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The reality behind investment trust revenue reserves

A magic lantern to signify the magical ability some people seem to think trusts have to generate dividends.

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.

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{ 26 comments… add one }
  • 1 Seeking Fire April 23, 2020, 10:18 am

    Great article and hopefully makes a few more people aware that there is no free lunch. In fact relative to passive investments you of course generally pay for the lunch by dint of higher fees. None the less the smoothing of income has a very important psychological effect that you alluded to and the concept of a regular income is very attractive in retirement even if it’s effectively a return of capital not a return on capital in bear markets. There are other benefits of IT as you and other readers no doubt are aware of including gearing and often a longer term outlook given no need to sell assets to match redemptions. So IT still win over most unit trusts for me.

  • 2 SemiPassive April 23, 2020, 10:33 am

    Or just take income from distributing ETFs and have your own cash reserve bucket/short bond ladder to weather years where dividends across the market are cut.

  • 3 weenie April 23, 2020, 10:36 am

    Well that’s kind of pulled the rug from under my feet, I’m one of those who’s been bedazzled by the ‘magic’ of investment trusts and now I see it was all just an illusion!

    Will continue investing in them but thanks for making me reconsider the higher risks.

  • 4 The Investor April 23, 2020, 10:42 am

    @SemiPassive — Absolutely another option, as discussed here:

    https://monevator.com/how-to-live-off-investment-income/

    Still not as easy as leaving a manager to do it for you when perhaps that’s the better choice but also of course no active risk and likely cheaper.

  • 5 Matthew April 23, 2020, 12:28 pm

    And thar be fees upon yon cash under management
    Manage it ourselves!

  • 6 Charley Hay April 23, 2020, 1:35 pm

    This misunderstanding regarding ITs’ revenue (& capital reserves) arises because the vast majority of investors, and the vast majority of “journalists” writing about investing, haven’t got the first clue about accounting/bookkeeping.

    But never mind, it’s only people’s life savings they’re punting around!

  • 7 Naeclue April 23, 2020, 4:36 pm

    Some people on the net seem utterly obsessed by revenue reserves. I guess the ITs themselves continue to bang on about them for marketing reasons. One of the most ridiculous things about not paying out all dividends is that for trusts trading on a discount, those withheld dividends would be worth more in the hands of investors than they are reinvested internally in the trust.

    I can see the attraction of the smoother dividend flow for smaller portfolios, where DIY costs might be significant due to trading costs. I can also see the attraction for some people who might want as completely a hands-off income stream as possible.

    Brokers have been slow off the mark here in offering low cost regular income alternatives, but the Vanguard literature says that they support free regular automated withdrawals from the ISA and General Accounts with no minimum withdrawal amount. I don’t have a Vanguard account, so don’t know how it works, but it looks like you nominate how much you want out of each fund each month (quarter?). It sounds as though you could just set this up and then just readjust annually or so, when you might consider rebalancing. The only thing missing would be the decision of how much to set the income to each year. Admittedly a decision entirely taken out of the hands of IT investors, which again some investors might prefer.

  • 8 Marco April 23, 2020, 4:41 pm

    Total return is what matters. I plan on selling units of vanguard all world for retirement income as well as taking the dividends.

    Never understood the dividend obsession.

  • 9 Rishi April 23, 2020, 4:57 pm

    Hi All,

    Revenue reserves is mainly a book keeping exercise. But we can look at the cash positions of ITs vs their yield to get a good understanding of how many years of divs they can cover before they have to sell investments to cover the full distributable revenue reserve (should fresh divs keep falling short qr-over-qr). Especially if you can buy an IT at 5%+ discount, this should be good?
    Eg:
    discount cash reserve yield
    Caledonia: 20% 4.9% 2.4%
    RIT 3.1% 10.1% 2%
    Personal Assets -1.4 11.7% 1.3%
    Majadie: 7% 15.4% 5.5%
    Scottish Investment Trust: 9% 9.3% 3.2%
    Lindsell Train: -17.9% 2.9% 2.5%
    Bankers: -0.2 2.5% 2.4%
    JPMorgan Global Grth & Inc -4.9% 4.6% 4.2%

    These numbers give me great relief that many of the core investments that investors have like caledonia, RIT, Personal Assets, Lindsell Train, Bankers etc. are in a great position to pay divs without liquidating investments for 1 or 2 years! This combined with the fact that ITs typically are 10-20% levered means that over the long term, given that markets tend to go from bottom left corner to top right coner on most charts, ITs like the ones above (especially with divs reinvested) should outperform trackers for accumulators and provide smooth income for retirees?

