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Sector Inspector: Shining a light on UK equity income funds

Sector Inspector: Shining a light on UK equity income funds

The hunt for yield has been a major feature of the post-financial crisis world as ultra-loose central bank monetary policy has served to suppress yields across a range of asset classes.

Investors have flocked to UK equity income funds, which aim to provide a high and growing income stream combined with prospects for capital growth. That is unsurprising: while the dividend yield on the FTSE All-Share index is around 3.5%, equity income funds typically produce 4%-4.5% per year.

This compares with just 1.44% for UK sovereign bonds and 2.73% for investment grade European corporate bonds, according to Bloomberg data.

‘The annual income will be higher than cash, tracker funds, government bonds and lower risk corporate bonds, although the latter is something of a historical anomaly caused by QE [quantitative easing],’ says Richard Hughes, Citywire AAA-rated co-manager of the M&G Extra Income fund.

He points to ‘relatively sticky’ dividends from UK companies: over the last 50 years significant dividend cuts have only happened in 1993 and 2009.  

MARKET INCOME

Income should grow over time – by 3%-4%, if inflation stays around 2% per year – preserving spending power in real terms: indeed, the market income in 2013 was 23.5 times higher than in 1963.

‘The high and growing income stream means the capital can be left untouched and should grow in line with income over the long term,’ says Hughes (pictured above). ‘This will not be smooth and capital values will fluctuate in the short term, but as there’s no need to raise extra capital by selling, the invested funds can be left undisturbed during bear markets, so the capital can bounce back when market conditions change and become positive again.’

Such an approach is equally valid for those investing for long-term capital growth, with reinvested dividends being redeployed at attractive levels during bear markets.

INCOME BOOST

FIVE-YEAR TOTAL RETURNS OF FUNDS GENERATING THE LARGEST INCOME IN THE SECTOR

 

Source: Lipper. Performance is based on total returns in UK pounds calculated gross of tax, bid to bid, ignoring the effect of initial charges and with income reinvested at the ex-dividend date. All data taken from 31/12/2009 - 31/12/2014.

Income-earned figures are based on how much income in sterling would have been paid from a £1,000 investment over five years. Yields have been calculated by dividing income dividends paid during the previous 12 month by the latest net asset value, adjusted for capital gains distributions.

Many of the highest-yielding funds in the sector (see line graph above), including: Schroder Income Maximiser, managed by Citywire +rated Thomas See; Fidelity Enhanced Income, run by A-rated Michael Clark; and Insight Management's Timothy Rees, invest in shares with a healthy dividend and then boost this income by selling derivatives called ‘covered call options’ to other investors.

Clark, who boosts underlying income from an average of 4% to 6% by writing these contracts, says: ‘Many investors are understandably nervous about buying a fund that invests in derivatives, but covered call options are the lowest risk form of derivatives contracts.

‘The fund manager only ever writes contracts on stocks that they own and the overall effect is to boost income from the premiums received, while giving up some capital upside.’

However, using covered calls to increase the income has drawbacks, says Citywire’s John Miller. As the manager sells options in a rising market, the capital growth tends to be impacted as investors will miss out on gains above a certain level – the strike price.

Miller says: ‘When digging deeper this is highlighted by the fact that Fidelity, Schroders and Insight’s capital growth over the period is among the lowest in the peer group. They have, however, been delivering on the income front.

Chelverton and Unicorn on the other hand have used their stock-picking skills in the small and mid-cap space to create a double whammy of strong capital growth and high income payouts. The area they invest in though is a more volatile part of the market.’  

The managers of all the funds have been running them for more than five years apart from Unicorn UK Income. After the untimely death of John McClure in June 2014, Simon Moon and Fraser Mackersie took the helm and were already named managers since December 2013.

High-yielding funds can also be poor performers on an absolute return basis.

Scott Gallacher, a chartered financial planner at Rowley Turton, points to a ‘worryingly wide differential’ in terms of performance.

The top-performing retail fund over five years, Unicorn UK Income, delivered a total return of 142.8% whereas the worst-performing fund, Fidelity Enhanced Income, delivered 58.6%.

 

Caspar Rock (pictured above), chief investment officer at Architas, the multi-manager business of AXA, points to a scope of investments in the sector which ‘means there should be something for everyone, ranging from the very defensive to the more cyclical’.

At the defensive end of the spectrum, he likes Clark’s Fidelity Enhanced Income fund. ‘Its overweights in pharmaceutical and utilities stocks give it excellent downside protection,’ says Rock.

It is clear there are several ways of looking at these income funds performance. Miller says: ‘From an adviser’s perspective a new way of communicating with clients will be needed. This will involve forgetting about the total return side of fund performance. Instead I believe assessing a fund’s income in pounds and pence, with capital growth sitting separately, provides a more meaningful message.’

The UK equity income has been a mainstay of investors’ portfolios for years. Despite the attractions of looking further afield, its prime position is unlikely to change. Last June UK equity income funds attracted a record inflow of £1.4 billion, buoyed by star manager Neil Woodford’s fund high profile fund launch, the Woodford Equity Income Fund, known as the Woodford Effect.

Indeed the upcoming pension reforms are such an important factor that flows into the sector could accelerate even more.

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