Funds for the UK dividend recovery

Say it quietly, but dividend hunters in the UK might finally be able to be optimistic. After a brutal 2020, a recovery of sorts seems to be on the cards: the Janus Henderson Global Dividend Index report for the first quarter of 2021 notes that the UK dividend market has shown “signs of revival”, even if the effect of last year’s cuts and the permanence of some reductions will weigh on the yield available.

Link Group, which conducts its own dividend research, expects headline dividends for 2021 to rise by 17.2 per cent to £74.9bn in its best case scenario, thanks to payouts from Tesco (TSCO), and mining stocks BHP (BHP), Rio Tinto (RIO and Ferrexpo (FXPO). If this scenario materialises, Link expects UK stocks to yield an underlying 3.1 per cent for the year, falling to 3 per cent if its worst-case scenario plays out.

This is a far cry from a pre-pandemic world in which the FTSE 100 index could at times be expected to deliver yields of 4.5 to 5 per cent, but it should still offer a good source of income. Also remember that some parts of the market may offer chunkier yields than others. Link, for example, expects the FTSE 100 to yield 3.4 per cent in its best-case scenario - double the 1.6 per cent it expects for the FTSE 250 - while some sectors have bigger recoveries to make than others.

This matters for funds. The dividend cuts of 2020 hit some portfolios harder than others and some funds will benefit more from a dividend recovery. It is worth noting which funds might capture more of this upside and how to strike a useful balance of exposures.

Green shoots

Data provider FE's analysis of the dividends paid out by open and closed-ended UK equity income funds suggests that some have already enjoyed better months. The data is not exhaustive: funds make payments with different frequencies, and, for example, ones that only pay out every six months would not be captured.

Yet certain names have already begun to make higher payouts in 2021 than a year earlier. These include Downing Monthly Income (GB00B625QM82) which made higher payments in March and April, and Man GLG Income (GB00B0117D35) which made bigger payments in January, February and April.

This partly reflects the fierce cyclical rally of the last six months, aiding funds invested further down the market cap spectrum or in value stocks. Downing Monthly Income has a focus on small and mid-cap names, and recently listed energy company Diversified Gas and Oil (DGOC), which upped its dividend earlier this year, as a major holding. Henry Dixon, who runs Man GLG Income, meanwhile, is known for taking something of a value tilt.

While early improvements in payouts are easier to spot in funds that distribute income each month, the full picture should become clearer later on. With no certainty that a strong run for cyclical names will continue, investors may instead want a spread of exposures, from different investment styles to market cap preferences.

Cyclical versus defensive

It should be noted that more cyclically positioned funds may continue to enjoy a bigger rebound than defensive portfolios.

"With the rebound in commodity prices some of the biggest dividend rebounds will come from the mining and oil majors," says Rob Morgan, pensions and investments analyst at Charles Stanley. "Banks have been reinstating too, while smaller, domestic firms are benefitting from re-openings which might take a bit longer to filter through. The upshot is that quality-oriented, defensively positioned equity income funds such as TB Evenlode Income (GB00BD0B7D55) were relatively resilient – both in income and capital terms. These are experiencing a shallower rebound compared with funds carrying more economically sensitive companies such as commodities and financials, as well as exposure to small and mid-caps."

Similar concerns may apply to funds with an environmental, social and governance (ESG) tilt. While investors may back them to eke out an income without exposure to the likes of miners, their income and total returns may lag more cyclical portfolios for the time being.

One more cyclical fund Morgan singles out is JOHCM UK Equity Income (GB00B95FCK64). He argues that it offers exposure to areas benefiting from the rebound, and provides good diversification from more defensive equity income funds that are "packed with consumer staples and other areas that have been more consistent dividend payers."

 He adds that holding both types of fund could offer a decent balance.

Broad exposure to the UK market and its cyclical sectors is also generally well achieved via passives. iShares Core FTSE 100 UCITS ETF (ISF) provides cheap access to the market and its improving dividend profile, while names like SPDR FTSE UK All Share UCITS ETF (FTAD) provide a broad market exposure. Investors should remember, however, that a passive approach has not tended to work particularly well in the UK. Even if a UK rally continues, this may be a market where the selective nature of an active fund is better in the longer run.

It is notable that iShares UK Dividend UCITS ETF (IUKD), which now sits in the Investment Association UK Equity Income sector, paid a greater dividend in March 2021 than it did a year earlier. We dropped this fund from the IC Top 50 ETFs last year due to concerns that a heavy focus on yield could lead it to hold potential value traps. We replaced it with the slightly more defensive SPDR S&P UK Dividend Aristocrats UCITS ETF (UKDV) which tracks companies with a long record of dividend increases.

However, more aggressive approaches have tended to fare much better amid the cyclical rally. iShares UK Dividend UCITS ETF made a 21.4 per cent total return in the six months to 27 May, putting it well ahead of the FTSE All Share index's 13.5 per cent and FTSE 100's 12.2 per cent total returns. SPDR S&P UK Dividend Aristocrats UCITS ETF has trailed all of these, returning 9.5 per cent.

Looking beyond the big payers

2020 has been a painful reminder of how reliant UK equity income funds are on the same handful of big dividend payers. Diversifying via some small and mid-cap exposure can be useful.

Some names like Man GLG Income have a mix of market exposures, but others make a virtue of generally focusing further down the market cap scale. These include FP Octopus UK Multi Cap Income (GB00BG47Q440), Premier Miton UK Multi Cap Income (GB00B4M24M14), ES River and Mercantile UK Equity Income (GB00B3KQG447), LF Gresham House UK Multi Cap Income (GB00BYXVGT82), Montanaro UK Income (IE00BYSRYZ31) and Unicorn UK Income (GB00B00Z1R87).