    Any opinions are welcome!

    Regards,
    Rishi

  • 10 Naeclue April 23, 2020, 5:37 pm

    @Rishi, pick the right ITs and you will do well, but the odds are against you making the right picks at the right times. For many retail investors, if they want to identify the biggest risk to their wealth, all they have to do is look in a mirror.

  • 11 Rishi April 23, 2020, 6:10 pm

    @Naeclue: I am making a case for Buying ITs and never selling them! Obviously not selling is ok when you are accumulating (I am), but the only way you can keep at it in retirement is if you are living of the natural yield.

    This article in some ways is trying to debunk the ‘live on the (growing) natural yield from IT’ argument based on the fact that revenue reserves are not equal to cash reserves i.e. ITs, just like other funds, will have to sell at opportune time to keep the divs going. So I made the observation that most ITs that form core investments for investors do have enough cash reserves to keep div payments without selling equity, when the market is down (like 3 weeks ago). And maybe Div yield as a % of cash reserve must a criteria investor must use to genuinely weed out ITs that are likely to do what everyone likes them for rather than just swinging at the fences like every other fund out there…

    In the long run the way to make good returns is for the IT to not sell chunks of invested NAV to distribute divs and for investors (especially ones seeking income) to not sell shares (ever or) when the market is down?

    Regards,
    Rishi

  • 12 Getting Minted April 23, 2020, 8:56 pm

    The important thing for me is that I have confidence that the actual or aspiring dividend heroes in my portfolio will increase or at least maintain their dividend through a downturn for one or two years. That gives me the option of taking their dividends so I don’t have to sell any shares.
    As they have a stated revenue reserve, they know that they may have to sell any of that reserve they have invested in shares if needs be. It appears to me that a typical UK equity income trust with a 6% yield may have to take about one third of that from its’ revenue reserves in what is an exceptional year. I’m OK with that. I don’t agree with trusts using capital to increase dividends routinely every year.

  • 13 marked April 23, 2020, 10:10 pm

    Definitely makes a good point when two stocks in my portfolio have a dividend problem

    HSBC told to not pay a dividend by BOE
    Deutsche Telekom can’t pay their dividend because they had to cancel their AGM, so will do later in the year.

    Both these dividends were fairly chunky to me and I’d have loved them for reinvestment now.

    By the way I like all these letters that people talk about for a recovery. You know, V, L, W, and really liked the Nike Swoosh that @TI talked about, but then I read Finimus’ latest article. He has a really good point. I am beginning to think a letter / logo doesn’t exist for the forthcoming recovery.

  • 14 HariSeldon April 23, 2020, 10:12 pm

    @Rishi and @GettingMinted

    The article explains revenue reserves very well indeed, the rising dividends that some ITs produce are reassuring to many investors, the reality behind those rising dividends may be a bit shaky ! but it’s not a huge problem either way. The additional costs for an IT vs a low cost passive fund often balance out, if you buy at a discount and the fairly gentle gearing on many ITs can over time mitigate the additional charges.

    The better IT’s may be a sensible choice against a passive IT, particularly if you want to cover a niche where the passive funds are not well represented , perhaps smaller U.K. companies, where otherwise the passive choice will likely the FT250 only, the problem being you have to be able to select the better trusts ahead of time, it’s not that easy.

    Investment Trusts allowed me to retire early and I like them, but it’s hard to argue with the results of low cost, mainstream, passive ETFs & funds, without the need to research trusts, in fact with very little effort at all, you can obtain really excellent results against most active choices.

