Not all equity income funds are created equal

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 240% 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 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.

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?

Selecting stocks purely on yield has its dangers. Firstly, rising markets may result in a reducing universe of stocks meeting the yield target. Over the last year, for example, the number of stocks around the world yielding 4%+ has fallen to around 400 from over 600 due to rising markets. This situation could cause a dilemma for a high yield manager – do they adjust their yield requirement downwards or do they just accept that they have a smaller pool of stocks from which to select? Another issue is that a high yield can also be a sign of stress when a fall in a company’s share price is artificially inflating the estimated yield. Indeed, research has shown that the higher a stock’s estimated yield is, the more likely the actual yield is to disappoint.

2. Barbell managers

At the opposite end of the scale are those equity income managers who buy a high percentage of capital growth stocks which offer very little in terms of yield, and then look to boost the fund’s income by holding some bonds or very high yielding stocks. This is known as a ‘barbell’ strategy. An advantage of this approach is that it gives the manager a much wider universe of stocks to choose from. However, this method can increase the fund’s volatility given that the underlying holdings tend to be predominantly growth stocks. The income profile can be more volatile too and so it may well be an inappropriate strategy for an investor who needs to be reasonably sure of the yield they will be receiving.

It is perhaps no surprise that this style generally proved to be successful last year, given that the market had a very good year with cyclical stocks out-performing defensives and small/mid cap stocks doing well. Selecting this approach could make sense for an investor with a medium-term view where the outlook for the market is bullish. However, we believe it is less likely to prevail over the long term. This means that an investor will need to monitor the barbell fund closely and potentially make a change if market conditions turn against the style.

3. Bottom-up managers

The third way is the one I adhere to in my funds. The strategy largely involves selecting solid stocks based on an assessment of the company’s earnings and its dividend payout. Rather than investing solely on the basis of a stock’s yield, my approach places great importance on dividend sustainability. Investments are made with a view to capital preservation based on a detailed consideration of valuation, stock and industry fundamentals which informs my view of the downside and upside potential of any portfolio candidate. I also look for stocks with the potential for dividend growth which helps with my aim of increasing the dividends from my funds at least in line with inflation each and every year.

The principle of income safety is central to my process on the Fidelity MoneyBuilder Dividend and Fidelity Enhanced Income Funds. I look to define ‘safety’ by answering three core questions when analysing a stock:

1. How sustainable are company returns through the economic cycle? I want to see strong and robust cash flow with low correlation to the economy – and a strong balance sheet.

2. Is the dividend covered by cash flow?

I have explicit dividend forecasts for my fund holdings and I look at whether the company has enough cash to cover current and future dividends.

3. What is the expected compounded return over the long term?

I analyse the company’s internal rate of return in the context of the company’s current valuation to understand the potential opportunity which may exist.

For me it is critical to understand how robust the company is: its profit record, financial strength, competitive position, and profit and dividend forecasts. I will sell out of a position in the event that a dividend looks unsustainable or is at risk of being cut.

In my view, equity income funds should only invest in stocks that deliver safe and growing dividends. I believe income sustainability is particularly relevant in the current environment, where the economic backdrop is resulting in some companies looking to cut or cancel their dividends. Funds investing in dependable dividend stocks are typically less volatile than the wider market and low volatility is a characteristic of my funds. Of course, by taking a more risk-averse approach we do have to accept that this style will not necessarily result in sector-leading performance in bullish markets. However, the approach may be the most suitable for investors seeking stability and dependable income payments.

Buyer beware

Knowing what type of fund you are investing in is, of course, vital. A sizeable market correction could be a big shock for an investor who believes their equity income fund is more cautious than it actually is. Perhaps a good example of how people can be caught out is to look back at recent history. Advisers will recall how some seemingly safe corporate bond funds acted more like equity funds than fixed income investments during the initial phases of the market crisis of 2007/08. We are not suggesting a similar scenario will occur within the Equity Income sector. However, you only need to look at the volatility numbers to see that some investors could be in for a surprise.

Our study of the largest peak to trough falls of UK equity income funds shows that many are, in fact, far from defensive holdings. Since 2009, some experienced a drawdown of over 15% compared to just 6-7% for less volatile funds.

The higher-risk nature of some UK equity income funds is further illustrated by the three year risk/return chart which shows that many portfolios remain more volatile than the FTSE All Share index.

Of course, there is nothing wrong with an equity income fund taking a higher-beta approach as long as investors are comfortable with the fund’s risk/return profile. Higher-risk equity income funds should be expected to out-perform the sector in a rising market but they should also be expected to under-perform in a falling market. However, for more conservative, risk-averse investors, it may be more appropriate to stick to less volatile options, avoiding funds which are arguably more like the equity growth funds found in the IMA All Companies sector.

Michael Clark is Portfolio Manager at Fidelity