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Lower-risk equity exposure for a better income

If you can take the risk, adding some exposure to equity income might get you a better income
May 10, 2018

It’s been a difficult 10 years for income seekers, with interest rates still at historically low levels. Even if there are more increases in the next year or two, interest rates are unlikely to rise much higher. So if you're seeking income but can't take much risk with your investments, or have a portion of your portfolio that you want to keep in lower-risk assets, this presents a problem. Cash isn't generating much, but higher return assets mean taking on more risk and potential volatility.

If you cannot risk losing your capital you should definitely remain in cash. If you do not have an investment horizon of at least five years you should also not consider higher-risk, volatile assets. And everyone should also hold cash worth at least three to six months' expenditure in easily accessible accounts.

If you have money over and above this on which you can take more risk and want to get better returns traditionally the next step up the risk curve has been bonds. However, years of loose monetary policy mean the prices of these assets are more expensive, so they do not offer very high yields, and their investors are taking on more risk for not much extra reward. And with interest rates rising in the US, and likely to rise in the UK, bond prices might fall – especially those of lower-yielding, safer government and higher-quality corporate bonds.

So an area that has many arguments in its favour is equity income. These include the ability to outpace interest rates and inflation, because if a company is doing well it can keep paying dividends and maybe grow them, unlike many bonds which have fixed payouts. Investors also have the potential to benefit from some capital growth if the company's share price rises.

The first port of call is UK equity income funds focused on mainstream companies, as these are probably at the lower end of the equity risk spectrum. The UK equity market has also historically offered one of the highest yields. And UK equity income funds are a good core holding for many types of portfolio – not just lower-risk ones looking for some income.

"We like the UK for a number of reasons," says Laith Khalaf, senior analyst at Hargreaves Lansdown. "Such a big sector tends to attract lots of top managers and the UK has a strong dividend-paying culture. The UK is also not well liked, so it could be a good point to enter."

But when choosing an equity income fund, don't just go for the one that offers the highest yield. Look for one that delivers good total returns alongside an attractive yield, because there is no point in having a high payout if you are losing capital. Also look for one that prioritises maintaining and growing its income so it can continue to outpace inflation and interest rates.

 

Reliable UK equity income funds

Funds with an investment trust structure have the benefit of being able to hold back dividend income in good years, meaning they have reserves that enable them to maintain or even increase dividends in leaner years. A UK equity income trust with a very good record of doing this is City of London Investment Trust (CTY), which has raised its dividend every year for 51 years.

This trust has been run by Job Curtis since 1991, who manages it conservatively, mainly investing in cash-generative businesses that can grow their dividends with attractive yields. The trust often trades at a premium to its net asset value (NAV) because of its attractive income, but it makes regular share issues to keep this in check, so the premium tends to be in the low single digits. And because of City of London Investment Trust's popularity it doesn't often fall down to a discount.

The trust beats the FTSE All-Share index and delivers positive returns in most calendar years, and has one of the lowest ongoing charges among all active funds of 0.42 per cent. It has an attractive 12-month yield of 4.1 per cent.

Many open-ended funds also have a good record of paying consistent dividends and delivering steady, positive total returns. These include Rathbone Income (GB00BHCQNL68), which has been run by experienced manager Carl Stick since 2000. It has a yield of 3.9 per cent and has one of the best track records in the sector for raising dividends annually over a period of more than 20 years. It has made positive returns in each of the last five calendar years.

The fund aims for above-average and rising income, without neglecting capital security and growth. Its manager looks to invest in shares with an above-average yield trading at a discount to fair value. Portfolio turnover is low, eating less into trading costs, and the fund typically holds between 40 and 50 shares. 

Rathbone Income also includes small and mid-caps in its holdings, so is less defensive than some equity income funds, although exposure to cyclically orientated shares is limited because of its manager's focus on quality and pricing power. But this means the fund can lag when the market is driven by economically sensitive sectors.

Its S share class has one of the lowest ongoing charges among UK Equity Income funds, at 0.53 per cent.

 

Equity income risks

With equities of any kind you need an investment time horizon of at least five years to be able to ride out the ups and downs of the stock market. Companies can cut their dividends and not pay an income, and when they do this their share price is likely to fall – so you would take a hit to both your income and capital. 

