DIY Investor Diary: why investment trusts form bedrock of my portfolio

In our new DIY Investor Diary series, we speak to interactive investor customers to find out how they invest in funds and investment trusts, what their goals and objectives are, current issues and concerns regarding their portfolio, and what they’ve learned along the way. The premise is to try and provide inspiration to other investors, and we would love to hear from more people who would like to be involved. We do not require those featured to be named. If you are interested, please email our collectives editor directly at: kyle.caldwell@ii.co.uk. 

For income-seeking investors who want a regular cash flow, the investment trust structure is arguably more attractive than open-ended funds. This is because investment trusts do not have to distribute all the income generated by their assets every year, as up to 15% a year can be retained in so-called revenue reserves. When there’s an income shortfall, those reserves can be utilised to keep dividends flowing.

In contrast, funds are required to pay out all the income they receive each year from the underlying investments. Therefore, when there’s an income drought, funds have no option but to cut their dividends, as was the case during Covid-19 and the global financial crisis. Most investment trusts, however, retained or increased their dividends by dipping into their reserves.

Therefore, if consistency of income is of high importance, investment trusts may be better than funds, which are structured as unit trusts or OEICs.

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The DIY investor who features in this article is 79 and taking advantage of the investment trust structure to supplement his retirement. He takes around £10,000 a year from his investments – held in a SIPP and an ISA – with investment trusts forming the bedrock of his portfolio.

He has a number of high-yielding trusts including Henderson Far East Income (LSE:HFEL) and Henderson High Income (LSE:HHI).

However, he also has lower-yielding trusts that strike more of a balance between delivering both capital growth and income. Among the holdings are F&C Investment Trust (LSE:FCIT), Caledonia Investments (LSE:CLDN), and Witan (LSE:WTAN).

He says: “I am using my investments to pay myself an income, taking £10,000 a year. This mainly comes from dividends paid, but I am also prepared to sell down or sell out of a holding.”

As well as investment trusts being consistent income payers, with nine trusts in the 50-year plus dividend club, another feature of investment trusts that is typically beneficial is their ability to gear (or borrow) to invest.

While this can go the other way, by causing greater losses in falling markets, over time stock markets generally rise. As a result, long-term investors in a geared investment trust can see their returns turbocharged.

“The ability to gear is one of the main reasons why I like investment trusts over funds. I have also benefited from some very nice special dividends over the years, particularly from Caledonia. Elsewhere, Henderson High Income has done exceptionally well for me, while I like Witan because it always just chugs along.”  

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This investor also has some individual stocks, favouring reliable dividend-payers, including Imperial Brands (LSE:IMB), British American Tobacco (LSE:BATS), Legal & General (LSE:LGEN) and Phoenix Group (LSE:PHNX).  

However, due to other commitments, having taken up a new position as president of a sports club, our DIY investor is increasingly preferring outsourcing the stock picking to a fund manager.

“As I have less time to focus on my investments, I have been adjusting the portfolio to become more self-managing.”

In hindsight, he says, “a lesson I have learned over the years is that I should have just stayed with investment trusts over individual shares”.

He adds: “After all, the fund managers have better insight into sectors and the stock market in general than I do.”

However, buying an investment trust at the wrong time can lead to an unsatisfactory outcome. One example cited, which he has now sold, is Smithson Investment Trust (LSE:SSON). The trust, managed by Simon Barnard, applies the investment philosophy of Terry Smith’s Fundsmith Equity fund, but instead focuses on global smaller companies deemed too small for the original Fundsmith.

While Smithson’s performance in 2023 has picked up, 2022 was a year to forget as its share price dropped 35.2% and the net asset value (NAV) of its companies fell 28.1%. For comparison, the MSCI World Small and Mid Cap Index declined by 8.7%.

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In terms of individual shares, he cites Lloyds Banking Group (LSE:LLOY) as a disappointing holding over the years, remarking that “the shares never seem to do anything”. Yet he has been picking up a reliable dividend.

Knowing when to call it a day on an investment is viewed by many as harder than hitting the buy button. Some of this stems from behavioural finance biases, including inertia.

Our DIY investor says that the difficulty of knowing when, or whether, to sell “has been my biggest weakness”.

His top tips for other DIY investors is to think long term, be patient, and watch out for fund charges. On the latter point, he says that investors need to always bear in mind that however a fund performs “the fund management firm still gets its fee”. Therefore, it is important to monitor fund performance and assess whether you are getting value for money.

How to decide whether to sell a fund

Among the questions fund managers ask themselves when deciding whether to hit the sell button is whether, over the long term, the drivers for the company are still in place, and whether the valuation has become too rich.

For funds and investment trusts, the same logic applies. First, step back and try to understand why the fund is underperforming.

If it is because the region it invests in, or the investment style, is out of favour, then a period of subdued short-term performance can perhaps be forgiven.

You could view it as a good time to buy more if you think prospects for the region the fund invests in, or the types of shares it holds, will likely improve over time.

However, if it has been a favourable market backdrop for the fund and it has still notably underperformed peers, then investors need to weigh up whether to hold on in the hope that performance improves, or hit the sell button. Ultimately, it is a judgement call that only you can make.