Join our community of smart investors

Diversify your UK equity income winners

It is important to diversify your UK equity income exposure to avoid potential problems in certain areas
November 2, 2021

UK dividends have made a good recovery this year

This is largely driven by certain sectors which might not do as well in future

It is important to diversify across different areas of UK equity income to mitigate problems in any one area

The good news keeps coming for UK dividend hunters. Headline dividends from the domestic market were up 89.2 per cent year on year in the third quarter of 2021 according to Link Group, driving a big upgrade in the company’s forecast for payouts over the full calendar year. Link now expects UK headline dividends for 2021 to be 45 per cent year higher than in the previous year, with underlying dividends up by more than a fifth. The company also expects further dividend growth for 2022, aided by progress in the banking sector.

This is good news for income investors and equity income funds which target yield. But the recovery has been fairly uneven. The third quarter income boost was largely driven by big payouts from the mining sector, which accounts for nearly a quarter of dividends paid this year. And Link worries that falling commodity prices could hurt mining payouts next year.

The oil sector has also enjoyed dividend growth - for now. As Link puts it,: “altogether, the extractive industries will make up almost one third of 2021’s UK dividends, leaving investors in UK equities uncomfortably reliant on two volatile, highly cyclical sectors for income”.

We have used FE data to see which funds have best captured this year’s dividend recovery so far, based on an investment of £10,000 made at the end of 2020. But when considering these, it is important to remember what is driving the recovery and ensure that your own investment portfolio is well diversified rather than just focused on one area.

 

Dividend fund leaders

So far this year, Schroder Income Maximiser (GB00BDD2F083) has paid out more than any other open-ended or closed-ended UK equity income fund. If you had invested £10,000 in it at the start of the year, by the end of October it would have paid out around £600.

The fund boosts the income it gets from its holdings by selling options - a type of derivative. The fund's holdings also have a value tilt with overweight allocations to sectors such as energy and financials. The fund targets an income of 7 per cent a year, though this will depend on market conditions.

Like other income maximiser funds, Schroder Income Maximiser effectively sacrifices market exposure by selling options and gives up some capital gains when its holdings rise. But if you are happy to make this sacrifice, you should get a reliable higher yield.

Other funds which boost their natural income by selling options have also paid out a good amount this year, including Premier Miton Optimum Income (GB00B3DDDX03) and Fidelity Enhanced Income (GB00B87HPZ94), .

 

A mixture of very different funds with cyclical exposures have paid also out richly so far this year. These include Merchants Trust (MRCH), which has performed extremely well more generally. The investment trust has decent weightings to more cyclical sectors and invests further down the market cap scale than some income funds, with around a quarter of its assets in FTSE 250 companies and 8.7 per cent in small cap companies at the end of August. Merchants' shares traded on a dividend yield just shy of 5 per cent at the end of October.

Other value-minded trusts, including Edinburgh Investment (EDIN), have delivered hefty payouts, as has Chelverton UK Dividend (SDV) which focuses on smaller companies.

But active management is not the only route: iShares UK Dividend UCITS ETF (IUKD) targets 50 stocks with leading yields and is among the top payers so far this year. We removed this fund from the IC Top 50 ETFs list in 2020 due to concerns that it might end up holding value traps because it focuses closely on yields. We favour SPDR S&P UK Dividend Aristocrats UCITS ETF (UKDV) because of its focus on companies with a multi-year track record of increasing their dividends.

 

Seeking a balance

Diversification can always be useful, although it takes different forms. Considering where some of the big dividend increases have come from this year, you may wish to add less cyclical UK equity income exposure. Funds with a quality bias such as TB Evenlode Income (GB00BD0B7D55) may stand out, though they have struggled this year and offer a relatively low yield versus some peers. Similarly, more cautious names like Troy Income & Growth Trust (TIGT) offer a lower yield but may provide some diversification.

Ethical funds tend to steer clear of some big cyclical sectors so can offer some style diversification. Janus Henderson UK Responsible Income (GB0005030373), for example, misses out on payments from areas such as mining but may have less of a cyclical bent than some other funds.

UK equity income can also be diversified by relying less heavily on a handful of big dividend payers that dominate the market. This means looking past large caps to small and mid-caps.

A number of UK equity income funds take this approach and some have delivered good dividend payments so far this year. They include Chelverton UK Dividend Trust and Marlborough Multi Cap Income (GB00B908BY75). The latter fund's top 10 holdings at the end of September are unlikely to appear as major positions in more mainstream income funds. These include Big Yellow (BYG), Polar Capital (POLR), Intermediate Capital (ICP) and 3i (III).

Funds with small and mid cap exposure have performed especially well in the past year, but may struggle if life gets harder for value investors. Generally, moments of slowing economic growth can be as tough for small and mid cap investors as for value style investors.

Some of the multi-cap funds might have big bets on the same sectors as value funds. Marlborough Multi Cap Income has significant exposure to financials, even if its top 10 holdings include asset managers rather than the big banks that often appear prominently in more conventional income funds.

You should apply similar diligence when considering environmental, social and governance investing funds. Some of those which put ethical criteria to work, such as the Unicorn UK Income (GB00B00Z1R87) and Unicorn UK Ethical Income (GB00BYP2Y515) funds, look beyond the likes of miners but it can help to understand where they invest. The Unicorn funds, for example, have a bias to small and mid-cap stocks (see Backing small and mid caps for income, IC, 30.04.21)