Following a flurry of fund launches in 2011, a new Investment Management Association (IMA) sector, Global Equity Income was launched on 1 January 2012, currently totaling £3.8bn.
However, there are those who argue that the strategy is a fad and, much like last year’s fashion purchase, in the cold light of the new season it is unlikely to shine. But lessons from history and thoughts for the future both suggest that equity income strategies can provide an attractive long term investment story.
The new IMA sector could not highlight this for investors at a better time. Equity income can provide an elegant solution for the new demographic of an increasingly ageing world. Rather than hanging up their boots and switching their funds to Government bonds on the day they leave work, retirees are faced with the conundrum of living longer in a world where returns are low and Governments are strapped for cash – a situation that may only intensify in the coming years. Retirees, much like global equity income strategies, are coming of age.
Keeping it real
When considering the benefits of equity income investing, it is easy to see why the strategies are proving so popular, and while once firmly the domain of the UK equity market, developments from global markets have permitted a much broader choice.
Low interest rates look set to be a feature of investing landscape in the developed markets for the near future. Combined with above-target inflation and anxious investors, this is making real, sustainable and meaningful income increasingly elusive.
Yields on traditional safe haven bonds and cash are at very low levels and generating meaningful income from corporate bonds means taking on higher and higher levels of risk. Meanwhile, the security of leaving money in the bank is offset by the negligible returns available through cash deposits.
When you think about the long term effect, the numbers are alarming. A traditional balanced portfolio today yields just 3%, compared to 6% 20 years ago – meaning that it would take 23 years instead of 11 to double your money through compounding income alone.
With equity income, dividend payouts are taken from company profits, which can increase over time and are not time limited by maturity date. They are often viewed as an important signal about corporate health, encouraging company management to at least maintain, if not grow, their returns to shareholders.
As a result, equity income investing can offer an indefinite and potentially rising income stream. And it is not just income, it is real income. Inflation erodes the purchasing power of returns on most bonds and on cash.
The ability to safeguard income from the erosive effect of inflation is a benefit of equity income investing. Companies with strong business models and pricing power can increase the cost of their products on the shelves in times of inflation. Therefore, they can grow their payouts at least as much – but often more than – the rate of inflation, so dividend growth can help protect the value of money. In fact, over the past 25 years, the dividend growth of the FTSE All Share has outpaced inflation by an average of 1.1% annually.
Securing reliable and meaningful income can often mean sacrificing capital growth. However, with equity income the very opposite is often true. These strategies provide access to the capital growth available in equity markets – and dividend paying shares are those that drive total return in the stock market.
While it is share price swings that make the headlines, it is the combination of dividend yields and dividend growth that has contributed as much as 90% of long term stock market returns. This startling figure shows the huge impact of sustained cash returns, coupled with the compounding effect of reinvesting dividends.
Lessons from history
What brings this story to life is to see how these equity income strategies have actually worked over time. Over the past 10 years funds in the IMA UK Equity Income Sector have returned on average 60.7%, besting the IMA UK All Companies Sector, which has returned 57.4%.
Alongside, many of these funds have provided a stable and growing dividend for investors.
Looking further afield, it is interesting to see how shares that fall naturally into active equity income strategies have fared relative to the rest of the market.
Companies that pay sustainable, rising and strong dividends tend to be high quality companies with robust business models. This often means that they are better placed to weather the bad times than less solid companies. The market knows this and rewards it.
As a result the share prices tend to be less volatile over the market cycle than those of stocks that do not pay and grow dividends.
Lessons from history have shown that, while higher yielding shares are unlikely to catch all the upside of a racy growth stock in an economic boom, they outperform the broader stock market in periods of low growth and are better cushioned in times of recession. This not only makes equity income strategies compelling long term holdings, but also in today’s world of sluggish economic growth is an optimum environment for these funds.
On active duty
To make the most of the opportunities in equity income investing, fund managers need to do more than simply pick the stocks with the current highest yields. Stocks can appear to have high dividends, but then cut the payments in downturns, or different stages of the economic cycle – known as a value trap. An active approach to equity income investing can avoid these pitfalls and find the best opportunities.
Experienced managers select stocks not based on yield alone, but because there is also scope for capital growth, or a high probability of increased payouts or special dividends. The result is dynamic investment strategies, expertly tailored to changing market conditions that can maximise both capital growth and income.
The search for income has only just begun, with the size of the global retirement population expected to triple by 2050 and lifespans increasing. To make matters worse, as retirees make up a larger and larger percentage of the population, income needs, whether those of individuals, Governments or pension funds, are rocketing.
Equity income strategies, which are well tailored to their respective markets, can offer the best of both worlds, high and sustainable real income growth combined with the potential for capital appreciation - an attractive long term proposition for the new world of lower yields and longer lives.
Tony Stenning is head of UK retail business, BlackRock
