Distribution funds: income vs growth

This article is part of
Distribution funds - October 2013

Distribution funds have traditionally fallen into the ‘steady’ part of an investor’s portfolio.

They deliver an income, alongside (hopefully) steady capital returns, from a well-considered blend of equity, bond and other asset classes. They are as far a cry from a turbo-charged growth fund as it is possible to imagine. Or are they?

The credit crisis changed the investment landscape and distribution funds may also be an option for the ‘growth’ part of an investor’s portfolio for a number of reasons. Firstly, since the credit crisis investors have become increasingly sceptical about traditional growth funds.

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The ‘jam tomorrow’ promised by a fund specialising in companies likely to be the big winners of tomorrow started to look like an increasingly unattractive strategy in an economic environment where ‘tomorrow’ was unpredictable. Therefore investors have looked for the growth in their investments to be delivered as income.

Rob Burdett, joint head of multi-manager at F&C Investments, says: “In the post credit crunch era, advisers increasingly prefer the ‘little and often’ return they get from an income-focused fund.”

Alan Burrows, manager of the CF Miton Distribution fund, agrees: “Income is more useful in providing a consistent return. It also enables an investment to keep in line with inflation.”

Companies themselves have sought to pay returns in the form of income rather than capital. Gone are the days when large-scale merger and acquisition activity is rewarded by the market, which is now more likely to prefer a reliable dividend. Mr Burrows says: “There is increasing demand from investors for income. This has particularly been seen in the US, where at one stage paying a dividend was seen as an admission of failure, but companies are now changing that view.”

Income has long been a vital component of capital returns. There are many statistics on the power of compounding dividends and the impact it has on overall portfolio returns in the long-term. For example, recent research from JP Morgan Asset Management showed the returns from three different stock market indices: One tracked European share prices, the second tracked the same shares, but assumed all dividends had been reinvested. The third tracked the returns from the highest-yielding shares, again with dividends reinvested.

The contrast was stark: The first index lost 21 per cent from the peak of the market in December 1999. The second index, showed that simply reinvesting the dividends turned this loss into a 27 per cent gain. Focusing on the highest yielding shares, however, produced a gain of 80 per cent.

While the time period may favour income stocks because it incorporates the severe fall in some growth stocks in late 1999/early 2000, it still shows why an income strategy - such as that employed by distribution funds - might be considered better for long-term growth.

But income is even more vital in a climate of low interest rates. Mr Burdett says that there are technical factors at play as from 1958 to 2007 there was a ‘reverse yield gap’, where for that period gilts yielded more than equities. In many cases cash yielded more than equities as well.