Look to equity income for growth with less downside risk

UK investors had already pulled around £2bn from equity funds on a net basis in the first six months of the year and government bonds have rallied extremely strongly, with investors piling into fixed-income funds. Other safe-haven assets, in which investors park money in times of uncertainty, have fared well too. For example, in August the gold price passed $1,500 per troy ounce, marking a six-year high.

However, predicting the end of a rising market is no easy feat, and even if the market is in a late stage of the cycle, equities could still make strong returns. Signs of an economic slowdown have prompted central banks to take a more accommodative stance, with the US Federal Reserve cutting interest rates at the end of July. This can help boost economic activity and drive equity markets higher.

Some specialists expect that central banks and governments will resort to more extreme measures to stimulate economic activity. Sam Banerjee, research analyst at Shore Capital, argues that central banks in areas such as Europe could try to boost inflation with 'helicopter money'. This is when central banks print money and distribute it directly to people, which can stimulate economic activity and lead to strong equity returns. Expectations of some form of stimulus, and the possibility that US president Donald Trump will soften his trade war rhetoric, could justify a decision to maintain or even ramp up your equity exposure.

“We advocate buying equities, as our base case remains that central banks will do what is required to boost inflation and the rhetoric of the trade war will be dialed down between now and the US presidential elections in November 2020,” explains Mr Banerjee.

Cautious approach

However, measures such as helicopter money may never materialise and nervous investors could continue to sell equities despite any ongoing support from the likes of central banks. And caution could be justified as share prices have been on the rise for so long. So if you are considering taking on further equity exposure, the high risks involved mean a cautious approach seems appropriate.

One way to do this is to invest in an equity income fund that has a focus on paying dividends but still offers exposure to equity growth via a more defensive exposure than a typical growth fund. This is because equity income managers invest in companies based on their ability to reliably pay regular dividends, which are in typically more defensive sectors such as consumer staples and utilities. These often have defensive characteristics both in terms of their business model and how they are run, meaning they could fare well in times of equity market volatility.

“Equity income has been an established cautious way of accessing equity markets for many years," explains Guy Stephens, technical investment director at Rowan Dartington. “The main thinking behind this is that the investor is gaining exposure to a secure, stable and hopefully growing, in real terms, income stream. This would usually come from secure, stable and hopefully growing businesses where the provision of a healthy dividend to shareholders is important.”

Tim Stubbs, an investment consultant, adds: “In a tactical sense, defensive dividend stocks have appeal due to the types of sectors that have outperformed over the past year. Defensive, boring sectors would be likely to hold up relatively better in falling markets, given their lower sensitivity to economic growth rates. But they would still offer some degree of upside if quantitative easing is extended.”

Performance figures from the latest period of severe volatility bear this argument out. When equity markets tumbled in the fourth quarter of 2018, the Investment Association (IA) UK All Companies fund sector average return was a fall of 12.64 per cent, and the IA Global sector average was a fall of 11.58 per cent, in sterling terms. But equity income funds fared better: over this period the IA UK Equity Income sector average was -11.04 per cent and the IA Global Equity Income sector average was -8.9 per cent.

This is not just down to the companies equity income funds invest in - they tend to sell stocks that perform particularly well because share price increases drive their yields down.

“This enforces a valuation discipline upon a manager, which can prevent the damage caused by the market falling out of love with a previous darling stock, resulting in its price crashing,” explains Simon Evan-Cook, who runs multi asset funds at Premier Asset Management. “So while an equity income fund is unlikely to be the standout winner over any given three-year period its tortoise-like approach means it has a higher chance of generating a very worthwhile return over the medium to long term.”

And he thinks that as prices look steep on high-growth stocks and bonds seem vulnerable to any return of inflation, equity income “looks like a sensible middle ground amid all these uncertainties”.

Slow and steady

However, a focus on dividends is no guarantee of a defensive approach and can drive fund managers to take greater risks. This is because companies sometimes pay high dividends at the expense of other priorities such as investing in themselves, to the detriment of future performance. A particularly high dividend can be a sign that future payments or the company itself are at risk.

These risks are illustrated by the latest edition of the Janus Henderson Global Dividend Index, a report on dividend payouts around the world. This reported that in the second quarter of 2019 the biggest dividend payers included mining company Rio Tinto (RIO), carmaker Daimler (DAIX.N:GER) and HSBC (HSBA). These companies are in risky sectors: mining companies can be reliant on volatile commodity prices, car makers are exposed to the current trade war and banks normally struggle without rises in interest rates.

The problems facing big dividend payers are also evident in the UK this year - several companies plan to scale back dividend payments or are trying to dampen down expectations of future increases in their dividends. These include Vodafone (VOD), a major UK dividend payer, which announced in May that it is cutting its payout by 40 per cent.

So you may be better to consider funds that seek income but are also focused on how sustainable the revenues from their holdings are. These can include, but are not restricted to, funds that target a lower yield but look to avoid excessive risk. Some of these funds, referred to as 'dividend aristocrats' or 'dividend heroes', offer a lower income than some of their peers, but focus on increasing their payout every year.

The 'dividend aristocrat' approach tends to offer defensive exposure because if companies put fewer resources into achieving a high yield, they can instead focus on becoming more profitable and ensuring the dividends they pay are more sustainable. So funds that take this approach might suit investors looking for defensive equity exposure.

