Read any article praising income-orientated investment trusts and you’ll hear about their revenue reserves.

These reserves, you’ll be told, are a hidden benefit of investment trusts – one reason the so-called dividend heroes have been able to grow their dividend payouts for 20 years or more.

The reserves will be compared to a rainy day fund. Some journalists will be more explicit, talking about trusts keeping back “some of the cash for the bad times”.

This is a typical from the Financial Times:

During bad years when dividends may be scarce, the investment trust can dip into the revenue reserve to either maintain or grow the trust’s own dividend payments.

And here’s Hargreaves Lansdown:

Investment trusts can put some dividends aside for a rainy day.

They can hold back up to 15% of their income in good years so they can top up dividends paid to investors in the bad years.

It’s known as a trust’s ‘revenue reserve’.

These statements are right – but they may give you the wrong impression.

It’s true that most investment trusts have a revenue reserve.

But this reserve is simply a bookkeeping entry. It’s not a pot of cash tucked away in the fund manager’s attic.

Tapping the revenue reserve will enable a trust to maintain – and even grow – its dividend. But there’s no adding a few notes from a fat wodge of crisp £50s going on here!

Instead, the manager will do what else anyone would if they were short of a few bob and needed income.

They will sell some of the trust’s investments (its net assets, or NAV) and pay out the proceeds as part of the dividend.

I don’t think that’s what most people think of when they hear ‘cashing in the rainy day fund’…

Smoother operators

You may be wondering then why everyone bangs on about revenue reserves? Are they useless – like some vestigial organ we’ve outgrown?

Well, not exactly (although trusts have indeed evolved in recent years, as I’ll get to before we’re done).

The first thing to stress is investment trusts really can provide a steadier level of income than open-ended funds, thanks in part to those revenue reserves.

That’s because a standard open-ended fund – whether an index fund or an active fund – must distribute all of the income it receives to its investors at regular intervals.

This means the income you get from such a fund will fluctuate with the payouts it recieves from its holdings.

In contrast, investment trust rules state they only have to pay out 85% of their income each year. The remaining 15% can be allocated to revenue reserves.

If the income the trust receives from its underlying portfolio dips, the trust can then top-up its own dividend by getting extra money via these revenue reserves.

So from an investors’ perspective, the trust’s dividend really has been ‘smoothed’. That may be preferable for planning purposes, for example, and the revenue reserving malarkey has done the job.

But there’s nothing magical going on.

At some point in the mists of time, this trust received some cash, paid out less than 100% of it, kept the change, and added to its revenue reserves bookkeeping entry. Now it’s paying that out later.

In contrast an investor in an equivalent open-ended fund would have received a higher payout (i.e. 100%) earlier.

So it mostly comes down to personal preference. Do you want to get your income as it comes from an open-ended fund, or would you rather have a manager smooth the payouts for you?

If I was using funds for retirement income, I’d rather the steady option, particular if I was getting on. Not having to think very hard is a big benefit of an income investing approach in my view. But your tastes may vary.

Of course many investors don’t care either way. They prefer a total return approach to investing. Their strategy is to sell a percentage of their portfolio to generate whatever spending money they need (as detailed in The Accumulator’s many articles on the sustainable withdrawal rate).

Again, personal preference. According to financial theory it should all work out the same in the end (assuming you’re comparing like-with-like).

Dividends paid out from capital profits

Why is this article still going? Aren’t we done?

No. There’s some mopping up to-do, because nothing is ever simple with investing.

Firstly, in 2012 the rules were changed so that investment trusts could pay dividends from money raised by selling their profitable investments – even though these capital profits weren’t ever allocated to a revenue reserve!

I forget why the rule was changed – probably something to do with offshore funds – but as far as I can see it’s made the whole concept of revenue reserves a bit moot. Perhaps these days they’re mostly a marketing gimmick?

There are now investment trusts that explicitly state they will pay, say, a 4% income, by selling 4% of their net assets over the course of a year.

If one trust can do that, I don’t see why another can’t sell any investment it has made a profit on – or cash it previously earned from selling profitable investments – to top-up an underweight dividend.

One niggle may be that trusts are companies with their own articles of association, so it may require shareholder approval to change the rules.

But they’ve had since 2012 to change the fine print – and were advised to by their trade body – so you’d hope most would have.

Years of dividend cover in reserves

Second bit of mop-up – the juicy-sounding concept of ‘years of reserves’ of dividend cover, which also invariably comes up in those revenue reserve articles.

As IT Investor wrote last week:

55% of trusts that pay a dividend have a revenue reserve covering at least 0.5 times their most recent annual payout.

