UK equity income sector must adapt to new reality: Wellian

Over the past few years, the UK Equity Income sector has seen a spike in flows, on the back of steady income in an increasingly low yield world.

But the sector, which has created and attracted many so-called ‘star’ fund managers, has been struggling to meet its 110 per cent yield requirement of the FTSE All Share index over three years, meaning a number of these top managers have jumped ship.

Several investment vehicles have been kicked out of the sector over the past three years, with the £934m Evenlode Income fund being the most recent fund to depart.

But Mr Mayo, investment director at Wellian Investment Solutions, said it was important to point out that the fund managers are sticking to their investment strategies, rather than chasing higher yields in companies they wouldn’t normally buy.

The investment boss also pointed to his own firm’s research, which showed that - based on current yields - as much as 20 per cent of the sector could fall foul of its rules.

The Investment Association launched a consultation in April which looked to propose alternative ways of classifying UK equity income funds.

Mr Mayo said some managers can boost a funds’ yield by making full use of the sector’s overseas allowance, move down the market cap to higher yielding small cap, or invest in higher yielding mega caps, which “won’t necessarily be a good thing”.

Hugh Yarrow, who runs the Evenlode Income fund with Ben Peters, criticised the sector’s “arbitrary” parameters, and earlier this month the pair warned about the outlook for UK dividends after several large companies reduced or cancelled payments.

Although the headline rate looks appealing, the quality of the income streams doesn’t look as good Chris Mayo

Mr Mayo said fund managers would prefer to exit, rather than stay and chase “unsustainable yields” to meet the 110 per cent requirement.

He said the past year has been tumultuous for UK dividends, with falls in profits making investors unsure which companies could maintain their payouts.

Many big-name mining and oil companies, retailers and utilities, had been solid dividend payers until recently, when a number decided to shave their dividends.

Mr Mayo said many see this as a signal that similar action will be taken by other companies, adding this nervousness makes it even harder for fund managers who are trying to meet a yield target.

In June, Thomas Moore, who runs Standard Life’s £1.2bn UK Equity Income fund, said investors should be “wary” of many large UK companies using debt to pay their dividend.

Mr Mayo argued just a quarter of companies in the FTSE 350 have an above average dividend yield, which is the lowest level for 25 years, meaning fund managers have a much smaller pool of companies to build a portfolio and scoop up the required yield.

“When looking at dividends in the UK, there is a big bias and concentration towards the high yielding mega caps,” he said.

“Although the headline rate looks appealing, the quality of the income streams doesn’t look as good, because the profits of many FTSE 100 companies are barely more than the dividends they pay.”

The Wellian director also said investors have a growing concern about the sustainability of dividends and are worried how future cuts could affect the share price, prompting many to move into small and mid-cap exposure, instead of chasing the mega-cap high yielders.

“With the current uncertainty in stock markets, dividends are unlikely to stay at their current level, as companies cut their dividends as a precautionary measure, meaning investors should expect a reduced level of dividend income generally,” stated Mr Mayo, who added he would not be surprised if the number of special dividends rose over the next few years.

He said it was probably time for the UK Equity Income sector to start looking at some potential changes, suggesting perhaps the 110 per cent yield of the FTSE All Share requirement could be reduced by 10 per cent.

Simon Torry, chartered financial planner at SRC Wealth Management, agreed with Mr Yarrow that the current requirement for equity income funds does seem a little arbitrary.

“In my opinion, fund managers will come under increasing pressure to meet this target and could be tempted in to using higher risk equities.

“It is therefore extremely important that advisers do their research and understand the risk profile of funds within this sector before they make a recommendation.”

Mr Torry said a “simpler and more practical” solution would be for the IA to reduce the yield requirement to being in excess of the yield of FTSE All Share.

katherine.denham@ft.com