Trust Dividend Heroes

The Association of Invest Companies (AIC)  which represents the Investment Trust industry is a valuable resource for the IT investor.  In addition to company data, it has a useful tool where you can simulate your portfolio and check the current and historical dividend payouts.  Trustnet can provide an even more detailed analysis of the proposed portfolio, with powerful charting tools to allow comparisons of the portfolio against indices, alternative portfolios, funds, ITs, and ETFs.
The Dividend Heroes list on the AIC site makes a good starting point for developing a shortlist of Income Investment Trusts.  The list is in two parts, companies that have increased dividends continuously for more than 20 years and those that have increased them for at least 10 years.  It should be noted that if a company just maintains its previous years’ payout this will break its track record of increasing payouts – in a low inflation environment or during a dividend crisis such as in 2020 some investors would be happy to accept income stability and wouldn´t exclude such a company from consideration.   For instance, although Law Debenture is shown as having only an 11-year dividend increasing track record it has in fact never decreased its payout in over 42 years.
Unfortunately for the dividend investor some of the companies denoted as heroes are not so heroic at providing income!  Of the 44 companies in the table, 19 have yields of less than 3% and one (Scottish Mortgage) has a yield of only 0.3%.   In fact, the AIC avoids publishing the yield in the table so the investor has to do a little bit of work to pull all of the data together.
In the table below I have added the dividend yield.  This is very much a starting point for analysis and when a final shortlist is produced it’s essential to dive deeper into the data.  Fortunately IT data is far more accessible than funds and ETFs as the published annual accounts of the IT companies provide a wealth of historical data.
I like to ensure that dividends are paid from revenue (dividend income) rather than capital (portfolio sales) and the published annual accounts are useful to identify any proposed changes in investment or dividend strategy. The historical level of dividends is also important as there are companies that for years paid out very low but increasing dividends and then changed to a more generous payout resulting in an excellent dividend increasing track record but one where the yield would have been too low for many years for a dividend investor. So care and a degree of scepticism is necessary but the table is a good starting point from which a shortlist can be created and the companies researched in greater depth.
Table of Dividend Heroes with Yield

Selection Criteria

I put all the companies in a spreadsheet and add the following data for each company:-
            • 5 Year Dividend Growth
            • Dividend Cover (years)
            • Total Assets
            • 5-year Total Return
Then I apply the following selection criteria:-
  • Minimum Yield 3.5% – roughly the safe withdrawal rate (SWR) of a drawdown portfolio
  • 5 Year Dividend Growth Rate >2.5%  – should at least beat inflation
  • Assets > £100m.  Small Investment Trusts are vulnerable to mergers and closures and will not attract the best managers.
This results in the initial 44 companies being reduced to an initial shortlist of 14 which are shown in the table below which is sorted by 5-year total return (taking dividends into account):-

 

Two benchmarks are shown, the Vanguard 60% Equity LifeStrategy fund and the FTSE All-Share total return. The graph below compares the 5-year performance (total return) of a portfolio of 9 Income Investment Trusts with the two benchmarks.

Graph of portfolio of income investment truss versus Vanguard 60% Equity LifeStrategy and the FTSE All Share Total Return
Only 6 companies out-performed the Vanguard benchmark, principally because of the sharp decline in the IT income sector in March 2020.  Vanguard was buffered by its bold holdings.  (However, all is not so rosy for LifeStrategy in drawdown – in my post  Pension Income – Investment Trust Income or Vanguard LifeStrategy Drawdown? the impact of drawing down when markets are at low results in an Investment Trust income strategy out-performing drawdown from a 60% Equity LifeStratregy fund.)
The table shows some stand-out performers such as JPMorgan Claverhouse and Schroder Income Growth which combine high yield, share price growth, longevity of dividend growth, and good dividend coverage.  This can be contrasted with the poor performance of income stalwart City of London whose commitment to rising dividends is commendable but has resulted in depleted revenue reserves and lackluster performance.

Conclusions

I will be looking in more detail at some of the shortlist ITs in my next post when I will be examining the performance of my Investment Trust Retirement Income portfolio.

Today it is certainly more difficult than 5 years ago to put together a diversified portfolio of Income Investment Trusts that fulfill my main criteria.  Several of my original portfolio constituents that met a key criterium of dividends surviving the 2008 crash have now fallen by the wayside and only 9 ITs in the list have an increasing dividend history post-2008.  This again highlights the need for portfolio monitoring.

My final shortlist is shown below:-

Table showing top performing income investment trusts

(It should be noted that infrastructure companies are like REITS and don´t have significant revenue reserves.)

It’s quite possible that we haven´t had all the bad news about possible dividend cuts from all the Income Investment Trusts so if the intentions of a particular company aren´t clear it would be wise to wait at least 12 months before investing.

It would be wise to have more geographical diversity in a portfolio by including a European Trust but there are few candidates that get close to the selection criteria. The best of the bunch is  JPMorgan´s European Income that offers an acceptable yield and has had over 5% annual dividend growth over the last 10 years (but has had several years of static payouts.)

Looking to the future, the dividend cover of many companies has fallen post-Covid and this must raise a warning flag.  From 2009 to 2019 we have had 10 years of rising markets and increasing dividends which have allowed Investment Trusts to strengthen their reserves.  If the next decade is characterized by weak market performance many of the companies will be unable to rebuild their reserves and this will put dividends at risk when the next crisis hits.  This emphasizes the need to select companies with good dividend coverage and companies that have shown commitment to maintaining or increasing dividends post the Covid dividend crisis.

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