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Equity income funds in transition

Created:

1 September 2009

Written by:

Stephen Spurdon

The past year has been characterised by dividend cuts and non-payments - bad news for those seeking income from UK equities. The full extend of the payout-slashing is highlighted in a recent survey of dividend payments by Capita Registrars, which estimates that UK companies will pay out £52bn in 2009, 13 per cent less than in 2008, and 15 per cent down from 2007.

The importance of dividends to total return is demonstrated each year in the Barclays Equity Gilt Study. This year's study shows that £100 invested in the UK stock market in 1945 would have grown to £5,721 by the end of 2008 in nominal terms (not taking inflation into account) by not reinvesting income, while £100 invested over the same term with gross income reinvested would have produced a staggering £92,460. On the same basis, gilts would have produced £5,135 and cash £6,091.

Over such long time periods, and given the importance of dividends, a comparison between fund sector averages might be expected to show the UK Equity Income sector beating most others. But according to data from Morningstar, this has not been the case over recent years.

In the five years leading to 17 August 2009, the top performing unit trust/oeic sector has been Global Emerging Markets, returning an average of 127.21 per cent. UK Equity Income & Growth sector returned an average of 27.26 per cent, while the UK Equity Income sector delivered 18.06 per cent.

Andrew Wilson, head of investments at wealth manager Towry Law puts the situation in to perspective: "We are in a state of transition. People have become used to strong and rising yields and investors have tended to see equity income as a one-stop shop for overall returns. They found they were cleaned out last year."

This is an unusual state of affairs given that UK equity income fund managers are amongst the most highly regarded. It was no surprise that the 'top manager' crown has effectively been handed from Fidelity's Anthony Bolton to Invesco Perpetual's income king Neil Woodford.

Mr Woodford's pre-eminence in this field is displayed in the tables. He has the top three funds in the unit trust/oeic UK Equity Income and Growth table (the St James Capital fund being a 'white label' version of his Invesco Perpetual portfolio), and also managers the Edinburgh Investment Trust which is in the top five UK Growth & Income investment trusts.

Income funds' track records

Notes: Figures to 17 August, based on an initial £100 lump sum based on a offer to bid basis

Source: Morningstar

In his latest note on the market, Mr Woodford dismisses the signs of green shoots as being 'illusory', saying that his focus is on companies set to do best in a period of little or no economic growth.

Not distracted by the recent past, finacial adviser Brian Dennehy of Dennehy Weller, thinks investors should focus on the opportunity these funds present in current circumstances: "Our research, back to 1900, has identified that in 85 per cent of rolling 10 year periods you would have outperformed the stock market by investing in higher yielding shares.

"Couple this knowledge with current depressed prices and almost zero-interest rates, and investing in equity income funds is one of the most compelling opportunities we have personally experienced since the 1980s."

Different strategies

One new factor on the income horizon, is the Investment Management Association's (IMA) decision to split the unit trust/oeic UK Equity Income sector earlier this year. Funds in the new UK Equity Income and Growth sector aim to have a historic yield in excess of 90 per cent of the yield of the FTSE All Share Index, while funds in the UK Equity Income sector aim for a yield in excess of 110 per cent of the index.

As the figures show, all the funds have comfortably outpaced the yield on the FTSE All Share which stood at 3.73 per cent on 11 August, with yields generally ranging between 5.5 and 7.5 per cent.

Reviewing the top unit trust/oeic income providers, it is surprising to see Aviva UK Equity Income, an insurance company in-house fund, topping the table. Until earlier this year it had been managed by Dan Roberts, so highly regarded by Gartmore that he now runs their UK Equity Income fund. He has in turn been replaced by Chris Murphy, who managed the Aviva Investors UK Equity Fund. In both cases it is still too early to pass a judgement on the two manager's performance.

Mr Wilson comments that investors need to understand that although the managers are all aiming for equity income, the strategies they employ to achieve this will vary.

"Some are total return oriented, while others are more focused on maintaining a rising dividend yield. An example of the total return type of fund is Karen Robinson's Standard Life Equity Income Fund; she is likely to focus the fund on a sector where she sees potential for capital return. Alternatively there is Adrian Frost, manager of the Artemis Income Fund who tends to be focused more on yield. So there are different approaches in the same sector."

There is also a very clear split between those managers who benefited from the 'sector rotation' of recent times and invested in cyclicals, and those like Mr Woodford who have stuck to companies such as Unilever that churn out results and dividends each year.

