Aberforth Split Level Income 10 December 2019

Aberforth Split Level Income Trust (ASIT) invests in UK smaller companies in order to provide a high income to investors, by aiming to identify undervalued companies with attractive dividend yields and use structural gearing to enhance the income they provide. The ordinary shares currently yield 5%.

ASIT is managed by a team of seven at Aberforth Partners, who have been employing a disciplined value strategy in the small-cap space since 1990. The track record of the team illustrates the outperformance potential of such an approach, while they also have experience in managing geared income portfolios like ASIT - find out more about ASIT's performance track record.

The trust has a fixed life and will be wound up in July 2024. It is geared through the issuance at launch of zero dividend preference shares (ZDPs), which pay back a fixed amount at wind-up and receive no dividends, allowing ordinary shareholders to receive a higher yield (see the gearing section for details). It is the successor to Aberforth Geared Income Trust, which was managed with the same approach for seven years to June 2017, and which successfully met its income objectives and generated a total return of 20% per annum to shareholders (up to the time when it was wound up at the end of its fixed life). These high returns were aided by an excellent period for small caps, which might not be repeated.

ASIT was launched into a rough period for a value approach to investing, but the portfolio it owns looks extremely cheap relative to the market, and relative returns since mid-August have been strong. The managers take a highly active approach which offers long-term outperformance potential. Following the strong run in recent months, the discount has narrowed and sits at 8.3%, wider than the average AIC UK Smaller Companies trust - read more on ASIT's discount.

ASIT offers an attractive way to diversify an income portfolio, in our view. The 5% yield is attractive relative to the average AIC UK Equity Income trust sector, which yields just 3.9%. At the same time, it offers income from a segment of the market which few income investors find their way to. In a recent strategy note, we highlighted concentration risk in the income of the FTSE 100 and how the yield in that index comes from a limited number of companies. Investing in a trust such as ASIT allows investors to increase the average yield on their portfolio while reducing concentration risk and enhancing income diversification.

The trust could also usefully be held by a small-cap investor to diversify the biases from which the average AIC UK Smaller Companies trust suffers. The use of a value strategy in small caps is itself quite rare, and most investors are invested in growth strategies in this area. As we discuss in the Portfolio section, the trust is also very different from the average small-cap fund. For example, the trust does not invest in AIM and is biased towards the smaller end of the small-cap market, in both cases at odds with the mainstream of UK small-cap investing at this point in time.

Given the value tilt, its bias to UK domestic earnings and even simply investing in the UK stock market at all, ASIT is exposed to a number of themes which have been out of favour for some time, which means it could do particularly well when those trends reverse. In particular, the portfolio could experience quite a rebound if we get a decisive UK election result and a pragmatic Brexit deal; although we think an unequivocal rising rate environment is likely to be necessary if we are to see a sustained rotation in market leadership in favour of value versus growth. For those investors who like the Aberforth approach and want exposure to its style of value investing, ASIT’s structural gearing offers greater long-term outperformance potential than the less geared portfolios run by the team.