“The aristocrat approach has proved to be good over the long run,” says Richard Philbin, chief investment officer at Wellian Investment Solutions. “If a company grows its dividend every year and only has a 1.6 per cent yield, then the capital appreciation must in essence be ahead of the growth of the dividend.”

However, companies with relatively low but sustainable dividend payments could perform badly if bond yields rise after tumbling this year, as that would make these companies’ yields look less attractive and be detrimental to their share prices.

Research provider Capital Economics warns: “Dividend aristocrats are unlikely to keep outperforming. Given our view that bond yields are unlikely to end this year much lower than where they are now, we doubt that these stocks will continue to outperform the rest of the market.”

Defensive funds for growth

There is a broad choice of equity income funds, with 87 in the IA UK Equity Income sector and 55 in the IA Global Equity Income sector. To be included in these sectors, funds have to yield more than the FTSE All-Share or MSCI World indices, respectively, over a rolling three-year period. This means that some income funds with lower yields are ranked in different sectors.

A fund with outstanding performance is TB Evenlode Income (GB00BD0B7D55) whose managers, Hugh Yarrow and Ben Peters, focus on “sustainable real dividend growth”. It has a historic yield of 2.9 per cent and had just 38 holdings at the end of July. It had returned 85.17 per cent over the five years to the end of August, versus 31.17 per cent for the FTSE All-Share index and the IA UK Equity Income sector average of 24.91 per cent.

The fund also tends to give investors a smooth ride. Mr Evan-Cook notes that it has “the kind of steady approach many investors would instinctively find comfortable”. It fared particularly well amid the difficulties of 2018, returning 0.39 per cent when the FTSE All-Share fell nearly 10 per cent.

However, last year the fund's managers decided to try to limit its size by levying an initial charge of 5 per cent on new investors. If you buy it via an investment platform, which is considered to be an existing investor, you will not have to pay this fee. But the fund’s size, which had reached nearly £3.5bn at the end of July, means that some might worry its future returns might not be as good because its managers may not be able to invest in the same types of companies as they used to.

A smaller fund that has a similar approach of focusing on sustainable dividend growth is TB Evenlode Global Income (GB00BF1QNC48), which is also run by Mr Peters alongside Chris Elliott. It has a relatively short track record having launched in 2017. But so far the fund has performed well, gaining 18.31 per cent over the year to the end of August in sterling terms, versus a 7 per cent sterling return for MSCI World index. It has a historic yield of 2.3 per cent.

Troy Trojan Income (GB00BZ6CQ176) has tended to perform well against other UK Equity Income funds and the FTSE All-Share index. It has a relatively high net dividend yield of 4 per cent, but its managers, Francis Brooke and Hugo Ure, take a defensive approach. At the end of July they said that it would be “too great a risk to capital” to grow the fund’s dividend so have been lowering the fund’s exposure to higher-yielding names and moving to a greater weighting to companies they think have better dividend growth potential.

Another fund with a similar level of yield and a defensive approach is Threadneedle UK Equity Income (GB00BDZYJV10). Its manager, Richard Colwell, combines higher-yielding investments with holdings that can provide a growing dividend or capital returns. The fund normally holds between 45 and 60 holdings, and can diversify across different sectors and company sizes.

When you invest in open-ended funds you need to pick the share class that suits your investment goals best. Accumulation units do not pay out dividends, but rather reinvest them on your behalf, so contribute to your overall total return. The decumulation units pay out an income.

“Buying the accumulation units could be an attractive way to play this angle,” says Mr Philbin. “Using capital gains as a way to pay [any required] income might be a good point from a financial planning perspective. And buying units on a monthly basis can help with volatility in markets. But if you buy the income units on a monthly basis and then reinvest dividends twice a year you are, in essence, making 14 investments which diversifies the timing.”

Closed-end benefits

If you want defensive equity exposure alongside some income, investment trusts offer some additional advantages, including the ability to use revenue reserves to pay dividends in difficult market conditions - even if the revenue from their investments doesn't cover it.

Mr Banerjee likes Scottish American Investment Company (SCAM), which has a growth-focused portfolio and has delivered strong dividend growth.

“Trusts like Scottish American are still likely to deliver returns that are superior to bonds over the medium term, especially if central banks try to meet their inflation objectives,” he says. “It has a dual mandate of a high dependable income stream, and real growth in income and capital over the long term.”

The fund had a stated yield of 2.7 per cent at the end of July. It is diversified across different regions and asset classes, with 36.2 per cent of assets in European equities, 26.8 per cent in North American equities and 13.1 per cent in property.

An income-oriented trust with a defensive profile is City of London Investment Trust (CTY). Its manager, Job Curtis, places greater importance on dividends and the trust had a yield of 4.37 per cent at the end of July. Fund rating agency RSMR notes that this dividend emphasis leads to a “defensive, low beta portfolio”, with the manager favouring businesses that have strong balance sheets and cash flow generation. However, this trust's total returns have tended to lag those of Scottish American and broad global equity indices.

Fund performance

Source: FE Analytics, *fund providers and platforms. Performance data as at 31/08/2019