An impressive 45% have reserves of at least 1 times their latest annual dividend.

13% have at least 2 times.

If we assume dividends fall by a third this year and take two more years to get back to 2019 levels, then a trust needs about 0.5 years in revenue reserves to see it over.

You can find out how many years of (notional) revenue reserves a trust has by reading its annual reports. Or you can dig around on the AIC website.

However following on from what I’ve written above, I don’t believe it matters much anymore.

Trusts can now pay dividends out of capital profits, so a trust with zero revenue reserves could increase its dividend if it wanted to, presuming it’s made some profitable investments

I suppose in a bear market that’s not guaranteed, especially for newer trusts.

Then again if a trust is seeing income fall and no gains on its investments, is this really a good time to be returning cash to shareholders? Is it even a trust you want to own?

Short of cash

Finally, I should say that as far as I know a trust could actually keep its revenue reserve in cash. And most trusts do hold a little bit of cash, after all.

However if you study their portfolios or read their annual reports, there is usually little indication this is the case – or in fact any sign of how a revenue reserve is actually invested.

To give an extreme example, the Caledonia trust said in its 2019 annual report that it had £1,794m in reserves:

“…broadly equivalent to 55 years’ payment of the current annual dividend, which could be used to smooth any investment income shortfall.”

Those revenue reserves are more than the current market cap of the trust! And as of that report, the trust held only £112m in cash.

Almost all Caledonia’s assets were (sensibly) in more productive investments, such as property, equities, and bonds.

This makes Caledonia perhaps the most glaring example of the fallacy of the ‘piggybank of cash’ mental model of revenue reserves.

Bottom line on revenue reserves

The ability of investment trusts to smooth their income payments is a nice enough feature. But don’t get bedazzled by talk of revenue reserves or hints of some semi-magical ability to plump up dividends.

To make up for a shortfall income, investment trusts will mostly have to sell capital, just like anyone else.

I like investment trusts, but they are much more complicated than normal funds. You have to get your head around premiums and discounts, and they can use debt, too, so will usually be more risky than an open-ended equivalent.

So – ahem – reserve your enthusiasm.

Last time we saw how the main asset classes are behaving during the coronavirus crisis. So far diversification is working just as if our predicament were a textbook exercise, rather than an ugly reality.

But what about the last time we went down the tubes? What asset allocation lessons can we learn by studying the Global Financial Crisis (GFC)? Did the same patterns play out and does that tell us anything about our fate this time?

Below I’ve tracked that market crash using the Exchange Traded Funds (ETFs) that were available at the time.1

All the ETF returns data and charts come from the excellent portfolio-building service JustETF. Returns include dividends but not inflation.

World equities peaked on 12 October 2007.2 They hit the bottom 17 months later on 6 March 2009.

It wasn’t until 9 March 2010 that equities climbed out of the hole – nearly two and a half years after their fall began.

100% equities during the Global Financial Crisis

The GFC was one of the worst bear markets on record, but it was a fairground ride in comparison to the first month of the coronavirus slide.

In 2020 we dropped like an anvil tied to an anvil: world equities plunged 26% from 20 February to 23 March. It took a whole year for world equities to tumble that far in 2007 to 2008. After the first month, equities had only slipped 7.5%.

In 2020 there is already talk about whether we’ve missed the great buying opportunity or whether there will be more downward legs to come.

There was certainly plenty of pain ahead of us at this point in the GFC. World equities closed just 1.5% down on 19 May 2008, only to trough out at -38% on 6 March 2009. Few were predicting we’d touched the bottom, even by then.

Volatility was wild, too – drops of more than 10% in a week, as confidence drained out of the economy in October 2008.

Equity correlations ‘go to 1’ in the Global Financial Crisis

What about a diversified portfolio? How did other allocations do when everbody was making their way not-so-calmly to the exits in the GFC?

In a global crisis nowhere is safe. And so once again there was nowhere to hide in equities.

Just like this time, the financial services exposure of the London Stock Exchange hit UK equities especially hard. Commercial property took a beasting in 2007-10, too.

Emerging markets did relatively well initially, again echoing the early stages of the coronavirus crisis. But as the recession took hold from September 2008, the fearsome volatility of emerging markets dunked them down by nearly 50%.

Mind you that same volatility eventually catapulted them back. Emerging markets were more than 12% higher by 9 March 2010. The developed world was still hovering around 0%.

