However, years of stodgy performance from many funds in the IA Equity Income sector, and more recently the plethora of dividend cuts that have been announced by some of the biggest companies on the UK market, means investors are starting to question the role of such funds.
The problems for the sector go back many years, and initially centred on the requirement that funds in the Investment Association UK equity income sector must achieve a yield of at least 10 per cent more than the market as a whole.
This led to a situation where mandates that were among the sector’s best performers in total return terms, such as Evenlode Income, were removed from the sector as they did not achieve a high enough income.
That fund was removed in 2016. Funds run by Neil Woodford and his successor at Invesco were removed from the sector in 2014.
Mr Woodford said at the time he believed his investors would much prefer him to achieve a higher total return and a lower income, than the reverse of that.
The IA subsequently reduced the yield target for funds in its equity income sector in 2017, stating that funds could remain in the sector as long as they at least matched the yield of the wider market.
Party of three
UK equity income funds are overly reliant on just three stocks to pay the bulk of the income they generate.
Among those stocks is Royal Dutch Shell, which this year cut its dividend for the first time since the second world war. UK banks have also been forbidden by their regulator from paying dividends this year.
The UK is full of a lot of mature companies in mature sectors, and those tend to be the businesses that pay dividends Tom Elliott, Mattioli Woods
Mark Preskett, portfolio manager at Morningstar, says he has “generally been moving away from UK equities, due to the narrow range of companies that pay dividends, and the sectors of the economy in which they operate”.
He notes that, unlike in the US, the largest companies in the UK market are not fast-growing technology businesses, but rather more traditional companies in sectors such as oil and banking, which risk being disrupted by technological change, rather than benefiting from it.
He says while the dividend outlook for those sectors will improve, he thinks it unlikely they will ever pay dividends at the levels they did prior to the crisis.
Mr Preskett prefers to invest in Japanese and US companies right now. He says the dividend yields are currently lower in those markets, but the income being generated is growing and the companies paying the dividends are in sectors benefiting from societal change.
Tom Elliott, market strategist at wealth management business Mattioli Woods, says the nature of the UK market is the reason dividend payments have been so high. He says: “The UK is full of a lot of mature companies in mature sectors, and those tend to be the businesses that pay dividends.”
He says a number of UK companies that have announced dividend cuts “actually have the cash to pay”.
“The pandemic has provided a sort of cover for them to cut the dividend and reinvest the cash in the business, which itself will help the companies pay higher dividends in future.”
He adds that some companies in the UK, such as consumer staples businesses Unilever and Diageo, have continued to pay dividends, and he expects this will continue as those companies sell products for which there is constant demand.
But he adds it is wise to have more capital invested overseas.
Wayne Berry, investment manager at Brewin Dolphin, says the focus on achieving a specific yield means too many funds have invested in the same small number of stocks, with the result that they are significantly invested in the companies at risk of cutting dividends.
He says: “Advisers have asked our thoughts on the equity income sector a lot, especially with the headlines surrounding some star fund managers performing poorly in the past few years.
“While income does have its place in any portfolio, it should not be the sole focus. Managing clients’ expectations of dividends is key to ensuring they know the risks they are taking.
“An abnormally high dividend should be a warning sign. More advisers are keen to see a balanced return from both income and capital rather than favour one over the other — and their clients agree.
“An income yield of 3 per cent which has potential to grow significantly is much more attractive than a yield of 6 per cent, which is at risk.”
Time to diversify
Investors looking to diversify the income streams in their portfolios have the option to buy more overseas, choose alternative equity assets or investment trusts, or buy smaller company funds that pay an income.
Equity income investment trusts can pay dividends from reserves. The City of London Investment Trust announced at the height of the pandemic that it will increase the dividend it pays by using accumulated reserves from previous years.
Open-ended funds cannot do this as they are required to pay out all of the income they earn in a year.
Luke Hyde-Smith, head of fund selection at Waverton, says investment trusts have “proved their worth” during the pandemic and are “part of the answer” for income investors.
Mr Preskett says investment trusts paying a dividend from reserves is a “short-term answer” only, as eventually the reserves run out.
Kamal Warrich, investment analyst at Canaccord Genuity, says investors may need to revise downwards their expectations for the income they can get from a portfolio to about 3 per cent to 3.5 per cent, instead of the previous 4 per cent to 5 per cent.
He says when choosing an equity income fund, one of the first things he looks at is the size of the fund, and to what extent the 10 largest investments are responsible for most of the income payments.
He says that if a fund gets too large it is unable to invest much into small and mid-cap companies, and so cannot be properly diversified.
Gervais Williams, who runs the Multi-Cap income fund at Premier Miton Investors, says the changing nature of the global economy is likely to mean smaller companies outperform larger ones in the years to come.
He says: “In general, most people think of larger quoted businesses as mature, with surplus cash flow paid out in dividends — small caps are supposed to be immature and investing for the future.
“At a time of recession, often it’s generalists that find it hardest to dodge the bullets. Meanwhile, some specialist markets continue to expand. So it’s possible to pick out a range of small-cap income stocks that are continuing to pay good and growing dividends — even through a recession.”
David Thorpe is special projects editor of Financial Adviser and FTAdviser