Money Makers

RICHARD CURLING, manager of the Jupiter Monthly Income fund, discusses the pros and cons of using investment trusts to generate an income. (Note: this article first appeared in the 2018 edition of the Investment Trusts Handbook and has not been updated).

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What is the objective of the monthly income fund?

Richard Curling: The objective is to pay an annual income of 4.5%. That is paid in regular monthly instalments. What we’re trying to do, in practice, is find investments with high-quality long-dated cash flows from which we will pay a secure monthly dividend over the long term, while trying to preserve and hopefully grow the value of the capital.

How much of the portfolio is represented by investment trusts?

RC: The monthly income fund has 90% in investment companies of one sort or another. Broadly speaking, about half of it is in traditional equities, some of which are UK equities and some of which are overseas equities. (The Asian funds have always been quite good at producing income, for example.) The other half is in so-called alternatives. That includes infrastructure funds, various kinds of real estate trusts, plus other more esoteric ways that investment companies now produce income.

Why is there such a high proportion of investment trusts in the portfolio – what are the advantages for a professional income investor?

RC: Investment trusts have some clear advantages over unit trusts and other types of investment vehicle. The most obvious advantages are the ability to borrow (gear up) – though that obviously works both ways – and the ability to smooth income, which is really important and something unit trusts don’t have.

Connected with the ability to smooth income is the very long track record of paying – and growing – dividends that some trusts have. If you are the board of a trust that has been paying a dividend for 50 years, as some of them have, you don’t want it to be you who decides to cut it. So I think you can have more reassurance that dividends are going to be sustained in some investment trusts than others.

The third benefit of a closed-ended vehicle is to do with investment flows. The fact is that unit trust investors, as a matter of human nature, have a tendency to put their money in at the top of the market cycle, when things are expensive, and take it out at the bottom, when they are cheap. That accentuates movements in the market and has a negative impact on the performance of open-ended vehicles.

Some recent work by Cass Business School showed that investment trusts have outperformed unit trusts or open-ended vehicles over time. That’s a useful bit of empirical research to support what we intuitively feel.

Does that mean you are able to pay your 4.5% yield (after fees) without having to draw on capital?

RC: Yes. Of course, unless you’re running an income fund, it is the total return that you should be looking at. Whether that return derives from income or capital doesn’t really matter, but the ability to convert capital into income in an investment trust is a trick that seems to be increasingly widely used and you obviously have to be aware of that when it happens. An increasing number of investment trusts are choosing to pay fixed dividends, regardless of whether that is covered by the trust’s income. I happen to think that paying uncovered dividends is legitimate when income is very expensive, which it is at the moment.

The main reason so much of the fund is invested in investment trusts today is that it opens up the universe of opportunities to lots of illiquid types of investment that are not so suitable for unit trusts. Good examples are the environmental infrastructure trusts (wind farms, solar farms etcetera), and property. Long leasehold property in particular offers a very interesting income stream for long-term income pursuers, particularly some of the ones that have inflation-linked rents.

In an income-scarce world, it’s very difficult to find income from the traditional sources – bonds, cash and equities – and when you can, the yields are low, so it is very expensive. And it can also be very concentrated. Half of the dividend income from the UK stock market comes from just five companies. You need a broader range of opportunities to be properly diversified.

Another important factor, as I have mentioned, is taking insurance against future inflation, which is very damaging to income investors. The investment trust universe is very helpful here. A lot of the newer trusts have underlying cash flows and revenue streams which are in some way linked to inflation. For example, you can invest in some long leasehold REITs that have 100% inflation protection. They have upward only, inflation-linked rents with an expired term on their lease of 25 years. Effectively it’s a 25-year index-linked investment. You get a yield of between 4% and 5% on those, whereas for an equivalent-dated index-linked bond – well, you’re lucky if it’s positive.

People who want a regular income tend also to be the ones who are most vulnerable to inflation.

