Income-producing investment going cheap

Investment that produces a good income is being sold at huge discount: what’s the catch?

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What would you say to the chance to invest in something that produces a great income - at a reduced price?

In a low-interest environment, when tracking down a decent income has proved virtually impossible, it's enough to make every investor sit up and take notice - especially anyone who has been thinking abut how they intend to generate an income in retirement. However, you need to understand exactly what you're getting into.

The investments in question are equity income investment trusts. The idea behind them is that there's a pool of money, which an investment manager uses to invest in the shares of companies that he or she thinks will go up in value and announce significant dividends. Dividends can then be taken as an income by investors - and a typical fund is producing between 3% and 5% a year in income at the moment.

What are they?

In many ways they are very much like the unit trusts and OEICs that dominate the investment fund scene, because instead of investing direct in shares, you give your money to an expert, who pools it with the money they get from all the other investors, and invest in a huge number of shares.

However, there's a major difference. With a unit trust, investors pay money into a never-ending pool - which gets bigger and smaller depending on how many people are putting their money in or withdrawing it. With an investment trust, it's structured as shares, and the number of shares is constant. In order to invest, you have to buy a share in the investment trust from someone who is selling up.

This brings a quirk to investment trusts. With unit trusts, the amount you have to pay to buy into the fund depends on the value of all the shares it holds in its portfolio. With an investment trust, the share price owes much to the value of the shares it holds in its portfolio, but it depends on the share price of the investment trust itself.

This overall share price rises and falls with the popularity of the trust and the sector, so often you pay less for the share than it is actually worth when you look at the underlying assets. This is known as trading at a discount. At the moment 21 of the 26 funds in the equity income sector are trading at discount - including some of the best-known and best-performing of them.

It means that you can buy into the funds at a knock-down price. At the moment the average discount is 3%, but there are some funds trading at a discount of more than 5% - despite some excellent performance in the past.

Of course, it's worth pointing out that when you come to sell up, you will sell at the share price again, so if the fund is still trading at a discount, you'll be selling at a knock-down price. In addition, if the share price has fallen, you'll lose money. However, in the interim you are exposed to the income. It means that for anyone desperately trying to get income from their investments, this sector is well worth considering.

Potential

The Association of Investment Companies says there's huge potential in this sector. It points out that £100,000 invested into the average UK Equity Income investment company in 1995 would have received £130,071 of income over the past 20 years. At the same time, the value of the initial investment would have grown to £260,259 – an increase of 160%. Of course, there is no guarantee at all that this performance can be replicated, but it goes to show what is possible.

Nick Britton, Head of Training at the AIC, said: "Investment companies are not a substitute for an annuity, both your income and capital are at risk and if you are in any doubt you should consult a financial adviser. But these figures make a compelling reason for investors to consider investment companies as part of a well-balanced retirement portfolio."

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