InvestmentsJan 29 2019

Top funds in the UK equity income space

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Top funds in the UK equity income space

Where does the nation stand on the UK’s post-Brexit prospects? With the scheduled departure date of March 29 drawing ever closer, the question is no less divisive than it was back in 2016. But the Brexit debate has proved less polarising when it comes to the behaviour of those investing in domestic equities.

Domestic shares have been heavily discounted amid Brexit-related uncertainty, with UK investors also fleeing funds operating in this market. The Investment Association’s UK All Companies sector has seen retail investors withdraw a net £3.9bn in the year to the end of November 2018 alone. While some may view UK equities as a steal, they look to be in the minority for now.

That said, one particular area where the appeal of holding UK stocks looks unequivocally more attractive is equity income.

Income funds focusing on the UK market have not escaped the adverse sentiment of recent times. Retail investors took out a net £1.2bn from the IA’s UK Equity Income sector in the 12 months to the end of November 2018, and every fund in the sector posted a negative return last year. But the UK market’s attraction for dividend investors – long one of its strengths – has been boosted further by the fact the FTSE All-Share index now yields even more than usual as a result of recent market volatility.

For those value-minded investors with money to deploy, there are now income bargains to be found: the FTSE 100, home to many of the big dividend payers, dropped by 7 per cent in 2018. These losses can be good news for a bargain hunter; share price falls mean dividend payouts have increased for those willing to buy in now.

As of the end of December, for example, the FTSE All-Share yielded 4.5 per cent, with the FTSE 100 yielding 4.7 per cent. The latter has a forecast yield of 4.9 per cent for this year, with the biggest single payer, Taylor Wimpey, targeting an eye-watering 13 per cent payout. 

No free lunch

Investors should be reminded of the risks before blindly ploughing in. In a time of market jitters, stocks could easily fall further, causing difficulty for clients relying on a portfolio for income. At the same time, the usual concerns remain around whether the high dividends seen in the UK market are sustainable. 

Russ Mould, investment director at AJ Bell, notes that dividend cover – the ratio of a company’s net profits to its payouts – came in at 1.21 times for the FTSE 100’s 10 highest yielders as of mid-December, a figure he described as “lower than ideal”. This suggests dividends face the risk of being slashed, or even cancelled altogether.

The challenges don’t end there. As discussed, a major unknown quantity also comes in the form of Brexit, which could dampen the prospects for UK-focused companies. 

Income investors arguably have some protection against these difficulties, given many of the bigger dividend payers are international companies with operations beyond the UK. But in the short term at least, these shares could be affected by developments in the Brexit process and their influence on the value of sterling.

With Prime Minister Theresa May’s withdrawal deal having been comprehensively voted down by parliament in January, the Brexit negotiation process is no closer to a resolution. The likelihood is that the answer – be it a no-deal Brexit, an extension to Article 50, or something else – will only emerge at the eleventh hour. 

Any rally in the currency is likely to cause some difficulty for the share prices of companies with overseas, dollar-denominated earnings. Equally, another tumble in the currency could provide a boost for many of these large-cap names.

All these unknowns mean that while yields look attractive, it’s useful to know which funds in this space have not just paid a good income but grown investors’ assets over time. 

Our analysis, the findings of which are outlined in Table 1, identifies the best performers over five years in the UK equity income space. 

The table includes names from both the IA and the Association of Investment Companies’ UK Equity Income sectors, and investment trusts have a strong showing among the top performers. Two of the top three names over five years have a closed-ended structure, with three other trusts also appearing in our 20-strong list.

Income vs growth

The analysis does exclude one group of UK equity income offerings: those open-ended products that still sit in the IA’s UK All Companies sector, having previously failed to meet the UK Equity Income sector’s old yield requirements. 

These requirements were eased in 2017 – members must now yield 100 per cent of the index yield over a rolling three-year period, down from the previous 110 per cent threshold – but some popular names remain in the UK All Companies group.

This means that Evenlode Income – which would sit in second place for its five-year returns, all things being equal, does not feature in the table. The Evenlode product’s 3.5 per cent yield at the end of December, well below that of the FTSE All-Share, does suggest this fund has sacrificed some potential income for greater capital growth. 

Intermediaries will be familiar with the table’s top performer over five years: the Finsbury Growth and Income Trust, run by manager Nick Train, has returned £1,613 from a £1,000 lump sum. The fund also comes out top over one, three and 10 years.

Mr Train runs a concentrated portfolio, with just 23 holdings at the end of November, and keeps turnover low. The product has nearly half of its exposure in consumer goods names, with large caps Diageo and Unilever each making up a position of at least 10 per cent. 

The vehicle also has more than a quarter of its assets in financials, with Hargreaves Lansdown and the London Stock Exchange among its 10 biggest holdings.

One issue with the trust is that, to a much greater extent than with Evenlode’s fund, it has made capital gains at the expense of income. At the end of December its net yield came in at just 2 per cent.

But there are plenty of alternatives when it comes to income: of the 18 funds in our table that disclose their yields, 17 offer at least 3.5 per cent. At the time of our analysis, Schroder Income, Chelverton UK Equity Income, and Majedie UK Income all paid in excess of 5 per cent. 

Notably, although both the Chelverton and Majedie offerings sustained heavy losses in 2018, the Schroder fund has managed to retain its healthy yield while simultaneously being one of the better performers over that period. 

Other approaches

The table’s second-best performer overall has similarly combined strong returns with a decent yield, this time over a five-year time horizon. Man GLG’s UK Income offering, run by Henry Dixon, has returned £1,457 over a five-year period and yields 4.5 per cent – though it did suffer in 2018.

The fund lists several high-profile dividend payers among its top 10 holdings, with 7 per cent in Royal Dutch Shell, 4.3 per cent in HSBC and 3.7 per cent in Rio Tinto. However, its market-cap leanings are more varied than this suggests. The fund does have more than half of its assets in large and mega caps, but Mr Dixon has also allocated 22 per cent to small caps, 8.4 per cent to mid caps, and 5.2 per cent to micro caps. 

This, and the fact that the fund’s 65 holdings mean it is much less concentrated than the top performer, suggests a more nuanced positioning when it comes to potential Brexit outcomes. The vehicle also had more than 7 per cent in cash at the end of November, which could drag on returns but does give it flexibility at times of volatility.

The third-ranked fund in the table, Troy Income and Growth Trust, again holds many of the big dividend names, but has diversified somewhat across sectors. Bar a 28 per cent allocation to consumer goods and 14 per cent in financials, the product tends not to invest more than 10 per cent in an individual sector.

These decisions being taken by UK income managers, particularly the high cash levels held by the Man GLG fund, point to the difficulties the sector could face as Brexit and other challenges draw closer. But as the shifting dividend yields of recent months have shown, such issues can also create opportunities for brave investors.