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How to choose an equity income fund

Low interest rates are pummelling income investors' options, but equity income funds still provide good opportunities. We look at how to select a good fund.
August 18, 2016

Ultra low interest rates mean income investors are facing testing times. Historically low rates have pushed gilt yields into negative territory and led to plummeting annuity rates. As a result, investors need to take more risk if they want to generate a higher level of income, and one of the few areas still offering decent returns to income seekers is UK equity income funds.

Equity income funds offer investors a regular income alongside the potential for capital growth. At the moment, these funds tend to pay out a yield of 3 to 4 per cent. Retirees and income investors have traditionally relied upon government bonds (gilts). But with gilt yields starting to turn negative, investing in government bonds is becoming much less attractive for income investors. Investors Chronicle economist Chris Dillow wrote last week: "Anyone saving for a pension faces a huge problem - that real returns on safe assets might remain negative for years. The index-linked gilt yield curve implies that even in 10 years' time real yields will be minus 1.2 per cent."

Sam Lees, head of research at Fund Expert, agrees. Although higher up the risk scale than gilts, he thinks income investors may be better off opting for equity income funds - particularly with the increased risk of a rise in inflation. Higher inflation is not good news for bond holders because it erodes the purchasing power of a bond's future cash flow.

"Inflation will probably come back, possibly towards the end of the year, but more likely into next year, because of the effects of lower oil prices," says Mr Lees. "If you've got bonds that are yielding so little and then inflation rises, that's going to be quite a dangerous place to be. That's [why] if you can get equity income funds that are focusing on consistency of dividend growth, then as someone who is retiring and looking for income, you're probably going to be better placed investing there rather than in bonds, which are looking very expensive at the moment."

And equity income funds typically invest in mature, well-established businesses. This means they tend to be more defensive than other equity funds. "Equity income investing tends to have a natural defensive bias," says Adrian Lowcock, investment director at Architas. "Companies which pay dividends often have better cash flow and management teams focused on shareholder returns."

The steady, regular flow of dividends which these funds aim to generate make them attractive options for income seekers, but they can also be useful to investors who want to grow their capital.

Patrick Connolly, certified financial planner at Chase de Vere, explains: "Traditionally equity income funds have been used for investors looking for a regular and rising income with the potential for capital growth. That perception has changed and these funds are now often used by those looking purely for capital growth with income reinvested. Today, investors are well aware of the advantages of reinvesting dividends to boost overall returns and the positive impact this can have over time."

 

Equity income risks

Despite the attractions of UK equity income funds, as with any type of investment there are risks. Chief among these is the impact of large dividend cuts by UK companies, especially against concerns about slowing dividend growth.

Over the past year, several large UK companies have announced they will be reducing or cancelling dividends. These include Rio Tinto (RIO), Glencore (GLEN), Standard Chartered (STAN), Barclays (BAR) and Rolls-Royce (RR). A number of other FTSE 100 companies, most notably energy companies, have come under pressure because of the volatility in the oil price, raising concerns they may also need to cut their dividends.

Investors also need to be aware of the risk which comes when a small number of companies are responsible for generating the majority of dividends paid out. BP's (BP.) Deepwater Horizon oil spill in 2010 showed this risk when the company's cancellation of its dividend made a notable difference to the total UK payout that year.

Mr Connolly says: "In the UK, around 80 per cent of all dividend income is produced by 15 companies and 50 per cent by just five companies. This means there can be a high crossover of stocks between UK equity income funds and so those who invest in a number of them may not be achieving the level of diversification they might expect."

According to a report on the UK Equity Income fund sector produced by Sanlam Private Wealth, there are now more funds with over £2bn than there were before the Deepwater Horizon oil spill in 2010. And these funds seem to have greater exposure to some or all of the biggest dividend payers compared to 2010, which could be a problem if one of the top 10 payers cuts its dividend.

The report also said the risk of dividend cuts is rising and warns that companies of all sizes listed on the UK stock market face challenges.

The report says: "For seven of the top 10 UK dividend payers the market estimates 2016's free cash flow cover of dividend to be below that of 2015; some 43 per cent of 2016 dividends are expected to come from these 10 stocks...Whether it is the large-caps' commodity exposure or the mid- and small-caps' vulnerability to a significant downturn in domestic fortunes, the volatility of the global economic environment will ensure there are few areas in the market where equity income investors can maintain total confidence and be certain of the income generation with the potential for capital appreciation."

Mr Connolly says investors can mitigate against these risks by diversifying across markets, both domestically and internationally. He says: "It makes sense to also consider equity income funds which invest in some smaller companies, as well as global and international equity income funds, and to hold these alongside traditional UK equity income funds to provide access to good quality overseas companies and additional diversification in your portfolio."

 

How to choose equity income funds

With around 80 funds in the Investment Association (IA) UK Equity Income sector, when choosing a fund you should look carefully at yield, the consistency of pay out and total return - as well as the usual criteria such as cost, past performance and investment process.

