Company dividends have come under a lot of scrutiny this year as the economic shutdown caused by the coronavirus has seen many companies cancel dividends to preserve cash as their income dries up.
But it is not just the short-term outlook for dividends that has been questioned.
Recently, Fundsmith chief executive Terry Smith repeated his criticism of investing solely for dividend income.
Mr Smith was not talking about being overly reliant on dividends in the short term. Instead, his complaint is that investing in companies due to their high dividends is a misplaced strategy for the long term.
He argues that investors are usually worse off investing for dividends and leaving the capital undisturbed than they would be investing for total returns and regularly taking profits instead of income.
He also takes issue with the idea of investing in dividend-yielding companies to reinvest the income to compound growth and instead argues that companies should use profits to maximise their growth.
This goes against the grain for a lot of retail investors who want to take the natural income from their investments to preserve their capital.
Conventional wisdom also suggests that companies with high and stable dividends tend to be well-run, established and consistent businesses and by extension these companies should do well in the long run.
A quick look at the data suggests Mr Smith is right about the drag on performance.
Income portfolios have consistently underperformed the wider market, while some portfolios that use strategies to boost their income do so at the expense of investment growth.
Comparing the average performance of the Investment Association UK Equity Income sector with the UK All Companies sector shows a very similar performance when markets fall.
Over the five years to end of March 2020, the maximum drawdown and downside capture ratio are very similar for both sectors. However, the UK All Companies sector has consistently outperformed in terms of alpha generation.
The comparison between the Global and Global Equity Income sectors shows a similar pattern.
The sectors display very similar reactions to falling markets, but the underperformance of the Equity Income sectors during rising markets is even more noticeable. In short, investors are sharing the downside performance while giving up a portion of investment upside.
Comparison of sector performance in falling and rising markets
| Max drawdown | Downside capture ratio | Beta | Alpha annualised | Jensen’s Alpha annualised |
IA UK All Companies | - 33.63 | 94.42 | 0.87 | -0.39 | -0.84 |
IA UK Equity Income | - 33.97 | 93.70 | 0.84 | -1.42 | -1.95 |
IA Global | - 21.61 | 90.70 | 0.80 | 0.06 | - 0.61 |
IA Global Equity Income | - 22.41 | 88.68 | 0.76 | - 1.60 | -2.40 |
Source: FE Analytics. 31/03/2015 to 31/03/2020
This divergence is even more pronounced when it comes to enhanced income strategies, for example using covered call options, to target a higher yield for a portfolio.
Using the same time period, of the 11 enhanced income funds available to retail investors only two – Fidelity Global Enhanced Income and Santander Enhanced Income – have managed to outperform their sector average or benchmark.
Of the enhanced funds with a five-year track record, only two – Fidelity Global Enhanced Income and Schroder Asian Income Maximiser – have generated a positive price return overthis period.
Enhanced funds have produced higher levels of income when compared with un-enhanced sister funds. This can range from a few basis points to five percentage points or more, but their total returns show the same pattern as income funds in general.
Enhanced income funds do provide some protection in falling markets.
They have performed better than their sectors and benchmarks, and very slightly better than their un-enhanced sister funds when markets are down. However, they significantly underperform during market rallies.
Over the past five years, enhanced income strategies have an average downside capture of 89.5 per cent compared to their sector benchmarks. In comparison, the average upside capture is 54.8 per cent.
I have not touched on the issue of yield and whether investors would be better investing for income or investing for growth and then selling a portion of their investments to generate cash.
But when it comes to investment performance, income funds offer a little in the way of downside protection, but give up a lot of upside when markets are rising.
Therefore, I remain a strong advocate for a total return approach to portfolio management, rather than income target.
Charles Younes is research manager at FE Investments