    A personal cash buffer to help smooth dividends from index funds and possibly selling a few shares to supplement dividends, is a pretty straightforward way of providing an income from investments that can be relied on.

  • 15 Naeclue April 23, 2020, 11:05 pm

    @Rishi, out of interest, where are you getting your cash reserves figures from? I cannot see them on AIC.

    Bit of a strange concept, a geared portfolio holding a significant amount of cash, but I guess it must make sense to some people out there.

  • 16 Naeclue April 23, 2020, 11:48 pm

    @HariSeldon,
    “The additional costs for an IT vs a low cost passive fund often balance out”.

    Often? Really? From what I can see in just about any sector you care to mention is that
    ITs deliver a very wide dispersion of returns, even over relatively short periods. I might agree if you said the expected returns from ITs may match/exceed market returns because buying at a discount+leverage may overcome the drag of higher fees, but using the word “often” is quite a stretch. Just look at 5 to 10 year returns in the global sector.

    From what I have observed, over the long term more ITs underperform the market than outperform it even with their supposed advantages, but this will depend on when you take the snapshot. The additional risks don’t appear to be worth paying for, unless you get lucky of course. If you want gearing, you could always do it yourself with ETFs and a broker that let’s trade on margin, such as IB. Much cheaper and you will get exactly what you pay for instead of risking huge underperformance.

    I agree with you about niche areas though. Closed ended funds are a much better structure when invested in illiquid stuff, assuming you don’t want to dabble yourself.

  • 17 Rishi April 24, 2020, 12:50 am

    @naeclue
    Aic go to portfolio tab when you go to any ITs page. https://www.theaic.co.uk/companydata/0P00008ZPG/portfolio

    Geared portfolio with cash is a great advantage! Cash is an option. Return on cash is not the low interest you get from fixed deposit or long dated bond ladder, but the ability to pay div without selling assets at low prices or indeed buying mispriced assets, which during crashes could be the wide discounts that open up in ITs (buybacks)

    Practically every business, yes even the most reliable money spinners like Apple, Google, Facebook etc. have debt on their balance sheet and healthy cash or cash equivalents. Gearing and cash reserves is a common and successful trait of business. Good CEOs/ managers understand and use the optionality of cash.

    Warren Buffet has a cash hoard and debt on his berkshire Hathaway balance sheet …. the optionality of cash (almost 15% of market cap) seems to have done him a world of good buying mispriced assets during crashes.

    Regards,
    Rishi

  • 18 Hari April 24, 2020, 11:21 am

    @naeclue
    Until recent years the AIC stats monthly publication used to provide some comparators for various global & regional markets, inflation, returns etc. (around 50 indices in all) I have numerous of these, downloaded from the early 2000’s and before that they were paper copies when you subscribed.

    I did some analysis using overlapping reports that covered 1997 to 2017, comparing various indices and a selected bunch of IT’s (that I have owned at various periods), it indicated that they generally performed as well as the indices ( without any costs), some periods they tended to do better and others less so, but on balance, at least as well over the time periods covered. I did look at a lot of different overlapping time periods in that time frame of 20 years, this tended to negate the influence of picking a set start and end dates that can plague these comparisons .

    This is not proof by any means, but some IT’s do just fine, eg Foreign and Colonial is pretty similar to an All World Index in performance terms over decades.

    On balance you might as well choose an index fund, but at times of stress you can pick up solid ITs at significant discounts (you need to check that these are related to the general market sentiment rather than a specific trust related factor)

  • 19 Matthew April 24, 2020, 1:41 pm

    @rishi – gearing inside a portfolio is something you might not recover from unlike simply waiting out a normal crash, if you get a margin call and having to sell at a bad price – it compounds the risk you have – potentially profitable but could you get better returns per level of risk with index funds?