RC: Yes, and I think unexpected inflation is one of the big hidden risks in markets at the moment. Nobody’s really talking about it. We’ve been living in a world where all the attention has been on trying to avoid deflation. It is true that there’s very little sign of inflation at the moment. There have been such strong forces counteracting inflation, like globalisation and ever cheaper manufactured goods from China, that inflation hasn’t appeared on people’s list of things to worry about. But I do think it’s a significant risk out there which you can protect yourself against while still getting a good income.

Even though we haven’t seen the evidence yet?

RC: Yes, inflation fear hasn’t yet broken out in any significant way. The factors suppressing it have been quite powerful so far. The big risk, though, is that if inflation does take off, the traditional response to dealing with inflation is to raise interest rates, and given the level of indebtedness around the world, it’s going to be difficult to do that without doing an awful lot of damage to the economy. So it may not be a very big risk, but the impact would be big, if it was to happen.

So you are not finding any difficulty at the moment in finding things that allow you to pay the 4.5%?

RC: No. There are quite a lot of opportunities now in some interesting new areas that are relatively new, ones where traditional investment trusts haven’t played before. In this space I would put housing, and in particular social and rental housing. In the healthcare space, GP surgeries and nursing homes; and then there are some very esoteric ones, like buying music rights, where an IPO (the HIPGNOSIS SONGS fund) happened recently.

Did you put money into that one?

RC: Yes, I took some of that, though not very much. I think we need to see the model prove itself. But I think the investment thesis may be right. Then you’ve also got the new lending companies which are essentially banks, but not deposit takers, so lenders to small and medium enterprises. They are interesting because the risks are likely to be less correlated to the normal stock market cycle – another benefit.

When we were talking earlier about converting capital to income, it is interesting that a number of private equity companies, which fall into the alternative space, are now agreeing to make distributions to shareholders as a way of returning some capital. Traditionally that hasn’t happened, as it’s more difficult for private equity companies to do, given their structure and their future funding commitments to companies they have invested in.

An example of that is NB PRIVATE EQUITY which recently confirmed that it was going to pay a 4%-a-year dividend. PRINCESS PRIVATE EQUITY, which is part of PARTNERS GROUP, also pays a fixed percentage of its NAV as a distribution. F&C PRIVATE EQUITY has done that for years. It pays 4% of NAV once a year. That meets a demand for shareholders to give something back and it seems a sensible way of doing it.

Where then is the downside in using trusts for income?

RC: My main worry is the levels of gearing that some of these new investment companies are adopting in order to achieve the target yield. It seems to me that the temptation is to say, ‘In order to get this issue away, we’ve got to have a 5% yield. How are we going to get there? We have to account for our fees. So given that the underlying yield from the assets is x%, let’s knock off our fees and then gear it up until we get to the required yield number.’

That’s one thing I’m watching carefully. You need to make sure that the income isn’t there simply because it’s over-geared investment. The other thing that I think we have to be aware of is style drift – trusts going into new areas because they have run out of opportunities in their chosen area of operation. That has happened a bit with the traditional PPI/PFI infrastructure stocks.

Because they are not making any more PFI deals in the UK, they have started buying PFI assets overseas. They may turn out to be good, but it gives you a different risk profile and it’s different from what they started off doing. Likewise, in the green infrastructure space, they’ve been investing overseas too, because the opportunities just aren’t available in the UK. I think we have to be very careful about that.

With the renewables, the generous initial subsidies are being wound down…

RC: Yes, subsidies have stopped so, people aren’t constructing the assets. There are some interesting opportunities as tax vehicles such as Enterprise Investment Schemes reach maturity; they are a good source of acquisitions for the listed companies. But in general they’re not making them any more. Underlying all of this is the fact that many of these companies are externally managed funds. As a fund manager their incentive, if this isn’t too cynical, is to increase the assets they are managing, even if it means reducing the quality of the portfolio. I wish there were more internally managed investment opportunities in this area, because that arrangement proudces a much better alignment of interests.

In some cases the management fees are quite hefty.