Emerging Markets (Orange line; ticker: IEEM)

• Low point: -49.43%, 24 October 2008 vs World -30.2%
• 6 March 2009: -42.32% vs World low -37.96%
• 9 March 2010: 12.38%

Global Property (Red line; ticker: IWDP)

• Low point: -56%, 6 March 2009
• 9 March 2010: -8.96%

UK FTSE 100 (Blue line; ticker: ISF)

• Low point: -44.78%, 5 March 2009
• 9 March 2010: -9.05%

Flight to quality: government bonds in the GFC

When we look at bonds versus equities on a bear market chart, the picture we hope to see is a mountain range reflected in a lake. When the plunging valleys of equities are mirrored by bond peaks, we know our losses are to some degree off-set.

Intermediate gilts (a blend of short, medium, and long-term UK government bonds) lived up to their safe haven billing during the GFC. You can see that gilts were broadly negatively correlated with equities for the duration of the panic. During most of the big equity sell-offs, gilts pitched in the opposite direction as investors sought refuge in safer assets. That’s the famous flight to quality.

Unlike in the early stages of the coronavirus crash, gilts didn’t turn negative, either, bar an irrelevant -0.1% day on 15 October 2007.

Unfortunately I don’t have any data stretching back to 2007 for long or short-term gilt ETFs.

However their returns would have reliably sandwiched the intermediate gilt ETF’s – long-term gilts doing even better, while short-term gilts provided only crumbs of comfort.

Intermediate UK gilts (Blue line; ticker: IGLT)

• High point: 20.28%, 8 October 2009
• Low point: 0.85%, 13 June 2008
• 6 March 2009: 18.56% vs World low -37.96%
• 9 March 2010: 16.3%

Inflation-linked gilts and corporate bonds – not so effective in a crisis

Inflation-linked gilts and investment-grade corporate bonds have performed poorly relative to conventional gilts so far in the coronavirus crash, just as we’d expect.

Corporate bonds didn’t do us any favours in the dark days of 2008-09, either. That’s hardly surprising – they were backed by companies that many feared wouldn’t survive as the Great Recession laid waste to the economy.

Inflation-linked gilts (‘linkers’ to their friends) outstripped conventional gilts for the first year of the GFC. But they sold-off once deflation became the chief concern. Central banks tried to jolt the economy back into life with their QE defibrillator. That led to talk of runaway inflation, but linkers still lagged as the balance of risks suggested the patient was more likely to lapse into a coma.

Index-linked gilts (Orange line; ticker: INXG)

• High point 1: 15.26%, 1 September 2008 vs gilts 6.72%
• High point 2: 18.49%, 30 November 2009
• Low point: -1.33%, 8 December 2008
• 6 March 2009: 7.17% vs gilts 18.56%
• 9 March 2010: 14.85%

Linkers bore up (though not as well as conventional gilts) even as the market rock-bottomed on 6 March 2009. Their inflation-fighting capabilities make them an important part of a passive investor’s load-out even though we haven’t witnessed rampant inflation in the developed world since the early ’80s.

Sterling corporate bonds (Blue line; ticker: SLXX)

• High point: 5.67%, 18 January 2010
• Low point: –20.46%, 26 March 2009
• 6 March 2009: -13.93% vs World low -37.96%
• 9 March 2010: 5.17%

Gold had a good crisis

It was gold’s time to shine during the GFC – so much so I’d have been tempted to put a few of my highest carat teeth onto the market.

The yellow metal is proving to be a good diversifier during the coronavirus crisis, too.

Gold is the one accessible, low-cost asset that demonstrably traces a different path from equities and bonds. Long-term returns may be low, but it was worth its weight in 2008-09.

Gold (Yellow line; ticker: PHAU)

• High point: 102.39%, 3 March 2010
• Low point: 0.14%, 22 October 2007
• 6 March 2009: 77.19%

Note that gold can be as horribly volatile as equities. It lost 20% in the week of 10-17 October 2008 while equities bounced along the bottom. Gilts didn’t help much that week either, but at least they only shed 0.5%.

Diversified portfolio vs 100% equities

You know the drill. The 100% equities portfolio (green line) is pitched above against a diversified portfolio comprising world equities, intermediate gilts, and gold (blue line).

This diversified portfolio is:

• 60% world equities (Ticker: IWRD)
• 35% intermediate gilts (Ticker: IGLT)
• 5% gold (Ticker: PFAU)

As the chart shows, when an emergency hits you’ll probably be glad you packed your parachute, inflatable arm-bands and fashion-forward face-mask. Your portfolio should be ready for anything.

Take it steady,

The Accumulator

1. The ETFs I used for last week’s post didn’t exist in 2007. [↩]
2. As tracked by the iShares MSCI World ETF; Ticker: IWRD. [↩]

What caught my eye this week.

