RIT Capital Partners, the investment trust set up by the Rothschild family, started paying dividends from capital profits to meet shareholders’ demand for yield, rather than compromise its investment approach by straying into higher-yielding assets.
A potential downside of this practice for some investors is the taxation differential between income and capital. Dividends from capital profits are treated just like normal dividends for tax purposes.
But the objections to paying dividends from capital profits run deeper than this. “Eating your seed corn” is one phrase I’ve heard used to describe the practice by those who seem to regard it as almost morally wrong.
Nevertheless, others point out that the distinction between income and capital is never entirely clear-cut. Like open-ended funds, investment companies have flexibility about whether fees are charged to capital or income. The argument goes that those which charge a higher percentage to capital in order to boost income distributions have effectively been ‘paying income out of capital’ since well before 2012.
These debates are likely to continue, and may take on new urgency if the depletion of revenue reserves at some investment companies leaves them with a choice between paying income out of capital profits and cutting the dividend.
The continuing relevance of investment companies
Despite the hit to income investors’ portfolios this year, the surprisingly resilient performance of global stock markets, and growth companies in particular, has softened the blow to some extent.
Meanwhile, faith in traditional income producers – from UK blue-chips to commercial property – has clearly taken a knock.
Nevertheless, it might be premature to write off income investing just yet.
Reliable income streams can provide peace of mind, a sense of security and a simple way to value assets.
One investor in the AIC’s survey sums it up: “You have to accept in investing that there is a fair amount of risk, but obviously we all want to minimise that risk and therefore have a certain amount of predictability in terms of the income you are getting.”
Investment companies, with their ability to smooth dividends over time, provide a tried-and-tested solution to the problems of natural income fluctuations and the uncertainty of capital returns.
They have also moved with the times by expanding into less liquid asset classes that can produce attractive levels of income.
The AIC’s research shows that many private investors rely on investment companies for income, and on average, those that do so feel less worried about the future than non-investment company users.
