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Equity income funds: seeking a middle ground

How 'low-yield' names get on
Equity income funds: seeking a middle ground

The dividend recovery is storming ahead and yields in the UK equity market look enticing. The expected yield on the FTSE 100 stands at 4.1 per cent for 2021, with payouts “in touching distance” of their pre-pandemic peak, according to AJ Bell. But life, as ever, is not so simple for income hunters.

We noted earlier this year that the dividend recovery has been worryingly uneven, with mining stocks and other cyclical sectors leading the substantial growth in this year's payouts. More fundamental concerns continue to linger, too, such as income investing is inherently flawed, with investors backing poor-quality companies offering high yields rather than hunting sustainable returns.

Writing for the FT at the start of December, hedge fund boss Paul Marshall took this argument even further, slamming the UK equity market as a “Jurassic Park” where an obsession with dividends prevents companies from investing in their businesses. He claimed UK managers “dedicate themselves to clipping coupons rather than encouraging growth and innovation”.

For now, the UK’s obsession with yield is still visible. Dividend-oriented portfolios remain popular: despite years of mixed returns and outflows, the Investment Association UK Equity Income sector was among the 10 biggest open-ended fund groupings by assets at the end of October. But the sector does allow investors to look beyond yield if they so wish.


Happy medium?

Running a balanced growth portfolio and banking capital gains is often touted as an alternative to investing for income, with good reason. But a key criticism of this strategy is that it requires a degree of market timing, meaning damage can be inflicted on a portfolio when assets are sold in a falling market. Generating some income can potentially offset this risk and a handful of funds in equity income sectors seek a middle ground of sorts. They tend to look for a mixture of income and growth, targeting more modest yields than many of their peers.

Within the UK equity income fund sectors, Finsbury Growth & Income Trust (FGT) tends to produce a much lower yield than other trusts, and this was just 1.9 per cent at the end of October. And the Lindsell Train team is not alone: Trojan Income (GB00BZ6CQ069), whose management team decided to exercise caution even before 2020, had a historic dividend yield of 2.5 per cent at the end of September. Elsewhere, Invesco Income & Growth (GB00B8N46P10) recently listed a 2.5 per cent yield, while the historic yield for BMO Responsible UK Income (GB0033144857) came to 2.9 per cent at the end of October.

If the Trojan fund has struggled somewhat (see chart), funds such as BMO Responsible UK Income and Invesco Income & Growth have delivered the goods, at least when it comes to five-year relative returns. Both have had a much stronger 2021 than the other middle ground examples given, although these two also had a more difficult 2020. They may therefore be somewhat reliant on market momentum, even if the BMO fund's ESG remit stops it from holding certain cyclical stocks.

Regardless of shorter-term performance, some of the funds will appeal due to their defensive nature or their focus on quality businesses with an ability to weather storms. For example, we we have already examined the case for sticking with Lindsell Train (Why Lindsell Train has underperformed, IC, 20 August 2021). Even so, the ability of their holdings to cope with sustained inflation has come into question. The team behind Trojan Income recently noted, for example, that the market had appeared “sceptical” that its holdings in the consumer goods space could bear rising prices.

Trojan Income's investment team counters that businesses with premium products have been better placed to absorb cost increases, giving the example of premium spirits at Diageo (DGE), and Nestle's (SW:NESN) offerings in coffee and pet care. Trojan Income had a quarter of its assets in consumer staples at the end of September, with 11 per cent in consumer discretionary businesses. Although asset allocation figures are less telling for Finsbury Growth & Income due to its concentrated nature, 48.8 per cent of its portfolio was in consumer staples at the end of October, with 17.7 per cent in consumer discretionary.


Going global

Global income funds are much less popular than their domestic peers, as judged by the size of the relevant sectors. But they may still appeal as a core holding. Several of these funds are also less focused on yield as part of their investment process. 

The managers of Guinness Global Equity Income (GB00BNGFN669), for one, focus on companies with a consistent high return on capital, as well as looking for businesses “well-placed to be able to pay a sustainable dividend into the future”. Part of the investment thesis relates to the idea that maintaining dividend growth can be a sign of a well-run company: the fund's managers point to the fact that dividend-paying companies outperformed non-paying peers over a multi-decade period in the US. Importantly, however, those that had cut a dividend were the weakest group over the same timeframe, an outcome that emphasises the potential perils of focusing on high-yielders.

The Guinness fund has been among the stronger-performing global equity income funds over time and sits roughly in the middle of the pack even when dedicated global growth funds are included in the figures.

Other names, such as Liontrust Global Dividend (GB00BMBP2F66), focus again on set criteria rather than headline yield. This fund's managers seek companies investing heavily in innovation, on the grounds that such businesses tend to be more adaptable and successful. The Guinness fund recently had a historic yield of 2.4 per cent, while the Liontrust fund’s net underlying yield at the end of October came to around 2 per cent.

That said, another approach can appeal. Of all the global equity income funds, it’s instructive that JPMorgan Global Growth & Income (JGGI) has had the strongest five-year total returns. Like a handful of other equity trusts run by the same investment manager, the trust pays a dividend amounting to a stated proportion of its net asset value (NAV) at the start of each financial year. It seeks to pay at least 4 per cent of its NAV at the time of announcement.

This approach brings us back to the argument on receiving dividends versus taking capital gains to fund an income. In theory the trust’s managers can simply focus on buying the best companies, with dividends then funded by whatever income and capital growth materialises. But once again investors run the risk of poor market timing and having to sell assets to fund the dividend when prices are low.