How re-investing your income can double your returns

4th February 2013

The benefits of compounding interest are clear-cut in the UK Equity Income sector, in one case boosting the total return of a £10,000 investment by an extra £26,000 over 20 years.

The impact on your portfolio of re-investing income should not be underestimated. Over the long-term, keeping your money in the market can dramatically increase the total return from an income-based fund.

An income fund is tailored to pay out a dividend yield on top of any capital gains.

Investors have the choice of taking the money and using it as a source of income, or re-investing it in the fund.

If they choose the latter, the principles of compounding interest come into play and the returns on a portfolio can escalate rapidly.

Neil Woodford’s Invesco Perpetual High Income fund is a good example of the impact re-investing dividends can have on total returns.

The five crown-rated portfolio is currently yielding 3.58 per cent. A £10,000 investment in the fund 20 years ago would have resulted in an income payout of £21,928.49 – after the basic UK tax rate.

The capital appreciation of the fund alone would have turned the original £10,000 investment into £48,153.26. Adding the additional income over the years, investors would have seen a total return of £70,081.75 from the fund.

However if investors had kept that money in Woodford’s hands, they would have made £96,558.06 on that initial investment – more than £26,000 more than if they had chosen not to re-invest dividends.

Performance of fund with and without dividends re-invested

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Source: FE Analytics

Even over an investment period of as little as three years, the effects are noticeable.

An investor who had bought the five crown-rated Fidelity Enhanced Income fund at launch in 2009 and decided to keep their income would have missed out on nearly 40 percentage points on the upside, without taking the income over the investment term into account.

Performance of fund with and without dividends re-invested

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Source: FE Analytics

In nominal terms, this means if they had invested £10,000 initially, this would have risen to £12,000, while the income paid would have amounted to £3,422.64. In total this is £500 less than the £15,864.49 figure that would have been accrued had dividends been re-invested. The yield on the Fidelity fund, at 7.11 per cent, is relatively high for the sector.

The benefits of re-investing dividends are more pronounced the more money that is put in and the longer it is invested for.

Looking at the popular four crown-rated Artemis High Income fund, which is yielding 5.92 per cent, a £10,000 initial investment over a 10-year period would have brought in £21,874.91, with dividends re-invested.

Spending this income would have meant the total investment was worth £1,595.32 less over the period – the initial investment would have grown to £12,093.36, while payouts would have totalled £8,186.23.

Performance of fund with and without dividends re-invested

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Source: FE Analytics

For the purpose of clarity, monthly savings plans have not been included in these figures; however the difference in total returns is even more pronounced when a drip-feeding technique is used.

 

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