Stocks vs trusts: which is best for dividend income?

UK investors looking for a regular passive income in the form of equity dividends have more than one option to choose from – they could either buy high-dividend stocks directly or, they can buy shares of an investment trust – effectively a publicly listed mutual fund – where a fund manager picks multiple companies for them.

But which of these is the better option for dividend income?

The Capital.com research team looked at the pros and cons of both the approaches and what emerged is a mixed picture. Here are the findings, in a nutshell:

• The 10 most dividend-generous FTSE 100 stocks offer a dividend yield that’s over 50% higher than comparable investment trusts
• However, the average dividend yield of 3.53 % for the whole of FTSE 100 slightly lags the 2.87% across the whole UK investment trust sector
• Furthermore, trusts have proved more consistent dividend payers, even amidst adverse financial conditions. They were able to boost payments in 2020, a year that saw the coronavirus pandemic devastate the economy and caused a 38% slump in dividend payments by British companies

This suggests that investors with a higher risk tolerance and a keenness for stock-picking may find it appealing to look at names that pay high dividends, while those who give more weightage to safety and consistency will probably gravitate towards trusts.

What pays the highest dividend yield?

Ten of the top dividend-paying stocks in the FTSE 100 index currently offer an average dividend yield of 9.35%, according to Capital.com calculations based on data from the website dividenddata.co.uk. That compares with 6.0% for the 10 investment trusts with a history of paying the biggest dividends, figures from the Association of Investment Companies show.

The dividend yield is nothing but the annual profit-share payments to equity holders by a company, expressed as a proportion, or percentage, of the stock price. For instance, the dividend yield on a stock would be 5% if its price was £100 and the company paid out an annual dividend of £5 per share.

However, the average yield across the whole FTSE 100 index is 3.53 %, slightly lower than the 2.87 % across the whole UK investment trust sector.

What is dividend yield?

In order to boost their own market allure, many companies choose to reward their shareholders with quarterly or annual payouts. That may burnish the appeal of these shares for investors who want to earn a regular income in addition to the prospect of any capital gains down the road.

The dividend yield can be a barometer for the company’s track record of rewarding investors – a consistent history of annual payouts could reflect the firm’s commitment to paying shareholders. Still, as always, past performance is no guarantee of future results. Also, stock buyers need to be mindful of the fact that higher dividend yields can also be a result of a decline in the share price.

Who pays the most consistent dividends?

Last week, the City of London Investment Trust raised its dividend payout by 0.5%, taking its track record of rising payments to 55 consecutive years and confirming its reigning position in the industry.

Investment trusts as a sector weathered the coronavirus crisis relatively well, continuing to make improved payouts even as the pandemic ended multi-year dividend-paying track records of several stocks. Up until recently, the FTSE 100 featured 15 companies with a track record of growing dividends for at least 10 consecutive years, according to data from AJ Bell, but nine of those dropped off the list amid the pandemic.

Meanwhile, 18 investment trusts have been growing their dividends for more than 20 years, data from the Association of Investment Companies, a trade body for investment trusts, show. Out of those, six trusts have been growing dividends for over five decades.

Still, as always, past performance is no guarantee of future results. Also, stock buyers need to be mindful of the fact that higher dividend yields can also be a result of a decline in the share price.

Pandemic impact on dividends

The pandemic hit corporate finances across industries and about three quarters of UK-listed companies scrapped or cut dividend payments in the second half of 2020, while just over a quarter increased them, according to Link, which publishes quarterly Dividend Monitor reports.

Typically high-paying sectors, such as mining, oil and banks, were hit extra hard. In April 2020, the Prudential Regulation Authority, the UK banking regulator, banned the nation’s seven largest banks from paying dividends to shareholders.

Lockdowns did not create particularly favourable conditions for oil and mining firms either. This led to a 38% slump in total UK dividend payouts in 2020.

Against this backdrop, investment trusts managed to actually raise their payouts by 4.2 % in 2020, Link calculates, with more than three quarters of them increasing their dividends in April to December 2020.

Reserves to the rescue

Investment trusts were able to largely sustain dividend payments thanks to their revenue reserves built over years – such companies can put away up to 15% annual income for these purposes.

The investment trust boards’ decision to use revenue reserves for a ‘rainy day’ was the right one, and “it has certainly been an unprecedentedly ‘rainy’ year in terms of the reduced dividend income that funds have received from their investee companies,” said Iain Scouller, an analyst at investment banking company Stifel.

Also Link hailed these buffers – which combined stood at £1.6bn – as a key to “to investment trust success”, which saw them distribute a record of £1.88bn in dividends in a highly challenging year.

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#FTSE 100 (UK100)

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