The popularity of UK equity income funds has soared as investors search for yield against a backdrop of rock-bottom interest rates.
UK Equity Income, with net retail sales of £6.3bn, was the best-selling sector in 2014, according to trade body the Investment Association. With volatility and uncertainty surrounding bond markets and savers getting pitiful returns from cash deposits, the sector is booming.
Typically, funds in this sector are known for their bias towards FTSE 100 firms offering stellar dividend payments, with many having 70 per cent or more holdings in this index. In recent years, five companies – Royal Dutch Shell, HSBC, Vodafone, BP and GlaxoSmithKline – have accounted for roughly 36 per cent of all UK dividends, with the 15 largest distributors in the FTSE 100 representing 57 per cent, says Jason Hollands, managing director at Tilney Bestinvest.
“This dividend concentration worries us, not least because some notable sectors within the FTSE 100 face serious headwinds. Such as oil and gas and mining companies, which are under pressure from weak commodity prices – and supermarkets, where margins are being squeezed by the competition from discounters, meaning a tough outlook for dividend growth,” he adds.
But the future for firms paying an income to bolster returns is more widespread, with plenty of British businesses offering payouts. Investors should diversify by pursuing a multi-cap strategy, suggests Patrick Connolly from Chase de Vere. “With more companies of different sizes and sectors recognising the importance of paying dividends, there is a far wider range of options for investors seeking mid- and small-cap holdings in their portfolio,” he says.
Darius McDermott, managing director of Chelsea Financial Services, favours multi-cap equity income over traditional UK funds at present. He says: “UK retail investors tend to have quite a lot of their portfolios in equity income funds, so a multi-cap fund gives some diversification of underlying companies.”
Funds Mr Connolly rates to sit alongside traditional equity income funds include Rathbone Income, Artemis Global Income and Standard Life Investments (SLI) Global Equity Income. Mr Hollands also highlights the Unicorn UK Income fund. “This has [the] greatest exposure to smaller companies,” he says.
Among the picks of Mr Hollands, Mr McDermott and Mr Connolly is the SLI Equity Income Unconstrained fund. This selects any UK stocks regardless of size or sector, but currently holds 44.1 per cent in the FTSE 250 and 17.7 per cent in smaller companies.
SLI manager Thomas Moore focuses on mid- and small-cap companies with very strong earnings, and healthy levels of dividend cover with greater exposure to the strengthening UK economy compared to their larger counterparts.
“The FTSE 100 is a source of concern with dividends cracking one by one amid deteriorating fundamentals,” he explains. “If you look at struggling sectors dominating the FTSE 100, such as oil and gas, they are paying dividends out of debt. Clearly there are question marks among the most widely held stocks on how they will sustain high dividends, with the same worries applying to pharmaceuticals such as Glaxo, and Glencore announcing a series of emergency measures and now not paying any dividend at all.”