"Companies grow and shrink all the time, and the dividends or income they pay out are variable as they are not guaranteed or fixed," says Adrian Lowcock, investment director at Architas. "Share prices are inherently volatile and investors can lose their capital investment as well as not receive an income from equities."

UK companies in particular have faced problems over the past few years, with banks cancelling dividends during the financial crisis, and more recently a number of major companies announcing dividend cuts.

The UK's forthcoming departure from the European Union (EU), meanwhile, could result in volatility in the UK stock market even if the underlying companies are still making good profits. And as an equity investor it is the share price return that you are exposed to.

Another problem is that a large proportion of the UK's dividend income is produced by just a few companies. For example, the top 15 payers accounted for three-fifths of all UK dividends in 2017.

This means that there can be a high crossover of stocks between UK equity income funds, as typically they invest in the sort of larger companies that pay attractive dividends. So even if you invest in a number of UK equity income funds you may not be achieving the level of diversification you expect.

 

Income maximiser funds

Because of the risks to UK equity income shares and conventional UK equity income funds that invest in them, you could consider an income maximiser fund to get a slightly more secure income. These are run like conventional equity income funds but make use of derivatives to boost their income, so typically offer higher yields than plain vanilla equity income funds.

A maximiser fund writes covered call options on shares it holds, and the buyers of these options pay the fund a fee, so it earns more income to pay to its investors. In return, the option buyers are entitled to any rise in the prices of the shares on which they buy options above a certain level over a set period of time, for example three months. As a result, the fund sacrifices some of the capital growth upside on certain shares it holds to boost its income.

This means that income maximiser funds are likely to underperform conventional equity income funds when markets are rising, but could be protected from the full downside when markets are falling and be less impacted than conventional equity income funds. "And income maximiser funds' managers can choose which stocks they wish to sell the upside on and retain the full growth on any stocks they think will perform particularly well," adds Pat Connolly, certified financial planner at Chase de Vere.

One of the longest-standing funds of this kind is Schroder Income Maximiser (GB00BDD2F083), which was launched in 2005. It targets a yield of 7 per cent a year and currently has a 12-month yield of about 6.9 per cent. Schroders says that covered call options boost its Income Maximiser fund's natural annual dividend by around 3.5 per cent.

Its managers target value stocks – those whose share prices appear low relative to their long-term profit potential – and that are typically paying an attractive and growing dividend.

The fund has beaten its benchmark, the FTSE All-Share index, over one and five years and the Investment Association (IA) UK Equity Income sector average over one, three and five years.

 

Fund/benchmark12-month yield (%)1-year total return (%)3-year cumulative  total return (%) 5-year cumulative  total return (%)Ongoing charge (%)
Rathbone Income*3.9-0.816.445.40.53
City of London Investment Trust share price4.15.620.846.10.42
Schroder Income Maximiser*6.911.321.150.70.84
Marlborough Multi Cap Income4.46.121.573.50.79
FTSE All Share index TR GBP 8.423.244.7 
FTSE 100 index TR GBP 8.721.840.2 
FTSE 250 index TR GBP 6.626.965.5 
FTSE Small Cap index TR GBP 9.838.376.8 
IA UK Equity Income sector average 5.220.550.5 
AIC UK Equity Income sector average share price 7.524.752.4 

Source: Morningstar

Performance as at 04/05/18

*Performance is of an older share class, rather than the one mentioned in the text

 

Overseas equity income

Another way to try to bypass the problems with UK equity income could be to put some of your assets into an overseas equity income fund. This arguably is going another step up the risk scale, because it introduces more currency risk and potentially exposure to countries and markets that do not have such good corporate governance as the UK, or such a strong dividend-paying culture.

If you want to minimise those risks the best option is a global equity income fund. These are not reliant on the fortunes of any one region, so their managers can avoid problem areas, and they have a wider pool of opportunities.

Global equity income funds also tend to invest most of their assets in developed markets, in particular the US, that have similar standards of corporate governance to the UK. And they offer access to companies with good records of paying attractive and reliable dividends.

