Dividend heroes vs enhanced income: which approach is best?

You might be approaching retirement and looking for an income stream, or keen to take a more “total return” approach to investing that incorporates dividends as well as capital gains; either way, investment trusts are a natural choice of collective investment.

That’s partly because of their listed company structure, which allows them to withhold some of the dividend distributions they receive from underlying companies and build up reserves; these can be used to supplement payouts to shareholders in years when there’s a shortfall of “natural” dividend income.

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But it’s also because trusts are allowed, if they wish, to finance distributions from capital gains as well as natural income (and reserves). That ability has become increasingly popular with investment trust boards over the past decade or so, as trusts have become more attractive and accessible to retail investors managing retirement portfolios.

Some boards have taken the opportunity to introduce policies that will give shareholders greater certainty in regard to the income they can expect. This may involve trusts dipping into capital if necessary to meet their income ambitions.

A number of trusts, including JPMorgan Global Growth & Income Ord (LSE:JGGI), The European Smaller Companies Trust PLC (LSE:ESCT) and Polar Capital Global Financials Ord (LSE:PCFT), have introduced “enhanced dividend” policies aiming to pay out a set percentage of the trust’s net asset value (NAV), say 4%, each year.

Others, such as Mercantile Ord (LSE:MRC) and Murray International Ord (LSE:MYI), have no target yield but simply aim to keep annual dividend growth ahead of inflation.

At the same time, there’s a high-profile movement led by the Association of Investment  Companies (AIC) in the shape of the “dividend heroes” - the rising number of trusts that have chalked up 20 or more consecutive years of dividend growth.

The longest-running heroes have almost 60 years of growing dividends under their belts. The AIC has further encouraged the trend with the “next generation” dividend heroes – those with between 10 and 20 years of payout growth.

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Dividend hero status is highly prized, and trusts that achieve it are unlikely to cut a dividend if they can possibly avoid it, so investors in those trusts can feel pretty sure of continuing growth in distributions in the coming years.

However, both approaches to improving income security have their critics. 

So, what are the pros and cons of each, and which strategy do the experts ultimately favour?

Enhanced dividends: ‘robbing Peter to pay Paul’?

The big plus about an enhanced dividend policy is that it frees up fund managers to invest in the best stocks for total returns, even if they have a low or no yield, rather than having to restrict themselves to those paying decent distributions.

Emma Bird, head of investment trust research at Winterflood, argues that the capacity to deliver “a higher level of income from an unconstrained investment approach” may in turn stimulate a benign investment circle. “It can help to attract new investors, which can support the fund’s rating.”

She points to JGGI as a good example of a successful enhanced dividend approach that has broadened the trust’s appeal for private investors. It pays out at least 4% of NAV a year, “while the investment approach remains unconstrained and style-agnostic, which has helped the fund to generate alpha in a range of market conditions”.

For Thomas McMahon, head of investment company research at Kepler Partners, such a policy really comes into its own across sectors that don’t traditionally pay dividends.

“For instance, investors can now draw an income while being invested in biotechnology, smaller companies and private equity, so the possibilities for diversification and generating growth as well as an income have expanded,” he explains.

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However, Job Curtis, manager of the dividend ‘superhero’ City of London Ord (LSE:CTY) trust, is among those who have criticised enhanced dividend policies as “robbing Peter to pay Paul” – effectively dipping into the capital gains prized by growth investors to ensure generous payouts for income seekers.

This could therefore deter growth investors, although James Carthew, head of investment company research at QuotedData, argues that it’s not an insurmountable issue if a dividend reinvestment plan is in place to enable them to roll up their gains within the trust.

McMahon makes the additional point that the process of moving away from an equity income strategy could in itself be a negative. “Equity income investing involves identifying some highly attractive characteristics: companies which can generate spare cash and grow that spare cash consistently could be attractive investments, particularly for those who are looking for steady compounding growth.”

There is therefore much to be said for a traditional approach in markets with a decent, diversified spread of high-yielding stocks, he suggests.

