Nobody likes losing money, even after years of rising capital values and income payouts, so the ‘flash crash’ that wiped a record number of points off the Dow Jones index of American blue chip stocks on Monday will have shocked many.
Since then, global markets have staged a partial recovery with most investment trusts’ gearing – or borrowing to buy – accentuating first the downswing and then the upswing. Scottish Mortgage (SMT), the only investment trust in the FTSE 100 benchmark, was among the biggest swingers, falling nearly 5% on Tuesday before bouncing back by 6% during inter-day trading on Wednesday.
Less obviously, investment trust shareholders enjoy important and unique advantages when it comes to coping with global stock market shocks. While most media attention focuses on fluctuations in capital values or share prices, it is worth pointing out that the majority of returns from shares over the last century or so was delivered in the form of dividends.
Not many people know this but nine-tenths of the real return from UK equities since 1899 came from income rather than rising share prices. Or, as Sreekala Kochugovindan of Barclays Equity Gilt Study told me: ‘Annualised average total returns in excess of inflation were 5% but just 0.5% came from capital gains; the rest is driven by dividends.’
While it may not be dramatic enough for the TV bulletins or tabloid headlines, income is where investment trusts have unique advantages to offer medium to long-term investors, especially during periods of extreme market volatility.
Unlike any other form of pooled fund, investment trusts can retain some of their returns in good years to top-up dividend distributions in bad years. This facility is particularly valuable for rising numbers of people who are relying on income drawdown to fund retirement.
You cannot pay a gas bill with a notional ‘total return’. Instead, you will need reliable and preferably rising income to do so.
Fortunately, many investment trusts have maintained rising dividend distributions over many years – several have done so for several decades – and many more can show substantial reserves, sufficient to sustain income payments to investors for years to come, even if the current market correction turns into a full-blown slump.
Annabel Brodie-Smith, a director of the Association of Investment Companies, pointed out: ‘Four investment companies – Alliance Trust (ATST), Bankers (BNKR), Caledonia (CLDN) and City of London (CTY) – have increased their dividend every year for over half a century and over twenty have increased their dividends for more than two decades.
‘The unique ability to squirrel away some of the income received each year to distribute in tougher times is a major benefit which comes into its own in challenging markets.’
For example, Caledonia yields 2.1% and has a revenue reserve of £333 million, which is equal to 10.9 years’ of dividend cover, while Alliance Trust yields 1.9% and has £121m in reserves, or sufficient dividend cover for 2.5 years.
Elsewhere, Charles Cade, head of research at Numis Securities, favoured Scottish (SCIN) investment trust for volatility-averse income-seekers. He told me: ‘It has increased its dividend for the past 34 years and has reserves equivalent to 2.5 years’ regular dividends.’
Another important advantage for medium to long-term investors is that these trusts' closed-end structure means shareholders will not be forced to subsidise short-term speculators who demand to get back into cash now.
By contrast, open-ended funds – including unit trusts – may be forced to sell assets at fire-sale prices to raise cash to meet redemptions if a correction morphs into mass panic.
The unfortunate fact is that nobody can be sure whether this week’s market turmoil is a short-term correction or the beginning something more serious, such as a medium to long-term slump. For what little it’s worth, my guess would be the former and I remain fully invested.
What can be said with confidence, though, is that those who will lose most from market fluctuations are people who panic and turn paper losses into real ones at the bottom of the cycle. They will exclude themselves from benefiting from the recovery that is likely to occur sooner or later.
History shows that the global economy tends to grow over time, as inventions and improved efficiency create wealth that was unimaginable before.
Anyone who is, like me, in their second half century will be able to remember how incredible today's mobile phones, personal computers and satellite TV would have seemed in our youth – and these are just three examples of how substantial wealth has been created out of thin air.
Shareholders are the owners of the multi-billion pound companies that have turned science fiction into commercial fact. Of course, the future remains uncertain and the present feels like a horribly bumpy ride. But apparently technical differences between investment trusts and other forms of pooled funds give investors in these tried-and-tested trusts valuable advantages in volatile markets.
Here is a complete list of Ian Cowie’s stock market investments. It is not financial advice nor is any recommendation implied.