"It makes sense to consider holding global and international equity income funds alongside traditional UK equity income funds to provide access to good quality overseas companies and additional diversification in your portfolio," says Mr Connolly. "Investing in global equity income funds is particularly important as only 9 per cent of companies yielding 3 per cent or more are listed in the UK."

Options include Artemis Global Income (GB00B5N99561), which has a yield of 3.6 per cent. The fund has beaten MSCI AC World index over five years and is among the top three funds in the IA Global Equity Income sector in terms of performance over five years. It has made double-digit positive returns in five out of the past six calendar years.

Artemis Global Income aims for a rising income combined with capital growth. The fund has about 38 per cent of its assets in each of the US and continental Europe, and only 3.5 per cent in the UK, making it a good diversifier if you hold UK equity income funds.

It has an ongoing charge of 0.8 per cent.

Fidelity Global Dividend (GB00B7778087) has a yield of 3.1 per cent, and 35.4 per cent of its assets in continental Europe, 28.9 per cent in the US and 17.9 per cent in the UK. The fund is also well diversified in terms of sector exposure.

Fidelity Global Dividend sector allocation (%)
Financials21.1
IT16.4
Health care14.9
Industrials14.3
Consumer staples11.2
Utilities5.9
Energy4.6
Telecoms4.4
Consumer discretionary2.4
Real estate1
Source: Fidelity as at 31 March 2018

 

It is typically less volatile than its benchmark, tends to outperform in falling markets and has made positive returns in each of the past five calendar years.

Its manager Daniel Roberts invests in companies that offer a healthy yield underpinned by a growing level of income, as well as the potential for capital growth. When considering potential investment opportunities, he places a large emphasis on the sustainability of the dividend and whether the current share price provides an adequate margin of safety.

 

Fund/benchmark12-month yield (%)1-year total return (%)3-year cumulative  total return (%) 5-year cumulative  total return (%)Ongoing charge (%)
Artemis Global Income3.65.430.178.90.80
Fidelity Global Dividend 0.632.868.30.96
MSCI AC World Index NR USD 8.437.674.6 
IA Global Equity Income sector average 3.627.753.1 

Source: Morningstar

Performance as at 04/05/18

 

Multi-cap income

Many UK equity income funds focus on larger companies that pay attractive dividends. So another way to diversify away from them is with funds that invest in smaller dividend-paying companies. But if you are a lower-risk investor the problem with these is that they are a good deal further up the risk scale again, as smaller companies are higher-risk and can be very volatile.

For example, in times of economic difficulty they may be less able to survive because they are not as financially robust as their larger counterparts, and they may be reliant on the fortunes of one type of market or product. If there is an economic downturn due to the UK's departure from the EU, the types of companies likely to be worst affected are smaller companies because these typically have greater domestic exposure.

So if you are investing a relatively lower-risk pot of money, rather than put it into a smaller companies equity income fund, a better option could be an all-caps equity income fund. These offer some exposure to smaller companies, but are not totally invested in them, and their managers have the freedom to move away from these into larger companies if necessary.

Options include Marlborough Multi Cap Income (GB00B908BY75), which has an attractive yield of 4.4 per cent and aims to generate an attractive and growing level of dividend income in addition to long-term capital growth.

The fund has just over a third of its assets in companies with a market cap of between £1bn and £5bn, and a similar amount in those with a market cap of between £250m and £1bn. About 13 per cent of its assets are in companies with a market cap under £250m. To manage stock-specific risk the fund is well diversified and has 141 holdings. Its largest position – Intermediate Capital (ICP) – only accounts for 2.6 per cent of its assets.

This fund is higher-risk because it invests down the market cap scale and in some years, such as 2016, makes negative returns. So it is very important to have a long-term investment horizon of at least five years, or preferably longer, if you invest in this fund.

 

Marlborough Multi Cap Income top 10 holdings (%)
Intermediate Capital 2.6
Phoenix 2.5
Polar Capital2.5
WH Smith2.4
Central Asia Metals2.2
DS  Smith2.2
Hastings 2.1
Telecom Plus2.1
Big Yellow2.1
RPC2
Source: Marlborough Fund Managers as at 3 April 2018