Beat UK equity income concentration with right fund combination

Funds with most exposure to Vodafone

Source: Hargreaves Lansdown/Lipper Hindsight

This is also the case with investment trusts, where a number of income-focused mandates have high exposure to Vodafone. Funds with high levels of exposure to Vodafone include well-managed ones with good performance records, and a number of IC Top 100 Funds such as City of London Investment Trust (CTY), Murray Income (MUT) and Murray International (MYI).

New fund launches are increasingly targeting different areas, for example, small and mid-cap income or income from across the market cap spectrum.

Investment trusts with most exposure to Vodafone

Read our interview with Gervais William, manager of Diverse Income Trust and CF Miton UK Multi Cap Income Fund

But, while some traditional equity income funds are making the effort to differentiate, many are still focused on large cap, equity income funds. The risk of this is that even if you hold more than one UK equity income fund they could have the same few top holdings, potentially over-exposing you to certain shares. This is not a problem if they are doing well, but as BP's (BP.) cancellation of its dividend in 2010, and the banks' cancellation of their dividends during the financial crisis showed, you could be hit hard if you are focused on one area.

However, one share is still a small part of a fund which holds tens of stocks and a problem with one generally doesn't make a massive difference to the fund's overall return.

"The clustering effect remains with many equity income funds having a commonality in their largest holdings," says Rob Pemberton, investment director at wealth manager HFM Columbus. "However, the universe of funds is large and a bit of time spent on due diligence allows one to construct a portfolio of several UK equity income funds with significantly different portfolios. This creates a fair degree of diversification with the funds producing markedly different returns depending on market conditions."

"We look at fund correlations rather than shares," adds Mark Dampier, head of research at broker Hargreaves Lansdown. "We look to diversify fund manager risk, looking at their investment styles and sectors and market cap size to get different fund performance."

Ben Yearsley, head of investment research at Charles Stanley Direct, also points out that a top 10 holding at one point could change soon. "You don't know what the manager will do, and the top 10 are not always going to be like this," he says.

Funds

A selection of UK equity income funds producing different returns to each other depending on market conditions include the following, according to Mr Pemberton. He suggests:

Artemis Income (GB0006572464): a classic UK equity income fund with significant exposure to healthcare, oil and gas, and telecoms.

Invesco Perpetual Income (GB0033053827): very overweight healthcare (34.6 per cent) and tobacco, but very little oil and gas, or banks.

Schroder Income (GB0007648909): focuses on recovery stocks so includes exposure to banks and retailers.

Old Mutual UK Equity Income (GB00B1XG7668): has high exposure to financials and industrials (26 and 16 per cent respectively), with low exposure to oil and gas, and healthcare.

Threadneedle UK Equity Income (GB0001448900): is very overweight industrials and consumer services, but very underweight in oil and gas, and financials.

(IC Top 100 Fund) Unicorn UK Income (GB00B00Z1S94) and Chelverton UK Equity Income (GB00B1FD6244): these are small-cap funds so have very different portfolios to the funds above.

To achieve diversity, investors could also consider Marlborough Multi-Cap Income Fund (GB00B42TBF45). This aims for attractive and growing level of dividend income in addition to long-term capital growth by investing in a diversified portfolio of equities and has just over 5 per cent of its portfolio in large and mega-cap shares. Nearly 63 per cent of its assets are in small and micro-caps.

This could be held alongside more traditional equity income funds, according to Mr Yearsley, such as Threadneedle UK Equity Alpha Income (GB00B12WJY78). This fund is among the top 25 per cent of equity income funds in terms of total return performance over one, three and five years, but does not chase the highest yield currently offering just over 4 per cent.

