It has been an eventful few years for UK equity income funds. After a period of sustained growth, a number of high-profile dividend cuts in 2015/16 flagged the risk of a tougher period approaching. At the same time, the Investment Association (IA) yield requirements led to an increasing number of funds being thrown out of the IA UK Equity Income sector for failing to meet these targets.
These two events were accompanied by the commodity price plunge of 2015, which raised the spectre of further dividend cuts. Miner BHP Billiton slashed its payout for the first time in 15 years in February 2016, while rival Rio Tinto made a series of reductions.
Crucially, though, Royal Dutch Shell and BP – two of the largest payers in the UK market – maintained their distributions. Other events have also played out in UK equity income investors’ favour.
Aided by special dividends from UK companies including InterContinental Hotels and GlaxoSmithKline, which made payouts of £1bn and £970m respectively to UK investors last year, dividend growth has continued to increase at a healthy rate despite some firms’ cuts.
The currency translation effect – when dividends increase as a result of exchange rates – has also given a helping hand to UK investors. The depreciation of sterling against the dollar means the payouts from numerous large UK companies that accrue their earnings in dollars look more attractive.
Meanwhile, the IA’s requirement for all UK Equity Income funds to yield 10 per cent more than the FTSE All-Share over a three-year rolling period has been lowered. As of 3 April, funds must merely match the index yield; the change raises the prospect of funds returning to the sector. Equity income funds run by the likes of Invesco Perpetual, Rathbones and Henderson Global Investors were previously ejected following their failure to meet what many fund managers suggested was an increasingly unrealistic standard.
In total, more than 20 funds were kicked out, and the likes of Neil Woodford’s portfolio were set to follow had the rules remained the same. Some of the funds removed from the sector have already confirmed their plans to return, including the Montanaro UK Income Fund, which was removed from the sector in 2016.
Top performers
Table 1 demonstrates the top 10 performing unit trust and investment trusts over five years, with cumulative performance based on an initial £1,000 investment over one, three, five and 10 years to 28 February 2017, as well as discrete annual performance over the past five years.
The data reveals that the average return for unit trusts over five years was £1,967.08, while the top investment trusts managed to secure a marginally higher £1,989.95 average.
Mostly owing to their access to revenue reserves (in which up to 15 per cent of income can be put aside for future use) and their ability to gear up in a bull market, investment trusts tend to see better performances over longer periods compared with unit trusts.
But the gap between open and closed-ended funds has narrowed. In Money Management’s last UK Equity Income Insight from 2014, for example, there was a £584 difference in favour of investment trusts compared with this year’s decidedly less impressive £22.80 figure.
Additionally, despite having a smaller number of 10-year-old funds, the top funds by this metric outperformed trusts by £106.10, with the average annual growth rate for unit trusts coming in 0.6 per cent higher than that seen for investment trusts.
The CF Miton UK Multi Cap Income fund, managed by Martin Turner and Gervais Williams, took the number one spot in the fund list with a return of £2,173.53 over five years.
Despite its comparatively weak performance during 2016/17 (a 7.7 per cent return over the past 12 months puts it in the bottom quartile of performers across the sector as a whole), the managers have secured higher and more consistent returns than the rest of the sector over five years.
This is owed in part to its focus on stocks from across the market cap spectrum. In the years prior to 2016, small caps were able to combine strong growth rates with healthy dividend payouts. Last year’s shift in market returns, which saw large caps start to outperform, may explain why the fund has struggled in relative terms since then.
The fund’s long-term record recently saw it overtake the Troy Trojan Income fund in the Sanlam Private Wealth Income Study ‘White List’, with the latter having previously held the top position. But the Troy fund, run by Francis Brooke, did top another recent equity income study produced by Hargreaves Lansdown. The platform found that the Troy fund was the best over the past decade for combining capital growth with income production.
It should be noted that some of the most well known UK equity income names – such as Mark Barnett and Mr Woodford – take a total return approach. Despite its name, UK equity income is not solely about payouts – an overriding focus on income risks sacrificing growth.
Top holdings
According to Sanlam’s White List, the Miton fund has another quality in its favour: a comparably low volatility. Launched in 2011, its top five holdings span a range of different companies: Burford Capital (2 per cent); Stobart Group Ltd (1.8 per cent); BHP Billiton plc (1.5 per cent); IG Design Group plc (1.5 per cent) and Park Group (1.4 per cent).
Despite not matching pace with peers over the past 12 months, its top holdings indicate the potential returns on offer from smaller companies. Legal finance firm Burford Capital’s share price has risen 255 per cent over the past year alone.
At the other end of the size spectrum, BHP Billiton has risen 75 per cent over the same period as a result of a turnaround in its fortunes. Crucially, both firms have also announced dividend increases over this period.
Smaller companies are also a focus of the top-performing investment trust over the past half-decade, the Chelverton Small Companies Dividend Trust. Managed by David Horner, managing director of Chelverton Asset Management, and David Taylor, who has 30 years’ worth of experience in fund management, the fund made a total return of £3,038 on £1,000 over five years, which is considerably higher than the £1,989.95 average across the top-10 funds in the sector.
The Chelverton’s fund’s 27 per cent growth over the past 12 months is better than some of its small cap peers, but lower than in previous years, for example in 2013/14 and 2012/13, when the fund made returns of 58.2 per cent and 35.2 per cent, respectively.
It has fully recovered from a 2014-15 performance lull, in which the fund shed 0.6 per cent due to expectations of an interest rate rise, falling commodity prices and geopolitical risks.
The fund’s top holding: Nottingham-based fantasy model company, Games Workshop Group, reported a considerable rise in sales and profits in the months between 28 November 2016 and 15 January 2017 – a trend the company says has continued. In the six months to 27 November 2016, the company also reported a 28 per cent increase in sales (£70.9m).
Success also followed for its second largest holding, Belvoir Lettings, over the past year. The property company, which is now the largest in the UK following the acquisition of lettings company Northwood, reported a £10m profit to the year to 31 December 2016.
Looking ahead
While a few of the elements that contributed to complicating growth within the UK equity market over the past few years have either subsided or changed, there remain risks on the horizon for dividend investors.
The US Federal Reserve’s quickening series of rate hikes, for example, may well see some of the top funds slip down a few places because of how so-called ‘bond proxy’ shares – stable, high-quality, income-paying companies such as consumer staples firms – are affected by higher rates of interest at home and abroad.
Similarly, the complex negotiations that are expected to follow once Article 50 is triggered may present some issues for UK equities, although triggering Article 50 itself is not forecast to have a significant impact on the sector.
Changes to the IA’s equity income sector yield requirement rules could level the playing field slightly, should more and more previously booted funds move back into the UK equity sector, but the new 100 per cent requirement has not met with universal acclaim. The Neptune Income Fund, for example, has said it remains committed to achieving a 110 per cent target yield for fear of deviating from its income focus.
Meanwhile, Mr Woodford has opted for his latest income fund to sit outside the sector. Nonetheless, it seems unlikely that advisers’ love affair with equity income will disappear any time soon.