The graph of this week’s GDP forecast from the Office for Budget Responsibility looks like something from a comic book:

That’s not an economic projection – that’s the punchline to a three-panel cartoon.

Of course the hope is that like a sack full of garden manure dropped onto a trampoline, what goes down must surely bounce up again. And it will. But how?

Will we see a V-shaped recovery? A U-shaped recovery? Maybe a W-shaped start-stop affair? Or even a Nike Swoosh?

The idea is to pick the letter of the alphabet that best fits how you expect the graph to go over the next few months.

Personally, I think it’ll probably be more like a Chinese character, darting up and down all over the place.

Modern economies are fabulously complex, and switching ours off wholesale will have broken numerous connections. When we restart, some areas will fly but others will be literally waiting for parts.

China tried to reboot its big factories first, but then discovered most of them relied upon smaller suppliers. So they were switched on, too – but then they found workers had nowhere to eat, because the street canteens hadn’t yet been allowed to reopen.

Britain on pseudo-FIRE

We’ve got plenty of time to think about all this, what with lockdown officially extended for “at least” another three weeks.

Indeed it seems that many Britons have become more reflective now their alarm clocks have stopped buzzing and they’re working within sight of their gardens and kids.

It’s bemusing to me to read articles or hear podcasts in which people gush about how proud they are to be managing to work from home.

Apparently it’s a revelation to many that the technology is available, and that people will get on with work without the clattering distraction of an office or the time suck of a commute.

Fifteen years ago I co-founded a company that eventually grew to dozens of employees and scattered contractors. We never had a central office and ran the thing using Skype, Gmail, and early on Google Spreadsheets.

We’d meet fancy clients in a London member’s club to avoid awkward questions. But mostly we plotted strategy around our dining room tables, and then beavered away in our homes.

It seems this is fairy story stuff for many workers. I’ve written before that I believe more things will stay the same than change post-Covid-19.

But maybe I’ve been presuming too much?

Sky News reports that only 9% of people want life to return to normal after lockdown:

The survey found that 61% of people are spending less money and 51% noticed cleaner air outdoors, while 27% think there is more wildlife.

Others say that having glimpsed the freedom of working from home, many won’t want to go back:

“Once they’ve done it, they’re going to want to continue,” said Kate Lister, president of consulting firm Global Workplace Analytics.

She predicts that 30% of people will work from home multiple days per week within a couple of years.

Lister added that there has been pent-up demand by employees for greater work-life flexibility, and that the coronavirus has made their employers see the light, especially as they themselves have had to work from home.

Indeed some are already anticipating a rearguard action from The Man and His Minions, who are presumed to be desperate to keep us in our (work)place and on the hedonistic treadmill.

In a widely-shared Medium article, Julio Vincent Gambuto celebrated the global lockdown:

The treadmill you’ve been on for decades just stopped. Bam!

And that feeling you have right now is the same as if you’d been thrown off your Peloton bike and onto the ground: What in the holy fuck just happened?

I hope you might consider this: What happened is inexplicably incredible.

It’s the greatest gift ever unwrapped. Not the deaths, not the virus, but The Great Pause.

It is, in a word, profound.

But Gambuto predicts capitalism won’t stand for it.

“We are about to be gaslit in a truly unprecedented way,” he says, using the neologism for manipulating somebody into doubting their own sanity.

Lock heeding martians

While of course I’m breezily doing as directed – it’s not a big weekday change for me, to be honest – I do have mixed feelings about the full lockdown strategy, as we’ve been discussing in the Monevator comments over the past few weeks.

Sweden, for instance, has no mandatory lockdown and yet far fewer deaths per million citizens, as cited in the links below. Indeed different countries are as figuratively all over the map with their Covid-19 pandemics as they are on the globe. It seems there’s a lot going on we don’t yet understand.

But all that aside, I’ve been moved by seeing the lockdown in action in London.

When China shut-up Wuhan, the few over here who were paying attention wondered whether we could ever manage anything similar in the individualist West. I admit I had my doubts.

Yet with no coercion and minimum fuss, the vast majority of us have followed the government’s strictures and it’s a little wonderful.

Out on my daily walk, every time someone steps off the pavement into the car-less road to give me space before I can do the same for them, I almost want to hug them. (Oh the irony!)

The London air is clean to breathe. You really can hear birds sing.

Even as the economy craters. Even as Romanian workers are being flown in to pick fruit because the farming industry still can’t find British workers to do it, despite a million more jobless than last month. And not even Covid-19 can slow down Brexit.

Irony indeed.

Have a philosophical weekend!

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