"Being relatively small (about £505m) the fund maintains an edge," says Rob Morgan, pension and investments analyst at Charles Stanley Direct. "It has the flexibility to invest more heavily in small and medium-sized companies where the managers can often find some interesting ideas. One example was steel construction firm Severfield Rowen (SFR), which its managers opportunistically bought following the firm's rights issue in April. Larger funds would have found it difficult to build a meaningful position, but it has appreciated nearly 50 per cent since. In addition, the fund remains concentrated at around 40 stocks. This high conviction approach means each holding makes a significant difference to performance, though it does increase risk. So with significant positions in stocks such as BT (BT.A) and Legal & General (LGEN), for instance, which have fared exceptionally well this year, the fund has managed to accelerate away from the sector average."

Mr Dampier suggests holding JOHCM UK Equity Income (GB00B03KP231) which does well when markets are more confident, and Invesco Perpetual Income and High Income (GB0033054015) funds which are more defensive when markets are less confident.

JOHCM UK Equity Income looks beyond the equity income staples of utility, tobacco and consumer stocks in search of firms that can grow their dividends more quickly, though not necessarily at a uniform pace. "The fund has already fared well this year with the assistance of a number of more economically-sensitive sectors," adds Mr Morgan. "For instance, ITV (ITV) has benefited from an expected pick-up in advertising and European real estate firm Segro (SGRO) has reported early signs of an improvement in demand for industrial space.

Construction stocks such as Balfour Beatty (BBY) have been added to the portfolio lately in order to help capture further economic recovery. In the quest for rising dividends the managers are not afraid to venture into unfashionable areas. The fund includes a small amount of mining exposure in the form of Glencore Xstrata (GLEN) and Polymetal International (POLY), and a position in Lloyds (LLOY) has been introduced. The bank does not currently pay a dividend, so most equity income managers don't consider it, but this fund's managers believe there are good prospects of payments commencing in the next year."

Meanwhile, Rob Pemberton suggests diversifying and offsetting the shortfall in income from bond funds by choosing equity funds which use a covered call derivatives structure.

"Two such funds are (IC Top 100 Funds) Schroder Income Maximiser (GB00B0HWJ904) and Fidelity Enhanced Income (GB00B3KB7682). Mr Pemberton says: "Fidelity Enhanced Income is a traditional rather defensive UK equity income fund with a similar composition to the Invesco Perpetual Income and High Income funds, but uses a covered calls derivative strategy whereby the fund can boost its yield to around 7 per cent by forgoing some potential future capital growth in exchange for a higher level of income. As such, investors can invest in a similar portfolio of stocks, but in a much smaller and potentially more flexible fund with a higher income payout."

Recommended UK equity income funds

Source: Morningstar and *fund manager.

Performance data as at 5 September 2013

How to choose an equity income fund

Rather than just worrying about the top 10 holdings, when choosing a UK equity income fund you should consider a number of issues.

"Pick a fund where you can see growth in income over the years even if the yield is not necessarily the highest," says Mr Dampier. "I favour a total return mandate where the manager is willing to cut the payout if necessary, and doesn't fall in love with fashionable stocks. You have got to look at the capital performance and dividend record, which you can, for example, see in the fund reports."

But it is not just about performance. Mr Yearsley suggests investors consider factors such as:

■ who the managers are;

■ what their record is;

■ the size of company they invest in - small, mid, large or a combination;

■ what the fund's aim is;

■ what resources its managers have; and

■ how much the dividends are and how often they are paid.

A fund's past performance is easy to come by on websites such as Morningstar and Investors Chronicle. A manager's historical performance is not as common, but FE Trustnet publishes managers' performance which you can access at http://www.trustnet.com/Managers/.

You should not invest in a fund on the basis of its top 10 holdings. For example, while Vodafone may be set to make a generous payout, in a fund with 40 or 50 holdings or more, this is not going to make a big difference. "The returns from the underlying holdings of a fund in aggregate obviously produce the return of the fund as a whole," says Mr Pemberton. "The danger is focusing on just a few of maybe 50 holdings and taking a view based on these few companies. Better to rely on the long-term returns of the manager and not try and second guess his stock-picking."

"Make sure the fund doesn't over distribute as this can lead to poor performance for a long time," adds Mr Dampier. "And don't just go for the highest yield."