Distribution funds: income vs growth

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.

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.

“Now once again, there is a gap. Investors get more from the dividend yield on the [FTSE] All-Share than they do from a gilt, or from the banks. If an investor leaves a bank, they instantly get a better income. The yield on cash is significantly below inflation and just below inflation for gilts. Equity yields are above inflation, and growing,” he says.

David Hambidge, head of multi-asset investment at Premier, says that yield has also proved a more consistent source of return over time: “Looking at the UK stockmarket, dividends are much less volatile than earnings and the movement of the underlying share price. This helps the smoothing effect for investors, but most of the time investors are also getting a higher distribution. Even if an investor has a losing year, they still have something to show for it.”

He points out that even during the worst year for equity markets, the group’s distribution fund saw a 10-15 per cent drop in the level of income. This was far lower than seen in the UK equity market for the same period.

This consistency means that an income-focused investment is more likely to be able to harness the effects of compounding. It is a well-used statistic, but if an investment of £1,000 loses 10 per cent one year, it falls to £900. It then has to make more than 11 per cent to get back to the same level. Even if it makes 20 per cent the next year, it only rises to £1,080.

The investment that manages to avoid those falls benefits, rising, for example 5 per cent in year one, to £1,050, can then benefit from compounding in year two. If it rises another 5 per cent, it is worth £1,102.

The market environment has changed since the credit crisis and this is forcing investors to reframe how they view ‘value’ and ‘growth’ in their portfolio. The low interest rate environment and other technical factors support the use of income-generative assets for long term growth in a portfolio. In this context, distribution funds look to be as much a source of growth as a source of income in an investor’s portfolio.

Cherry Reynard is a freelance journalist.

REINVESTED INCOME

DOES IS MAKE A DIFFERENCE?

Ewen Cameron Watt, chief investment strategist at BlackRock’s Investment Institute, explains:

“Reinvested dividends make all the difference in equity returns over the (very) long run, many studies show.

“Returns on equities can be split into three components: dividend yield, divided growth (after inflation) and multiple expansion (the increase in the price investors are willing to pay for earnings or dividends).

“Dividends usually increase over time, in line with corporate earnings and cash flows. Outcomes across countries vary significantly, but overall dividends have accounted for four-fifths of equity returns since 1900.

“Yet there is a rub: Equities are volatile. Market swings can swamp the impact of dividends in any single year – many times over. Many investors don’t have the luxury or patience to wait decades for their dividends to compound.

“In addition, companies reinvest their capital to boost growth (some more successfully than others). Google, for example, has increased its share price around tenfold since it went public in 2004 – without paying a cent in dividends.

GOING FOR GROWTH

ARE DISTRIBUTION FUNDS VIABLE?

“Getting some return regularly and in real terms, even if an investor is not spending it, is attractive. Capital growth is up and down and depends when you sell. Income, on the other hand, is additive.

Rob Burdett, joint head of multi-manager, F&C Investments

“Looking at the UK stockmarket, dividends are much less volatile than earnings and the movement of the underlying share price.”

David Hambidge, head of multi-asset investment, Premier

“The majority of distribution fund performance appears to have come from the style as opposed to stock selection, with some exceptions.”

Adrian Lowcock, senior investment manager, Hargreaves Lansdown