How to make sure income funds are on the right track

There are two lessons which can be quickly drawn from this latest series of central bank interventions, which include an increased Quantitative Easing (QE) programme from the European Central Bank and interest rate cuts in both the Eurozone and New Zealand:

  • First, advisers and clients who are holding out for interest rate increases to boost returns from cash could be in for a long wait. The first UK rate rise has been priced in by the markets for some time in 2017. Also note that every developed central bank to have raised rates since the financial crisis has subsequently cut them again, the European Central Bank and Reserve Bank of New Zealand included:

Developed central banks have failed to make rate rises stick for long

Source: Thomson Reuters Datastream

  • Second, derisory returns on cash and minimal bond yields place a premium on dependable yield and bring equities into consideration. After all, the UK’s FTSE 100 is yielding around 4.3% at the time of writing, a good mark relative to its 31-year history, and one that looks tempting relative to cash near zero and a 10-year Gilt yield of 1.5%.

FTSE 100 dividend yield stands above 4%

Source: Thomson Reuters Datastream

Chop, chop

But here lies the problem. Stocks do not offer the degree of capital protection offered by bonds and there are few worse investments than an income stock that cuts its dividend - the share price tends to crater, and this adds capital injury to yield insult. And 13 FTSE 100 firms have cut their shareholder distributions in the last year alone, to perhaps suggest that 4.3% yield figure is not as safe as it looks.

This is where route to market becomes important if an adviser feels that UK equities fit with an income-hungry client’s overall investment strategy, target returns, time horizon and appetite for risk.

  • Stocks. Few if any will want the aggravation of picking individual stocks, even if the 13 dividend cuts over the past year show just how important it is to get this right.
  • Active funds. This means that a really good income fund manager can truly prove their mettle in this testing environment. Note that there are two distinct options here as shown by the difference between the highest-yielding funds and those offering the best returns.

The five highest-yielding UK equity income OEICs

Source: Morningstar, for UK Equity Income category.
Where more than one class of fund features only the best performer is listed.

The five best-performing UK equity income OEICs over the past five years

Source: Morningstar, for UK Equity Income category.
Where more than one class of fund features only the best performer is listed.

Analysis of their top 10 holdings shows a remarkable difference on average between these two groups. The highest yielders will tend to feature names like BP and Shell, firms where the dividend is high but growth unlikely as earnings cover is relatively skimpy. (They will also use derivative transactions to generate additional income, potentially sacrificing some capital gain in return.) These funds will serve a purpose by providing regular income and risk management through diversification and stock selection, and perhaps be suited for a client already in drawdown so they can bank quarterly or six-monthly distributions from the fund.

Yet a client who is younger and yet to go into drawdown may be seeking capital growth and income, and this is where those funds with stronger near-term performance may be worthy of further research. They seem to show a lesser focus on the megacaps and offer a greater role to mid-caps. History does show it is the firms with the best dividend growth record over time that provide the best share price performance, rather than those plodders who offer a fat, unchanged payout for years to come, so this difference in approach does have merit – although around a quarter of the FTSE 100 have managed to increase their dividend for each of the last 10 years.

One track minds

There lies the danger of excess generalisation here and advisers would do well to check out top holdings lists or ask a fund manager about their process and philosophy when they get the chance to do so. There are also some well-established UK equity income investment trusts to consider:

The five best-performing UK equity income investment trusts over the past five years

Source: Morningstar, Association of Investment Companies for UK Equity Income category.
* Share price. ** Includes performance fee

  • Trackers. Tracker funds and Exchange-Traded Funds that seek to deliver the performance of the FTSE 100 (minus their running costs) will deliver the index’s yield as well as its capital return. However, there are now factor-investing products which seek to follow a basket of securities which they themselves select. There are just three UK Equity Income ETFs – BMO MSCI UK Income Leaders, WisdomTree UK Equity Income and iShares UK Dividend. They have different top-holdings lists but will tend to lean toward stocks with the highest yields – which is all well and good but this is where some of the nastiest share price falls have been. As the market has taken fright those yields may not be sustainable.

Yield-seeking UK ETFs hit a rocky patch but have rallied of late

Source: Thomson Reuters Datastream

There are two relatively new UK equity income ETFs for advisers to consider

Source: Thomson Reuters Datastream

This is not to say these ETFs are a bad idea or poor value for money. Far from it. But it just goes to show that when picking any type of fund, advisers and income-seeking clients still need to do some due diligence on its philosophy, process, style and current holdings before they commit any capital.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.