What is the future for income funds?

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.