Income investing: Helping your money work for you

Indeed, many people favour a low-maintenance approach to their finances, regardless of the weather. 

They know that planning for retirement and building long-term wealth are hugely important – but it’s not how they would choose to spend their spare hours, so their investment priorities revolve around long-term steady growth, reliability and not too much market choppiness. 

If that’s the way you feel, it’s worth considering income investing – channelling your money into investment trusts designed to generate regular cash distributions to shareholders through a portfolio of dividend-paying businesses. Such an approach could well suit your needs even if you don’t yet need the investment income potential. 

In this article we’ll be focusing on equity income trusts, but income-focused trusts may also use other assets such as bonds, infrastructure or property. 

Equity income for income or growth

Equity income investing is actually a somewhat misleading title. It’s certainly true that the dividends that may be paid out by these investment trusts are great for retirees looking for additional income to supplement their pensions in a sustainable way. 

But what if you’re still working, decades from retirement and very much focused on building up your ISA or SIPP through regular contributions? The good news is that equity income trusts can also work very effectively if you don’t require an immediate cash flow.

Crucially, you don’t have to take your investment income as cash withdrawals. You have the option of automatically channelling it back into additional shares in the same investment trust, by reinvesting your dividends. 

If you hold your shares through an online platform (as most retail investors tend to do these days) you can easily arrange for any dividends you select to be reinvested automatically. The service is cheap to set up. Interactive investor, for example, charges just 99p per trade. If you hold your shares on the main register you can still participate by enrolling in a Dividend Reinvestment Plan (DRIP). Whichever way you invest, once up and running dividend reinvestment can be a remarkably painless way of boosting your long-term returns. 

Compounding at work

And it really can make a big difference. That’s because you’re taking advantage of a phenomenon known as compounding, whereby your new shares themselves generate dividends, which in turn can be reinvested into additional shares, and so on. 

Over the long term, compounding can have a profound effect on the value of your portfolio. As a simple example, let’s consider an investor, Ella, who has £1,000 to invest in an equity income investment trust. 

Ella is able to contribute an additional £100 per month, so £1,200 per year, to her investment. The share price rises by an average of 5% a year; the trust also yields 5% a year and the dividend payout grows at 2% a year. 

If Ella takes the dividend cash and uses it to fund an exotic holiday every year, after 10 years her investment is worth £16,700, a total return of 29% on her capital investment. However, if she reinvests them back into the trust, it grows to £21,000 over that time, providing a total return of 61%. 

Importantly, the gap widens exponentially – so after 30 years Ella’s trust with dividends withdrawn is worth £84,000 (a return on capital of 127%), but with dividends ploughed back in it’s worth more than 75% more, at £149,000. That’s a return of over 300% on the capital she’s invested. 

The attraction of potential dividend growth 

Investment trusts are a natural choice for income investors, because the trust structure allows them to hold back some of the dividends received from the underlying companies and build up reserves. That cash cushion can then be drawn on by the board to improve payouts to shareholders in leaner years, effectively smoothing dividend ups and downs. 

But some trust boards have gone further, committing themselves to a target of dividend increases each year. There are no guarantees, but the ability to draw on dividend reserves means that those trusts that prioritise income can generally stick to their knitting. 

Indeed, the importance of reliable dividend growth for shareholders reliant on investment income has been brought to the fore by the Association of Investment Companies (AIC). Its Dividend Heroes table comprises the 20 trusts that have achieved more than 20 years of growth. 

The AIC has also introduced the Next Generation Dividend Heroes to highlight the 30 names with between 10 and 20 years of dividend growth under their belts. 

Thus, for instance, Dividend Hero Aberdeen Equity Income Trust (AEI), with a current 5.2% yield, aims for dividend growth ahead of inflation each year; it has chalked up 25 consecutive years of dividend rises. Meanwhile Aberdeen Asian Income Fund (AAIF), yielding 4.9%, is a next generation hero with 16 years of uplift to its name. 

For these and the other dividend heroes, this status is highly prized, giving shareholders additional reassurance that the board will do all it can to protect its dividend growth track record over coming years.

Moreover, while dividend growth may seem less significant to investors looking at long-term total returns rather than an immediate income stream, it does mean that they receive a reliable and rising chunk of return each year – even if stock markets are struggling and capital growth is hard to come by.

A less volatile ride 

There are further advantages to equity income trusts for investors in search of a relatively quiet life in investment terms. 

The dividend-paying companies that attract equity income managers tend to be more mature, established businesses with strong earnings and little debt, well-placed to return cash to their shareholders. Such businesses also tend to show greater resilience in the face of market downturns. As a consequence, equity income investments may experience less volatility than their growth-oriented peers. 

But importantly, maturity does not necessarily equate to stagnancy. For example, a £10,000 investment in AEI, which invests in the managers’ best ideas across the market cap spectrum of UK income-paying businesses, would have more than doubled in value to £21,600 over the 10 years to 6 July, assuming dividends were reinvested.

AAIF’s focus on the dynamic Asian economies has served it even better over the decade, and £10,000 invested in July 2016 with dividends reinvested would have increased by 200%, to £30,000.  

Conclusion 

Equity investors seeking capital growth plus a secure, sustainable and rising income stream to keep them abreast of inflation will be well-served by equity income investment trusts such as AEI or AAIF. But they may also be an excellent choice for those with their sights on rewarding and reliable total returns in decades to come. 

Aberdeen Asian Income Fund Important information: 

Risk factors you should consider prior to investing: 

Aberdeen Asian Income Fund discrete performance 

Discrete performance (%)

Source: Aberdeen, total returns. The percentage growth figures are calculated over periods on a mid to mid basis. NAV total returns are calculated on a cum-income basis.

Past performance is not a guide to future results.

Aberdeen Equity Income Trust Important information: 

Risk factors you should consider prior to investing:

Performance

Discrete performance (%)

Total return; NAV to NAV, net income reinvested, GBP. Share price total return is on a mid-to-mid basis.

Dividend calculations are to reinvest as at the ex-dividend date. NAV returns based on NAVs with debt valued at fair value.

Source: Aberdeen and Morningstar.

Past performance is not a guide to future results.