Yield

How much a fund pays out in dividends is a key consideration when choosing one, and will be partly based on your personal income needs. But in the current low interest rate, low growth environment investors should be careful about choosing a fund just because it has a higher yield says Charles Brand, director of private wealth at Sanlam Private Wealth.

He says: "The highest yielding shares are not always the highest quality companies. They could be high yielding because the market thinks the dividend is going to be cut - and quite often it is, or because the market thinks the company has got particular risks. For example, financial companies were high yielding before the credit crunch, and oil stocks are another group that has been high yielding but offered quite a scary ride in terms of capital return."

The topic of how much an equity income fund ought to yield has recently been in the spotlight after a number of funds previously included in the IA's UK Equity Income sector were kicked out for failing to meet the yield requirement. This requires funds to yield more than 10 per cent above the FTSE All-Share index to be included within the sector.

However, some fund managers have said that against a backdrop of looming dividend cuts and unsustainably high payouts by some companies, they are being punished for seeking sustainable dividend payers.

Darius McDermott, managing director of Chelsea Financial Services, thinks equity income funds should at least match the market's return. "The market is yielding about 3.5 per cent today, so if a fund is a true income fund it should be delivering a yield at least as good as the market," he says.

However, because of the dividend cuts within the FTSE 100, he says investors need to consider where the yield is coming from and should diversify their income by investing in funds which target smaller companies.

"Historically, nearly all equity income funds would have been large-cap income focused, but in the past five years we've seen a good range of small- and multi-cap income funds, which means investors are actually getting diversification as to where [their] income is coming from," he explains.

He suggests that investors who have higher income needs consider buying enhancer or maximiser funds which use covered call options to generate higher yields. These funds may be useful for people seeking a yield of 5 to 7 per cent, and who are less concerned about substantial capital appreciation. He particularly likes Schroder Income Maximiser (GB00BDD2F083), an IC Top 100 Fund, and Fidelity Enhanced Income Fund (GB00B87HPZ94), which typically yield about 6 to 7 per cent.

These funds use options whereby they sell the upside on certain stocks. An example of this would be if a fund owns Vodafone (VOD) it could enter into a contract with an institution such as an investment bank, whereby it effectively agrees to exchange the profit on selling the stock exceeding a level, for an agreed fee. The income from this fee is used to boost the fund's income.

However, the fund gives up some capital growth if the stock price rises above the agreed price at expiry, and if the market rises sharply the fund will not participate.

"If you're in a bull market because you're selling away potential growth with the call options, you are likely to underperform," explains Mr McDermott. "For example Schroder Income Fund (GB00BDD2DX75) will probably outperform Schroder Income Maximiser when markets are very strong because the latter is selling away some potential growth for that premium income."

Pay out consistency

Mr Lees thinks it is more important for investors to concentrate on the consistency of payouts rather than the headline yield figure.

"You can get funds that will have great payout growth for one or two years, but might be terrible for a couple years," he says. "You also don't want the fund to have a yield that's very high, but a payout that isn't going to grow year on year. For long-term investors who are going to want these funds for 10 to 20 years in retirement, the consistency of payout growth is one of the most important things to look at.

"You don't want to be chasing yield and I think the fact that [some funds] have fallen out of the IA Equity Income sector doesn't really say anything about them as a fund, but rather says something about the constraints of the sector. For example, Rathbone Income Fund (GB00BHCQNL68) has fallen out and it has a very consistent record of growing payouts over the years.

"If you're being pushed into those high yielding stocks then it's possible that you're getting into stocks that are not going to make consistent payouts."

Fund Expert has generated a list of equity income funds ranked for consistency of payout growth, using its Income Tool which allows investors to profile funds on a number of different criteria.

 

Funds with consistent payout growth

FundYears of payout growth
Rathbone Blue Chip Income And GrowthNine out of 10 years
Rathbone IncomeNine out of 10 years
BlackRock UK IncomeNine out of 10 years
JOHCM UK Equity IncomeEight out of 10 years
Liontrust Macro Equity IncomeEight out of 10 years
Aviva Investors UK Equity IncomeEight out of 10 years
M&G Dividend GBPEight out of 10 years
Premier IncomeEight out of 10 years
Artemis IncomeEihht out of 10 years
Royal London UK Equity IncomeSeven out of 10 years

Source: Fund Expert as at 2 August 2016

 

Total investment experience

Investment analysts say you should look at a range of factors when choosing an equity income fund.

"One should take into account three things when assessing a fund's success in the past: total return, volatility (we could call that risk) and income generation," says Mr Brand. "And you should be careful not to over-weight any one of these.

"If you focus too much on income generation, there is a risk that you will find a manager who is stretching too hard to meet income growth and taking risks with the capital. A vital clue to this would be volatility. Investors must be very wary of these managers as you can give up far more in capital than you gain from a few extra pounds of income."

