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Advocate: Is it time to exit UK income funds?

Advocate: Is it time to exit UK income funds?

This month's question: Should advisers move away from UK equity income funds?

No 

Ben Conway, senior fund manager, Hawksmoor

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No – with caveats. The idea that the recent travails of several large income-generating UK stocks should undermine the case for equity income investing in this country is absurd. It is true that a significant percentage of the income generated by the UK stockmarket has been undermined by struggles in the pharmaceutical and tobacco sectors. But this is not the same as saying an investor cannot still derive a healthy income from good quality UK shares.

The answer lies in the type of fund that investors use to access this income. Too often, the focus is on large funds that focus only on large-cap stocks. The fact is there are a huge number of stocks in the UK, outside of the large and mid-cap indices, that generate good growing yields. There are some really talented managers running smaller funds that can give you exposure to these stocks.

People often argue that going down the market-cap spectrum brings extra risks. Smaller stocks, it is argued, are less liquid and can be more volatile as a result. For us, risk has never been about historic volatility. It is about the permanent loss of capital. Currently, the valuation discrepancy between larger and smaller stocks is very wide – wider than at most times in history. 

While you might argue that smaller stocks should be cheaper to compensate you for the extra liquidity risk, their current relative undervaluation offers a sufficiently large margin of safety. Beyond large caps, the prospects for deriving income from UK equities remains healthy. 

Yes

James Calder, research director, City Asset Management

The answer to the question is not binary, but at this point in the economic cycle City Asset Management is firmly underweight the UK equity income space. This has been a gradual move over the past 18 months. I have become increasingly concerned with valuations; the ‘bond proxy’ theory has been around for some time, but still has merit. 

Dividends are highly concentrated across a small number of stocks, within some very specific sectors. Concerns over the outlook here leads me to believe that cuts are on the horizon. 

Nevertheless, some clients are highly reliant on income-producing assets for their retirement. Therefore, some exposure is required. 

City Asset Management’s approach is to source income from as many areas as possible. However, quantitative easing has meant traditional assets, such as bonds, do not have an attractive risk-return profile. Alternatives, such as infrastructure, have stepped up to the plate to some extent, but have pricing issues. 

Where I do find value within UK equity income space is via investment trusts. These tend to be managed on a traditional and, dare I say it, conservative basis. Some can use their balance sheets to their advantage. Rules allow for a revenue reserve to be built up, allowing trust boards to support the dividend in weaker years by paying out from the reserve.