The importance of income: Regular dividends will make a massive difference to your portfolio

Most new investors build a portfolio in the hope of capital growth. You put money into shares, the price rises, and you sell out with a handsome profit. But investing in assets which make regular payments can make a real difference to the overall performance of your portfolio, and some of the world's most successful investors have relied heavily on this strategy to make their fortune. Here's why.

 

Some companies, typically large multinationals, will make quarterly payments to shareholders – which are otherwise known as dividends. For equity investors a decent dividend is a boost alongside the expected capital growth of the shares.

 

Regular cash payouts can also be gained from bonds, property, and funds which invest in income-paying assets. 

 

Pensioners and those nearing retirement focus heavily on income-generating investments, as they can withdraw the payments and live off them.

 

But people under 50 tend to think less about how income can boost their portfolios. Crucially, dividends are more useful to a younger person if they are not withdrawn from the portfolio. Instead, leave any quarterly payments from shares or bonds invested. This will make the capital in your portfolio larger, which in turn will be able to grow.

 

This effect is known as “compounding returns” – which Albert Einstein called the “greatest mathematical discovery of all time”. Say an investment of £1,000 generates an annual income of 5 per cent. Re-investing that £50 after the first year will mean there is now £1,050 to grow at 5 per cent. This generates a return of £52.50 in the second year, which should be re-invested to compound again in the next year.

 

These figures are small, but in a portfolio worth thousands and given a long timeframe, the effect is enormous. “The key to long-term investment success is how much you take out of your portfolio,” explains David Miller of Cheviot. “This is why the re-investment of income is such a powerful predictor of returns.”

 

The UK has a deeply ingrained dividend culture and the FTSE 100 is home to some big dividend payers. The chart on the right shows how the index has risen 116 per cent over the last ten years. But if dividend payments are included and re-invested, the total return of the index is 326 per cent.

 

So far, so logical. The problem with income is that it is becoming harder to find. The big dividend payers on the FTSE, such as supermarkets and oil companies, have been going through a tough time. Many have been forced to cut their dividends.

 

“It is getting hard to find income, and the reason for that is many low risk investments have very low yields,” Miller says.

 

One solution is to turn to overseas companies for dividends. Two of the most highly regarded funds investing for income around the world are the Artemis Global Income fund and the Newton Global Higher Income fund. There is also a top-performing Asia fund in this space, the Somerset Emerging Markets Dividend Growth fund, which we profile on page 26.

 

The income from government and corporate bonds is also lower than it was in the past. But there are some funds which have been able to search the market and achieve a decent level of income for investors.

 

“With corporate bonds in general the level of income you get has fallen, but is still quite attractive as the average bond fund yields 3 per cent,” says Nathan Sweeney at Architas. He highlights the Fidelity Moneybuilder Income fund as an example, because it is conservatively managed and has a strong track record.

 

Property funds have been very popular in recent years as an income alternative to equities and bonds. Companies invested in property will take regular rent payments from their tenants, and can pay this back to investors in the form of a regular dividend.

 

Sweeney likes the Tritax Big Box investment trust for its reliable income. The trust’s managers buy up large warehouses and lease them to the likes of Tesco, Next and Marks & Spencer. With the rent it receives, Tritax pays investors an annual 4.5 per cent yield.

 

“These companies thrive on having huge warehouses… The leases they sign can be anything up to 13 years in length. That gives you the safety in terms of yield,” he says.

 

Another alternative Sweeney likes is the aircraft-leasing fund Doric Nimrod. This is very unique, as the managers have bought nine Nimrod aeroplanes and are leasing them to Emirates airline on 12-year contracts. The fund pays investors 7.5 per cent annually – a sizeable return in this climate.