The more things change, the more they stay the same, or so it seems among the highest payers in the UK Equity Income sector.
The last time we looked at this sector was at the start of 2016, looking at the five years to December 2015. Of the five funds that distributed the most income in this category in the five years up to December 2015, four kept their places in the latest rankings to November 2016. Of those four funds, two have changed managers since then, which is unusual in a space better known for the longevity of the likes of Citywire A-rated Woodford Investment Management partner Neil Woodford, and Citywire A-rated manager of the Royal London UK Equity Income fund Martin Cholwill.
The newcomers are Mike Hodgson on the Schroder Income Maximiser fund and Graham Ashby on the Santander Enhanced Income Portfolio. Hodgson replaced Thomas See, who left Schroders in July 2016, while Ashby succeeded Stephen Payne in April last year.
Payne, a Citywire AAA-rated manager when he left Santander, was recruited by Henderson Global Investors, while See departed Schroders in what was announced as a restructuring. See subsequently took Schroders to an employment court in a case the firm is ‘defending vigorously’.
Hodgson and Ashby sit at the top of the table, alongside stalwarts Michael Clark, Citywire A-rated manager of the Fidelity Enhanced Income fund, and the Citywire + rated pair of David Taylor and David Horner on the Chelverton UK Equity Income fund. They are joined by Citywire A-rated Chris Wright’s Premier Optimum Income fund, which has supplanted the Insight Equity Income Booster fund run by Tim Rees.
Despite the new faces, the links between today’s top income producers and those of 2015 are words such as ‘enhanced’ and ‘maximiser’. An internet search for products described in such terms may raise eyebrows, but applied to portfolios they undoubtedly raise incomes.
Four of these funds, the Premier, Schroders, Fidelity and Santander strategies, employ derivatives in some way to boost their distributions, typically by writing call options. This procedure entails selling to other investors the right, but not the obligation, to buy some of the shares held in the fund’s portfolio for an agreed price.
The money a fund earns from doing this can be distributed to the fund’s investors to increase its yield. The drawback of this process is if the option buyers exercise their rights, the fund misses out on some capital growth.
For example, consider a fund owning shares that trade at 100p each. Another investor expects those shares to hit 200p within a year, but rather than taking the risk of buying them outright pays a few pennies for the right to buy them for 150p if they reach 200p within an agreed timeframe. If they do not, the fund keeps the shares and those pennies. If they do, the fund has to sell shares worth 200p for 150p, missing out on the full appreciation for only those few pennies paid earlier.
As the total returns from these enhanced funds show, this is not a hypothetical risk. Despite their strong income records, the Fidelity, Premier and Santander funds undershot the average total return of 73.4% in this sector over the past five years. The Schroders fund did beat that average though.
The Chelverton UK Equity Income fund takes a more conventional approach, albeit with exceptional results. As well as the income performance, the fund has posted the highest total return in the entire sector over the past five years.
Although not a purely mid or small-cap mandate, the fund’s portfolio is biased towards the lower end of the capitalisation spectrum. Less than a third of its assets are in companies larger than £1 billion, with 46% in stocks smaller than £500 million.
Managers Taylor and Horner said the market’s recent rotation may suit their fund, although they have to contend with a countervailing aversion to smaller companies. ‘We have already seen the first signs of a shift from the bond-proxy equities into sectors and stocks more geared to benefit from fiscal stimulus,’ they said.
‘At the margin, a switch from quality growth into more value-orientated stocks should benefit our portfolio. But we understand that the noise surrounding Brexit negotiations continues to present a headwind for small and mid-cap
Offsetting that to some degree is a nascent takeover revival, with the weaker pound encouraging overseas firms to acquire British targets. Two stocks in the Chelverton portfolio, industrial supplies firm Brammer, and aerial work platform manufacturers Lavendon, have already received offers.