Not all equity income funds are created equal

This article is part of
UK Equity Income - October 2013

A notable trend in the past couple of years has been the popularity of UK and global equity income, as investors turn to the strategy of reinvesting dividend income to help deliver portfolio growth. So far this year, the IMA UK and Global Equity Income sectors have seen combined gross sales of £8.4 billion - 50% higher than in 2012.

The popularity of the asset class has been on the up for quite some time with the UK Equity Income sector growing significantly over the last 10 years. Assets have increased by more than 200% over the period. Growth is being seen in the sales of global dividend funds as well, with assets in the IMA Global Equity Income sector more than doubling since the sector launched in January 2012. At Fidelity, we believe equity income funds should be core holdings. It is therefore encouraging to see such support for these two sectors.

UK firms paid out a record of £25.3 billion gross dividends in Q2 and UK equities currently yield 3.4%, significantly more than cash and gilts. Shares are the only major asset class paying higher yields today than they were immediately before the financial crisis began in mid-2007. As well as the potential for a regular income, dividend stocks also provide a lower-risk way of accessing the equity market. They are traditionally less volatile than the wider market and provide more downside protection in uncertain times. History also shows that higher-yielding stocks outperform lower-yielding stocks over the long term. Perhaps the strongest argument for equity income investing is the compounding effect of dividends. In fact, in real terms, dividends have accounted for 2/3rds of long-term total returns.

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So, the case for equity income investing is a compelling one. However, investors do need to be vigilant when selecting an investment – funds within the UK Equity Income sector can behave very differently. Some, for instance, very much resemble higher-risk growth funds in terms of investment style and volatility. Indeed, of the top ten performing equity income funds of last year, four had a small cap focus while another two had a mid cap bias. Some also fail to meet the yield requirement for the sector, which is 110% of the FTSE All Share yield. This issue can cause funds to be expelled from the sector and there have been high-profile examples of this in 2013 with other funds on the cusp of suffering the same fate. So it’s clear that not all funds in the equity income sector may be what they claim to be. Investors do need to have a clear idea of what they are buying and so understanding how a fund is being managed is crucial.

Three distinct approaches

Our analysis shows there are broadly three ways that funds within the UK Equity Income sector are managed:

1. High yield managers

Firstly, there are those managers who filter on yield.

To adhere to the sector’s yield requirement, managers may choose to only consider stocks that provide an income above – and sometimes significantly above – the 110% level. When a stock’s yield falls below this mark, this could be the trigger for the manager to sell the stock. This process is uncomplicated and easy to comprehend and it can also comfortably deliver the yield requirement. This approach does prompt some questions though. For example, at what level is the yield target set at and what is the process for arriving at this figure? In addition, does selecting a stock on yield alone mean that other factors are overlooked?