A well-diversified fund is more important than ever

The announcement that after 25 years Neil Woodford will leave Invesco Perpetual to launch his own fund management house is news that has registered with investors far and wide.

Of course one consideration for advisers invested in the IP Income and High Income funds will be whether to stay with them and trust in the man who now runs the products, Mark Barnett, or follow Mr Woodford – the conventional wisdom and educated guessing pointing to the likelihood he will run a similar mandate when he joins his new employer Oakley Capital.

But there is much more that advisers need to consider about the UK equity income space – especially considering its continued popularity. The sector had the best net retail sales in April and September last year.

Many managers are focused on companies with larger capitalisations so liquidity is unlikely to be an issue for them. But size can create a style bias and with an increasing number of funds above £2bn, this is a growing concern.

Shifting larger amounts of stock when you want to sell a company obviously takes longer than liquidating a smaller amount.

There is also the historic issue of concentration. Many of the funds in the IMA UK Equity Income sector focus on the same stocks for their income, meaning if something happens to one of the companies, most of the sector constituents feel the pain.

The most notable example is BP and the Macondo oil disaster. Large numbers of UK equity income funds held the oil major and were hit by the disaster, particularly Tineke Frikkee’s Newton Higher Income fund.

It was the largest holding at May 31 2010 – the month after the accident – and in 2011 the fund slashed its yield target.

But new issues are arising in the sector.

Nicholas Wilcox, a member of the UK and European equities team at JPMorgan Asset Management, says the group has carried out research on the sector to uncover recent trends over a 12-month period.

“At least nine of the 24 funds have a significant bias towards small cap, at least 10 have in excess of 10 per cent of their assets invested outside of the UK.

“Also at least 15 funds have 60 or fewer holdings, and hence take relatively high levels of stock specific risk,” he reveals.

Mr Wilcox says for these reasons a “simple comparison of returns” is “not necessarily the best way of comparing funds” and recommends a risk-adjusted return metric.

Elsewhere, Rathbone Unit Trust Management’s multi-asset team says that the ‘traditional sectors’ which are the hunting ground for income managers are “expensive” and that areas such as healthcare have experienced a “tremendous run”.

Because of this, the team feels there is more potential for income funds to take more risk, particularly as they look to more cyclical areas.

But advisers must also be aware of funds that don’t hit their yield target. IMA data shows five funds were removed from the sector last year for not exceeding – on a three-year rolling period – 110 per cent of the yield of the market.

One of these – Henderson UK Equity Income – moved to the IMA UK All Companies sector in September and in November became the UK Equity Income & Growth fund, removing the requirement to provide income in excess of the yield of the FTSE All-Share index.

There remains a large amount of talent in the UK Equity Income space and asset flows could be choppy in coming months.

Advisers must make sure the fund they pick is well diversified and takes the commensurate amount of risk for the returns it gives.

Bradley Gerrard is news editor at Investment Adviser