Despite Mr Woodford's funds having under performed noticeably in recent months, Mr Dennehy strongly recommends buying these funds, saying that the underperformance has occured because Mr Woodford has stuck with his tried and tested investments. Commenting on this recently, Mr Woodford noted: "Dependability as an investment characteristic now trades at a substantial discount to the rest of the market. History suggests that this discount will not persist for long."

Mark Dampier, head of research at Hargreaves Lansdown, also warns against drawing conclusions too rapidly on the basis of recent figures: "With regard to the favoured managers appearing not to have done very well, I have seen it all before. People seem to forget the periods where there were market rallies that subsequently fizzled out.

"Both Clive Beagles at JO Hambro and the Schroder Income Fund have done well by being cyclical. Others have decided not to play the market and have remained in the companies they trust to ride out the next few years. I am more interested when you find such funds at the bottom and they go out of favour – I would be a buyer."

Mr Dampier favours the Invesco Perpetual Higher Income Fund, managed by Mr Woodford and Mr Beagles’ JO Hambro Income Fund because as he puts it: "Basically they have different styles and I see no point in buying two of the same."

Shauna Bevan, collective investment manager at stockbrokers, Charles Stanley also favours the JO Hambro Fund which is included in her portfolio alongside the Jupiter and Neptune Income funds. She comments: "Charles Beagles came from Newton, so has a disciplined approach with regards to yield. He can only buy stocks with higher than FTSE All Share yield and will sell when they fall below that. This focus on yield drew him to the more cyclical areas of the market and this has benefited him since the March rally. In contrast, Jupiter and Neptune have continued to focus on quality companies and strong balance sheets."

Ms Bevan points to Charles Stanley research which shows 90 per cent of those companies yielding 3 per cent or more are outside the UK's borders. "In addition many of the FTSE 100 companies are operating globally and make their money globally, so it does no make sense to stick to the UK alone for equity income."

She favours the Newton Asian Income Fund given Newton's strong track record as an income house, and the fact that they were one of the first asset managers to launch an Asian income fund, and hence have a track record in this space.

On investment trusts

Similar patterns are emerging in the investment trust sectors, where the value investing style of fund managers such as Alastair Mundy has seen his Temple Bar Trust outpace others over recent months.

Investment trusts' track records

Notes: Figures to 17 August, based on an initial £100 lump sum based on mid-market valuations.

Source: Morningstar

By their nature investment trusts are more complex than their open-ended peers. That said, they are attractive to equity income investors because of a greater ability to smooth dividend flow.

Francis Brooke of Troy Asset Management manages the Trojan Income Fund, and this year won the mandate to manage the Glasgow Income investment trust, so he is well placed to comment. He says: "Unlike in the investment trust arena, where long term dividend growth records are highly valued, equity income investors in unit trust/oeics appear to be less sensitive to volatile dividend records. This makes for a more consistent record of income growth in many investment trusts, although their managers are aided by the fact that they can carry forward revenue reserves from year to year enabling them to smooth dividends over time. By contrast, the open-ended funds must pay out all of the income accrued in each twelve month period.

City of London investment trust is a good example, having recorded 42 consecutive years of rising dividend payments to summer 2008. But not everyone is a fan. Stephen Peters, investment trusts analyst at Charles Stanley, says the fund has under-performed the FTSE All Share index on a net asset value (NAV) basis and thinks there are better opportunities in the sector. He points out that the portfolio is closely tied to the benchmark index, commenting: "You could argue that with such funds you might as well buy an index tracker and get the yield from that."

But, Nick Sketch, senior investment director at Rensburg Sheppards Investment Management, disagrees. He comments: "If you buy City of London it is 1.1 times geared which the index is not, and it pays a respectable 5.7 per cent yield. What the manager Job Curtis is not trying to do is to produce an aggressive portfolio and it is worth noting that FTSE 350 high yielders are down 17 per cent over three years while City of London is down 15 per cent."

Mr Peter, however prefers the Edinburgh trust and/or Perpetual Income and Growth and Finsbury Growth & Income funds. He likes the Finsbury fund because manager Nick Train's style differs from most others: "He has a concentrated portfolio of around 20 stocks some of which are well known like Diageo and Cadburys - with good long term records undervalued by the market, but then he also has unusual ones like a small holding in Celtic football club. Here Nick reasons that they will benefit from TV rights should a European super league be formed and their share price will soar."