RC: Yes, they are. That is also something that concerns me. I’m surprised at how high the management fees are on some of these investments. I know that lots of them have introduced scaling, so that the fees reduce as funds under management increase, but that doesn’t really resolve the underlying issue. The trusts have raised a lot of money and they’re charging big fees on it, certainly big sums in absolute terms.

In some cases I think they are difficult to justify. As investors maybe we need to put more pressure on fees and maybe become more imaginative about how these fees are structured. So, maybe you would have a structure where they’d earn a higher fee for the first three years, while they are making the investments, and then a lower fee when it moves into what I call ‘reading the meter’ mode.

What is clear that the way you are investing the monthly income fund has changed a lot since the great financial crisis.

RC: Yes, ten years ago we had a lot of bonds. We basically just had bonds and equities. There were virtually no alternatives. It’s been very much a recent development, mainly in response to low interest rates.

So the obvious question is how are these type of investments going to perform if and when interest rates start to rise, as they have begun to do?

RC: The risk for any income-generating asset must be rises in underlying interest rates. That basically means the US bond yield, which underpins the whole financial system. I’m well aware of that, and so the things that I’m looking at particularly is having fewer bond-like assets – that is, those which offer a fixed rate of return over a fixed period of time. What I want now is a greater proportion of floating rate returns – and inflation-linking is also helpful, certainly if interest rates go up because of higher inflation.

It is also important to look for opportunties where the income can grow, rather than just pay a fixed amount. That’s becoming an increasingly important part of what I do because I’m very aware that the bond cycle is turning, and interest rates are likely to go up. I don’t know when and I don’t know how much and I don’t think it will be very much, but that is a threat to any income-generating investment.

Have you been able to make capital gains as well as paying out your target income yield?

RC: Yes. So far, that’s been the outcome. But my priority is to ensure that we can pay that income month in, month out, and that there’s a reasonable cushion there to do that, and that it’s reasonably protected from events that are likely to happen. Preserving capital is important, but if we can grow it too, then that’s good.

Why don’t you own any of the big five UK dividend payers directly in the fund? Surely you might as well buy them yourself rather than pay someone else to buy them?

RC: There’s nothing that would stop us doing that. It’s just that the mandate has always been to do it through investment companies. Under half of the fund is now in equity funds, and relatively little of that is in the UK. We don’t want to have to rely on the big five equity investments that everyone else is forced to buy. For example, we own the multi-cap DIVERSE INCOME TRUST as a way of spreading that income across a wider base. As it happens, the way the fund has evolved, it has become a useful vehicle for taking advantage of the growth in alternatives in the investment trust sector, where all the issuance has been in the last few years.

Is it your policy to buy the trusts at IPO or at a later stage, when the price has settled down?

RC: Both. But one of the things that I have found is that because of the scarcity of income, a lot of the alternative trusts have become quite popular and so trade at premiums. I don’t like buying assets at a premium to NAV. So I’ve tried to be a patient investor, waiting for secondary issuance as the opportunity to buy more shares in some of the things that I particularly like. So, buying both at IPO – and then, if there’s something we really like, buying it in secondary issuance; but not buying it in the market, purely because the premiums tend to be too high. I guess that’s one advantage of doing it through a fund like this, rather than as a private individual, as individuals mostly can’t do that.

Do you worry that it is getting harder to launch a new investment trust because of the minimum size wealth managers say they need to see a new trust reach to justify supporting in an IPO?

RC: Everyone is concerned about how easy it is to buy and sell shares in trusts they invest in. The big wealth managers certainly want to see the size of the trust they invest in increase because of these liquidity issues. We have the same problem because we’re an open-ended vehicle investing in closed-ended vehicles or illiquid assets. We have to keep a close eye on liquidity too. We never want to be a forced seller of something. That is why I tend to run cash balances in the fund of between 5 and 10%. It also gives me ammunition for secondary issuances or opportunistic purchases when they come along. But you are right that some companies struggle with this chicken-and-egg situation; investors won’t invest in you until you’re bigger, and you can’t get bigger until they invest in you.

