10 investment trusts to give you a £10,000 annual income

Investing for income will be in the spotlight this year, as the government's pension reforms take effect in April. As the purchase of annuities continues to slump, investors will be looking for other ways in which to secure themselves a reliable income.

Investment trusts are a particularly good way of achieving this goal, thanks to their ability to smooth out their income payments.

The reason they can smooth their dividends is that they are allowed to hold back some income in reserve and use it to top up dividend payments in tough times - unlike investment funds, which are obliged to pass on virtually all the income they receive each year.

It is partly this ability to maintain income reserves that has enabled some trusts to build up long histories of increasing their dividends every year, through good times and bad.

Achieving a target income

To show how trusts can be used to provide a meaningful income, Money Observer has created a portfolio of 10 trusts that could pay an estimated starting income of around £10,000 a year. To achieve this income an initial investment of £245,000 would be required, according to our calculations.

Relatively high-yielding trusts have been chosen for the portfolio. Individual yields vary between around 3% and over 7%. The average is 4%.

We have created the portfolio from a mixture of solid, mainstream UK-invested trusts, globally diversified trusts and two more specialist, higher-yielding but potentially riskier trusts. The main aim is to provide a good starting income which we anticipate will rise over time.

There is also the potential for capital growth over the medium to long term. However, investors should be aware that there are likely to be fluctuations along the way.

Most of the trusts in the portfolio pay dividends on a quarterly basis and some income will be received by investors every month, but the flow will be uneven. Although it would be possible to create a portfolio that provided a more even spread of income across the year, that would have meant the income tail wagging the investment dog.

Premiums

The majority of the trusts in the portfolio are trading at a premium to their net asset value (NAV) at present. In the past we would not normally have recommended buying at a premium, because if the premium disappears it can reduce your gains or increase your losses.

On the other hand, providing trusts are held for the longer term, a modest premium, paid at the outset will have little impact on your overall returns. Even so we would not usually advocate paying a premium of above 5%, other than in exceptional circumstances, which we believe to be the case currently with Murray International.

We are not only including it in the portfolio despite its high premium but are also making it the largest holding. We believe its experienced manager, good yield, international spread and excellent long-term track record still make it an attractive investment with potential for future outperformance.

UK exposure

To give the portfolio a solid bedrock, around 40% is invested in four UK-focused income trusts that we believe are dependable in terms of both future dividend payments and capital preservation.

City of London, for example, has the distinction of having the longest record of annual dividend increases in the investment trust industry, stretching back 48 years. Its ongoing annual charges of 0.43% are also the lowest of any trust in the Association of Investment Companies (AIC) UK equity income sector.

City of London's manager, Job Curtis, has run the trust since 1991. He takes a conservative approach, focusing on companies with cash-generative businesses. It is biased towards UK-quoted blue-chip companies, which currently make up around 70% of the portfolio. However, Curtis favours companies operating internationally and therefore exposed to economies likely to grow faster than the UK.

Another stalwart is Perpetual Income & Growth, managed by Mark Barnett since 1999. It has one of the strongest levels of dividend growth in the UK equity income sector. Barnett's approach is unconstrained, so he can invest in whichever types of stocks he believes have the best prospects.

However, he also tends to take a defensive approach. The trust's performance has benefited from good stock selection and its exposure to small and medium-sized companies, representing around 40% of the portfolio.

Temple Bar has been increasing its dividend payouts for more than 30 years. Its total returns have been good over the long term but in recent years its results have been below average.

This is largely because of the contrarian approach taken by its manager, Alastair Mundy, who likes to invest in out-of-fashion companies that he expects to recover. This can lead to periods of underperformance, but we believe his approach will come good over the longer term.

Our fourth UK holding is Troy Income and Growth (formerly Glasgow Income) which moved its mandate to Troy in 2009.

Manager Francis Brooke focuses mainly on long-term defensive stocks, seeking out companies that are well placed to withstand difficult economic conditions thanks to powerfully branded goods and services with the ability to raise prices in the event of inflation. Besides aiming to grow the trust's income over time, the managers also emphasise the importance of capital preservation.

Overseas exposure

The remaining 60% of the portfolio is spread across six investment companies investing outside the UK. Four invest internationally while the other two are focused on the emerging markets and Canada. The largest holding is Murray International.

We have made this our largest holding because we believe Bruce Stout is an exceptional investment manager and we also like his decision to overweight the portfolio in favour of Asia and emerging markets, which make up around 50% of the portfolio, and which we believe will serve investors well in the long run.

Scottish American is another trust with a broad remit. It has been managed by Dominic Neary, head of Baillie Gifford's global equity income team, since the beginning of 2014. It is somewhat unusual in that it holds commercial property (10%) and bonds (6%) as well as global equities.

It has a long history - 34 years - of dividend increases. Although it has somewhat underperformed its sector over the past year, partly due to its under-exposure to the US, we believe there is scope for improvement under its new manager. In the meantime it is paying a good yield.

Majedie Investments, our final mainstream international selection, appears in the AIC's growth-oriented global sector. However, it has a yield of over 3%, and part of its investment objective is to increase its dividends by more than the rate of inflation over the long term.

Since the beginning of 2014 it has been managed by Majedie Asset Management, which runs open-ended funds. It has essentially become a fund of Majedie AM's funds. Their good performance records will benefit the trust.

Over the longer term we still believe emerging markets are likely to outperform developed markets. Hence we have included JPMorgan Global Emerging Markets Income in the portfolio. It has an attractive yield and invests in a wide spread of emerging markets.

However, these markets have been under pressure, so although the trust's board wants to increase its dividends over time, this may not be possible in all market conditions; but over the long term we think this will be a rewarding holding.

The smallest holdings in the portfolio both have good yields. Middlefield Canadian Income invests in a broad spread of Canadian equity income securities, including real estate investment trusts, financial, energy and utility stocks, with around 10% in bonds. We believe this trust provides useful diversification, especially bearing in mind the stability of the Canadian economy.

At the other end of the risk scale is Princess Private Equity, a Guernsey-based investment company that invests in unquoted companies and is now trading on a discount of over 20%, though it once traded on a premium.

In May 2011, its shareholders approved a revision to the fund's investment policy to focus on direct rather than fund-based investments, and its performance has been improving. In addition, a dividend objective of returning 5-8% of net asset value each year to shareholders was introduced.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.