29th January 2014
In the first of series looking at the options for investing your Isa, investment journalist Cherry Reynard looks at the UK Equity Income sector.
When companies make profits, they can either reinvest them to grow the business, or they can pay them out to shareholders in the form of dividends. Funds within the UK Equity Income sector aim to build a portfolio of companies that, in aggregate, will give a higher income from dividends than the overall stock market.
The range of fund strategies within sector
While all funds have to have an income in excess of 110% of the FTSE All Share, different managers will strive to achieve that in different ways. Some managers will aim to find those companies with a high absolute income – investing only in those companies paying, say, 10-20% higher than the market. Others will prioritise those companies that are growing their dividends.
Managers will also vary in the extent to which they aim to generate capital growth alongside income – some will be ‘pure’ income managers, while others will aim to provide more of a balance. For example, some managers will employ a ‘bar bell’ strategy, blending companies that pay a high dividend with companies that pay low or no dividend at all to give a higher aggregate income, but with the potential for capital growth.
Equally, some fund managers will invest exclusively in smaller or medium-sized companies, while others will stick to the large blue chip names. Others will aim to be flexible and switch their portfolio around, depending on the business cycle and where the managers sees the best value.
Finally, there are so-called ‘enhanced’ income funds. These funds use derivatives to boost the income for the fund. This type of approach caps the upside of a fund, so these funds will tend to lag rising markets, but pay an income of around 2-3% higher than the average fund in the sector
Over the past five years, the average fund in the UK All Companies sector has grown by 108.2%. This compares to average growth from the UK All Companies sector of 121.9%, and from the Global Equity Income sector of 80%.
By far the best performing funds over the past one, three and five years have been those with a smaller companies bias, such as Unicorn UK Income and Chelverton UK Equity Income, though these funds will tend to suffer disproportionately when markets are trending lower. They were hit hard in the 2008 sell-off, for example.
The other top performers have been those with a flexible approach, where managers have shifted the focus of the portfolio through the business cycle. This includes funds such as the Cazenove UK Equity Income fund, the JO Hambro UK Equity income fund and the Royal London UK Equity Income fund.
The weakest funds have tended to be those focused on the mega-caps, which have trailed the wider market. These are funds such as the Newton Higher Income fund, which has a large cap bias and a strict yield discipline. Jupiter Income has suffered for similar reasons.
When does it perform well/badly?
In general, if a company has the ability to pay a dividend, it is profitable and generating cash. This means that the UK equity income sector will tend to focus on more established businesses. This provides some protection for investors, making UK equity income a more defensive investment at times of market turmoil. Equally, equity income investing imposes a natural valuation discipline. The income from a stock is always quoted as a percentage of the share price. For example, the current income for GlaxoSmithKline is 4.6% on a share price of 1,675p. If the share price rose, that income would go down. This means it would no longer fit the criteria for many equity income managers. In this way, they avoid companies where the share prices have risen too high.
That said, funds within the UK Equity income sector will perform differently at different stages of the market cycle. For example, those focused on large cap, defensive companies such as tobacco, utilities or pharmaceuticals will tend to do better in a climate of weaker economic growth, where stock markets are struggling to make progress. In contrast, they will lag the wider market at a time of stronger economic growth and better stock market performance. In this environment, UK equity income funds focused on smaller companies will tend to do well.
What sort of investor does it suit?
It goes without saying that UK Equity income suits an investor focused on generating an income from their investments, but in reality it suits all types of investor. Reinvested dividends are a powerful way of compounding returns over time, so it can be equally appropriate for an investor focused on capital growth. That said, investors have to be willing to take stock market risk and see the value of their income and capital fluctuate over time. The sector now offers sufficient choice to suit investors willing to take more or less risk. While Global Equity income is becoming an increasingly popular alternative, UK equity income suits those whose outgoings are in sterling as investors take little or no currency risk.
How much of a portfolio for low/mid/high risk investor?
Most multi-managers have UK Equity Income at the core of their UK exposure. They may vary this between higher risk smaller company equity income funds and more defensive blue-chip equity income funds over the course of the market cycle, but UK equity income is always likely to be a significant chunk (50% or more) of the UK exposure of the average investor.
The popular funds
Top 10 by performance (5 year)
Unicorn UK Income
PFS Chelverton UK Equity Income
Standard Life UK equity Income Unconstrained
JOHCM UK Equity Income
Royal London UK Equity Income
Cazenove UK Equity Income
Henderson Global Care UK Income
Lazard UK Income
Old Mutual UK Equity Income
Questions for investors to ask
Do I only want income?
Do I want income and some capital growth?
Do I want to be in large, blue-chip companies?
Am I happy to take more risk in a smaller capitalisation or more flexible fund?
Do I want a more defensive fund?
Or something that may be able to perform throughout the market cycle?
The view of investment advisers
Tim Cockerill, head of research at Rowan Dartington
“Equity Income suits income seekers, but dividends also give an underlying support to share prices. Another key benefit is that the rate of growth in income often exceeds inflation, so it is a good source of growing income.”
Invesco Perpetual UK Strategic Income
Threadneedle UK Equity Alpha
JO Hambro UK Equity Income
Patrick Connolly, financial planner, Chase de Vere
“The UK economy seems to be on the road to recovery and this is positive for the stock market, although it is important to recognise that overseas sales make up about 70% of the revenue of FTSE-100 companies, so what is happening elsewhere in the world is also hugely important.”
Threadneedle UK Equity Income