Sanlam compiles a half-yearly investor guide which ranks UK equity income funds and categorises them into top, middling and weak performers via its White, Grey and Black lists. Its Income Study uses a methodology which considers a fund's absolute income generated over the past five calendar years, capital growth for each of the past five 12-month periods and volatility over the past five years. The funds which come up top are included in its White List.

 

The White List Funds

RankFundNet Dividend Yield 30/06/16Net income five years to 30/06/16 (based on £100 investment): £Total return 01/07/15 to 30/06/16 (%)Total return 01/07/14 to 30/06/15 (%)Total return 01/07/13 to 30/06/14 (%)Total return 01/07/12 to 30/06/13 (%)Total return 01/07/11 to 30/06/12 (%)Volatility 01/07/11 to 30/06/16
1Troy Trojan Income I Inc3.718.89.18.913.115.47.92.5
2Threadneedle UK Eq Inc Ret Net GBP3.920.02.54.818.023.51.43.0
3Marlborough Multi Cap Income A Acc5.121.5-10.312.925.530.31.73.1
4Royal London UK Equity Income A4.119.42.46.520.127.81.63.3
5Fidelity MoneyBuilder Dividend4.420.05.13.913.819.27.32.6
6Threadneedle UK Eq Alpha Inc RN GBP4.420.80.25.017.827.91.73.2
7Franklin UK Equity Income A Inc4.218.26.05.414.819.32.43.0
7Threadneedle UK Monthly Inc RN GBP4.318.50.47.415.819.21.72.9
9FP Miton Income Inc4.619.31.410.312.114.92.42.8
10RBS Equity Income 14.319.20.96.812.222.22.13.0
11Ardevora UK Income A5.218.52.910.115.533.5-2.53.7
12Smith & Williamson UK Equity Inc A4.319.4-0.79.514.921.5-5.52.9
13Newton UK Income GBP Inc3.620.212.14.010.915.21.92.9
14Fidelity Enhanced Income Inc7.427.52.32.711.214.06.02.4

Source: Sanlam Private Wealth

Meanwhile, Mr McDermott says his firm does not consider the process of picking an equity income fund to be that different from picking any other type of fund.

"We look for the consistency of returns and for a manager's ability to perform in both up and down markets," he says. "On top of that we also look at how often they pay - is it half-yearly, quarterly or monthly, as some funds now pay more frequently, which is attractive to some investors."

The equity income funds he likes include those which invest across the market capitalisation scale such as Royal London UK Equity Income (GB00B3M9JJ78), which he says has good weightings in mid- and small-caps. For the same reason he also likes Standard Life UK Equity Income Unconstrained (GB00B7G8Q193).

He also rates Threadneedle UK Equity Income (GB00B8169Q14) and Schroder Income because of their long-term track records. The former is a more traditional large-cap equity income fund while the latter is a value style fund.

Mr Connolly likes equity income funds that have a proven investment team or manager, a consistent track record and a repeatable investment process. He also cites Threadneedle UK Equity Income, as well as Aviva UK Equity Income Fund (GB0004460803) and Rathbone Income Fund.

 

Performance of suggested UK equity income funds

Fund1-year return (%)3-year cumulative total return (%)5-year cumulative total return (%)
Artemis Income I Inc4.822.281.1
Aviva Investors UK Equity Income 2 £ Inc5.623.283.5
BlackRock UK Income D4.331.867.3
Fidelity Enhanced Income W Inc5.020.463.4
Fidelity MoneyBuilder Dividend Y Inc8.228.684.5
FP Miton Income Inst Inc6.531.179.3
Franklin UK Equity Income W Inc11.934.192.1
JOHCM UK Equity Income A GBP Acc-2.415.179.4
Liontrust Macro Equity Income I Inc-1.321.666.6
M&G Dividend GBP I Inc4.519.767.8
Marlborough Multi Cap Income P Inc-5.127.9104.7
MGTS Ardevora UK Income Instl Net Inc7.533.9na
Newton UK Income GBP Inc15.831.076.9
Premier Income C Inc2.024.078.3
Rathbone Blue Chip Income And Gr I Inc8.627.582.9
Rathbone Income R Inc*5.124.584.3
RBS Equity Income 15.421.080.1
Royal London UK Equity Income M9.033.3110.8
Schroder Income Inc*1.316.082.8
Schroder Income Maximiser A Acc*-0.211.166.1
SLI UK Equity Income Uncons Plat 1 Inc-4.723.698.1
Smith & Williamson UK Equity Inc B4.726.078.6
Threadneedle UK Eq Alpha Inc ZNI3.824.894.9
Threadneedle UK Eq Inc ZNI7.030.194.8
Threadneedle UK Monthly Inc ZNI4.126.779.7
Troy Trojan Income O Inc11.738.690.3
FTSE All Share TR GBP5.418.270.5
IA UK Equity Income sector average3.421.973.3
Source: Morningstar as at 10/08/16. *Older share class shown rather than the one mentioned in the article.