UK investors, in particular, have continually placed great stock in income, whether through dividends, coupons or interest.
Somewhat unsurprisingly in the current low interest-rate environment, the popularity of the UK Equity Income sector is at an all-time high. In April 2014, it was the most popular IMA sector among retail investors, with a record £500m being invested, as investors scrambled to use their Isa allowances before the end of the tax year.
Certainly the cult status achieved by fund manager Neil Woodford during his 25 years at Invesco Perpetual, where he ran the Invesco Perpetual Income Fund so successfully, has heightened interest in the sector. Mr Woodford’s high-profile performance has undoubtedly added to the popularity of income funds, and the move to set up his own boutique has now put even more focus on the sector, as investors eagerly follow the developments.
Perhaps it is fair to say that the traditional UK investor is fairly risk averse and places a great deal of emphasis on security. Investors appreciate that prices can be volatile, but through receiving regular and better-than-average income, they feel more relaxed about the risk inherent in their investments.
However, the yield requirement of the UK Equity Income sector is not onerous. Constituents of the IMA UK Equity Income sector are “funds that invest at least 80 per cent in UK equities and which intend to achieve a historic yield on the distributable income in excess of 110 per cent of the FTSE All-Share yield at the fund’s year end”.
If one considers the current FTSE All-Share dividend yield of 3.32 per cent at May 31 2014, this means that income funds need only deliver a yield of 3.52 per cent or higher.
Certainly compared to the prevailing low deposit rates available, income funds are a good choice to consider. However, one must think about the individual investor – are they looking for income or total return?
Investors must look at the actual or target yield of a fund. It is also important to discover if there is dividend progression within the fund or if dividend requirements have not been met in the past, and to understand the reasons behind this. For income investors, there may be other vehicles that can provide a higher income.
Part of the allure of income funds may also be their focus on value stocks, which is a good thing for long-term investors, as these funds look to outperform the broader index. As with any fund, though, it is important to understand its mandate, read the factsheet and be clear on the approach and structure of the fund.
A variety of different strategies are employed. Some income funds use a Barbell approach, which includes a mix of high dividend stocks and growth stocks, while others include pure value stocks. Some use convertible shares to boost their income with coupon payments, while still leaving exposure to capital growth.
Over the past few years, there has been a new development as these funds look to further boost income. This is the use of maximiser funds, which use derivatives written on the underlying holdings. For example, a fund may write call options on its holdings. It receives the premiums, and while the stock falls or remains below the strike price, there will be no effect apart from the additional income received by the fund.
If a stock reaches and exceeds its strike price, it will be sold at the strike price to the holder of the call option. Derivatives need to be carefully managed, but they do add value to the fund in return for giving up potential return above a specified level.
Clearly this strategy could detract from the fund’s potential value in a market that’s rising strongly, but it does introduce a level of stability, as the income from derivatives can offset any portfolio losses.
Investors should ensure that they investigate whether maximiser funds are being used in their holdings and if the fund manager is applying a limit on their use within the fund.
It seems that the popularity of UK equity income funds shows little sign of subsiding. However, many investors forget that the sector is not actually that large. In a universe of close to 3,300 unique funds, the UK equity income sector only contains 93.
Nicola Robinson is corporate manager at Parmenion
UK DIVIDEND-PAYING STOCKS
TOP FIVE
The UK equity market is extremely concentrated in terms of dividend payers. Here are the top-five UK dividend paying stocks in Q1 2014, according to the Capita UK Dividend Monitor.
Vodafone Group
Vodafone was the top dividend payer in the UK in Q1 2014 with its special dividend of £14.3bn net, accounting for approximately half of the quarterly total of £30.7bn. It is one of the world’s largest telecommunications companies with more than 411 million customers across roughly 30 countries. The announcement in September of the sale of its US group, including its 45 per cent stake in Verizon Wireless, for $130bn (£77.6bn) has helped drive the recent strong dividend performance.
Royal Dutch Shell
Royal Dutch Shell is a global group of energy and petrochemical companies. It operates in more than 70 countries, with roughly 92,000 employees. The company’s policy is to grow the US dollar dividend in line with “our view of the underlying earnings and cashflow of Shell”.
AstraZeneca
The British pharmaceutical business that recently rebuffed takeover attempts by US competitor Pfizer is a pure-play biopharmaceutical company with a primary focus on three areas of healthcare: Cardiovascular and Metabolic disease; Oncology; and Respiratory, Inflammation and Autoimmunity (RIA). It works in more than 100 countries and employs approximately 51,500 people worldwide. In 2012 it recorded total sales of $25.7bn.
BP
Another oil major, BP temporarily fell from grace in the eyes of income investors when it suspended its dividend payments following the Deepwater Horizon oil disaster in the Gulf of Mexico for the first three quarters of 2010. It has since made a return to the top-five dividend payers, with a quarterly dividend per share of 5p or more since Q4 2011.
GlaxoSmithKline
This global healthcare company researches and develops products in three primary areas of Pharmaceuticals, Vaccines and Consumer Healthcare. It has operations in more than 150 countries. In 2013 it recorded group turnover of £26.5bn, with 39 per cent coming from outside the US and Europe.