Bear market challenges

There are undoubtedly potential drawbacks to the enhanced dividend approach in some market conditions. The UK hasn’t seen a sustained bear market for a long time, but Carthew warns that “there are plenty of reasons why we might be approaching one”.

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As Bird points out, an enhanced dividend policy in such a scenario would result in “either a reduction in dividends (based on a lower NAV) or a need to sell more holdings at lower prices to maintain or grow distributions”. That’s far from ideal, especially for growth-oriented shareholders.

An associated risk is that the sort of growth sectors that don’t pay dividends (but might be favoured for an enhanced dividend approach) may be more volatile and therefore lose more in falling markets. Income investors accessing these areas through trusts with enhanced dividend policies “need to think about their attitude to risk”, warns McMahon.

Dividend heroes: low yields and token increases?

The dividend heroes concept is a great piece of marketing and a valuable tool for investors to assess the likely reliability of a trust’s income stream.

As Bird explains: “We would expect most boards classified as dividend heroes to be keen to demonstrate their commitment to continued regular dividend growth, and to utilise revenue reserves when necessary to maintain this record as far as possible.”

However, one grumble around heroes is the fact that some have made only minimal increases to dividends in recent years, thereby ensuring their status is maintained but certainly not providing investors with inflation-beating income.

For McMahon, this could actually be a benefit rather than a detraction, as it indicates prudent housekeeping. “One justification for investing in dividend-paying stocks is that a regularly increased dividend is a sign of a well-run company. The same could be said of some of the investment trusts which make small increases each year,” he suggests.

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Carthew agrees tokenism is a risk, but he too points to contrary arguments that indicate management strength, even at the expense of dividend hero status. “Temple Bar Ord (LSE:TMPL) is a good example of the opposite stance,” he says. The trust cut its dividend to a more manageable level when management was taken over by Redwheel in 2020, losing its status as a dividend hero.

“But that move gave the managers more flexibility to buy recovery stocks on low to no yields. The reward has come in great performance and a rising dividend that surpassed the previous peak some time ago.”

In Bird’s experience, most dividend hero boards – certainly those with an income mandate – in practice “recognise the importance of delivering dividend growth ahead of inflation over the long term”.

Another, arguably more pervasive, concern is that uninformed investors may be confused by the fact that dividend hero status is based on growth rather than yield. Four of the 20 current dividend hero trusts yield under 2%, while eight of the 30 next generation heroes are yielding less than 3%.

In effect these are trusts with a focus on capital growth or total returns that are making modest but rising distributions to shareholders.

Bird highlights dividend hero Scottish Mortgage Ord (LSE:SMT) as a particular example. “It has 44 consecutive years of dividend growth, but its investment approach is purely focused on investment in growth companies, and its dividend yield currently stands at just 0.3%,” she points out.

That’s fine, so long as you understand that you’re buying long-term growth and a small but secure payout, not an income-oriented investment.

Importantly, if you’re seeking income from a fund, pay attention not just to its dividend hero status but also to its dividend yield, investment policy and approach, and long-term dividend growth rate.

Conclusion

So, is there a preference among the experts for dividend heroes or enhanced dividend policies? The consensus is that both are valuable approaches, but the best option will depend on the individual investor.

Carthew notes that value investing tends to outperform growth investing over the very long term, so for younger investors seeking long-term growth, dividend hero trusts make more sense. “A sensibly managed natural income trust without too high a yield target might deliver the best overall long-term returns.”

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Income investors should consider where they plan to invest as a first step, points out McMahon. “Core income sectors with well-established dividend cultures are probably better invested in with a natural income approach, to benefit from the steadiness of operational performance underlying the income generation,” he says.

Dividend hero status is a valuable plus in this context. Conversely, enhanced dividend payouts can vary as NAV fluctuates, so they’ll be less reliable.

In the end, both strategies can work well for investors, but you do have to do your homework and delve beneath the alluring headlines to understand what you’re really investing in.