    I put it that if it really was that profitable to mess with gearing and timing, wouldnt we see private equity firms that do something like youre suggesting gravitate up indexes, and youd see hedge funds whooping passive. There is survivurship bias amongst the stories ye hear

  • 20 Factor April 24, 2020, 2:35 pm

    Recommended reading – Investment Trusts, Unlocking the City’s Best Kept Secret; Pearson

  • 21 Naeclue April 25, 2020, 5:14 pm

    @Rishi, Cash does not have a strike or expiry, as such it is absolutely not an option 😉

    I agree with you that businesses often have debt and cash. They could operate without debt, but not without cash. ITs can also operate without debt, but again will need some cash. I accept that an ITs investment model may include holding quite a lot of cash at times and at the same time as having outstanding issued debt securities – it takes all sorts. However, you are suggesting that cash is being held as a backup to dip into when there is insufficient income from investments to cover the desired level of dividend payments. This is the aspect that I was alluding to.

    Take Majadie as an example. From their accounts I can see they have a debenture outstanding that they are paying 7.25% on. Yet at the same time you are claiming they are maintaining a cash buffer (earning a fraction of a percent) to avoid cutting the dividend when income dries up. You may think this is a sensible thing to do, by I do not and would have no interest in any investment vehicle that did such a thing. Nor for that matter am I interested in a fund that uses leverage. I hold cash/bonds and by the same logic it makes no sense for to me to hold an IT that uses leverage costing more than I am earning on cash and bonds. Note I am talking about investment vehicles here, not underlying businesses, many of which are, quite naturally, leveraged.

  • 22 Naeclue April 25, 2020, 5:30 pm

    @Hari, I accept that your findings on ITs may be true, that on average they have performed “at least as well” as the market, I don’t have enough information to confirm or refute your analysis. I would point out though that both stock and bond markets have been haphazardly rising for over 30 years, so it would be dismal if the use of leverage did not allow ITs to have done at least as well as the market.

    However, even if ITs have done as well, they carry a lot more risk, and I don’t just mean the leverage. Just one example – Edinburgh. 5 years ago they were very near the top of the UK Equity Income table over 10 years, helped along as I recall by Woodford avoiding banks. Yet over the last 5 years they are well below average for the sector and have a total return LOSS of about 22%. All the while increasing dividends – it will be interesting to see how that pans out for investors.

    This is not a solitary example either. In the same sector, Perpetual Income & Growth had almost as good a record as Edinburgh 5 years ago and they have lost even more (35%), again whilst increasing dividends. On average, the sector may have done well, although it does not look that way to me compared to the FTSE 100 and definitely not versus FTSE World, but it shows a risk of significant under performance in individual ITs. This risk could be mitigated by diversifying across multiple ITs, but then you are just dragging returns down to the average and so may as well buy a tracker fund 😉

    Of course some people delude themselves into thinking they can pick the winners or will be able to trade out when an IT stops out performing…

  • 23 Naeclue April 25, 2020, 5:42 pm

    @Rishi, if a “Geared portfolio with cash is a great advantage!”, please can you explain how this squares with Majadie losing 5.5% of their investor’s money over the last 5 years, compared with a gain of 50% for an iShares world tracker ETF?

  • 24 Rishi April 27, 2020, 12:32 am

    @Naeclue: can you give me ticker of trackers that you are referring to? Also, why compare just 5 yrs performance???

  • 25 Naeclue April 27, 2020, 11:37 am

    @Rishi, I was comparing against the FTSE 100 index, not a tracker, but there are plenty of trackers you could use. ISF for the FTSE 100, but be aware that this distributes income. For global markets SWDA tracks the total return of the MSCI World Index and covers developed markets, EMIM tracks MSCI Emerging. Both are priced in sterling, which is helpful.

    I looked at the last 5 year performance to illustrate what can happen to ITs (or open ended funds) that were previously good performers. There is a very good reason that regulators insist fund managers say “Past performance is no guide to the future” in smallprint in their literature. It is an established empirical fact.

    Had you bought either Perpetual Income & Growth or Edinburgh 5 years ago, when both were star performers, do you think you would you continue to hold now they look like dogs?

  • 26 Rishi May 3, 2020, 10:15 am

    @Naeclue: with regards to perpetual or Edinburgh…. FTSE 100 today is roughly at same level (or lower?) as in 1998! What is your point? You can have dogs whether you buy index or IT.

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