One obvious question: why don’t you create a closed-end version of the monthly income fund?

RC: I think that is a very good idea and we should, precisely because the main issue with investing in the alternative space – which is where the really interesting income opportunities are – is the liquidity. Some of them are frankly not suitable for being held in an open-ended vehicle. A closed-ended vehicle to take advantage of this whole new area of alternatives would be very interesting. They are all very different and it takes a lot of research to pick out the best ones. I suspect that the opportunity to buy a portfolio of the best opportunities would be an attractive proposition.

Is there a lot of crossover between the monthly income fund and the other one you run, the fund of investment trusts?

RC: No, there isn’t. The fund of investment trusts doesn’t have an income requirement, whereas the monthly income fund clearly does. The fund of investment trusts tends not to have alternatives in it, just equity exposure. But there are one or two that overlap – private equity funds is one example – and some common themes. I quite like the small and mid-cap space in both, for example, but for different reasons. I like it in the fund of investment trusts because it’s growth, and I like it in the monthly income fund because it is a more diversified approach to income, rather than the big five.

What’s your thinking about discounts – how much of what you do is about finding attractive discount opportunities?

RC: I think it’s down the list of priorities. It’s a ‘nice to have’ rather than an ‘essential to have’. If you can add some value by buying at a discount, so much the better. If you look at the ranges that these trusts have traded in over time, there are, within the subsectors, clearly times to buy them and times not to buy them. So, infrastructure is the classic example. Everybody got very overexcited about it, it became very popular, infrastructure trusts traded at a very high premium, and apparently nothing could go wrong.

Then John McDonnell, the shadow chancellor, stood up at the Labour Party Conference and threatened to nationalise them – and suddenly political risk entered into the whole equation. That knocked back the share prices quite a bit. In practice, there are a number of ways the political risk could happen. It wouldn’t necessarily just be nationalisation. It could be special taxation. There are lots of ways of skinning that cat.

And then Carillion went bust and that introduced some operational risk into the equation as well. The effect of this was the premiums on infrastructure trusts evaporated. The two big trusts, JOHN LAING INFRASTRUCTURE and HICL, started trading at a discount. That to me was a good buying opportunity because the markets often overreact. They overreacted on the upside, put them on too high premiums, and then overreacted on the downside, putting them on too big discounts.

Since then the share prices have rallied and the discounts have reduced again?

RC: Yes. A number of things have happened. We saw a bid for John Laing Infrastructure which was at 20% premium to NAV. That was quite reassuring, although slightly surprisingly it was a bid from another fund manager rather than a bid from a pension fund bid, which would have been more reassuring. But to my mind it did underpin the asset value and the central case. And then HICL sold an asset for at a 20% premium to what they had it in the books for. That was reassuring that the secondary market for PFI assets was good.

So, sometimes there is an opportunity to buy these things when something happens. Look at social housing. A housing association went bust and that provided a reality check for that sub-sector and provided a good buying opportunity. Unlike conventional investment trusts, where you try to buy at a bigger discount, with alternatives it’s about avoiding buying at a big premium and then taking advantage when there’s further issuance at NAV, or something happens and there’s an overreaction in the share prices.

What is the most important lesson you have learnt about investing in investment trusts?

RC: The mistake that I have made on occasions has been topslicing and selling too early. With funds even more than companies, you want to stick with your winners, particularly if you feel that you’ve found a really good manager. That is more important than whether a sector is in or out of favour. For example, I really like HENDERSON SMALLER COMPANIES. The manager, Neil Hermon, has outperformed in 15 of the last 16 years. That is up markets, down markets, flat markets. SCOTTISH MORTGAGE has also worried me a bit for ages, but it’s continued to perform extremely well. I’ve sold an awful lot of shares over the years, which has been completely the wrong thing to do!

RICHARD CURLING joined Jupiter Asset Management in 2006 and is a fund manager in the UK Growth team. He manages the Jupiter Fund of Investment Trusts and the Jupiter Monthly Income Fund.