With the Bank of England base rate now 5 per cent and best-buy tables advertising instant access savings rates of 4.25 per cent – even higher if you are prepared to commit for longer – the appeal of income funds requires more examination than it did in the previous era of near-zero interest rates.
After all, the 12-month historic yield of the FTSE All-Share index is currently just 3.77 per cent – now comfortably below the risk-free rate offered by instant access bank accounts.
Investors looking for an attractive level of (growing) income alongside the opportunity for meaningful capital appreciation should not dismiss all income funds just yet.Against this backdrop, income-seeking investors need to be a little more selective with their income fund choices.
The FTSE 100 continues to dominate the UK dividend picture – generating consistently around 90 per cent of all UK dividend income.
This is skewed by 15 of the largest names, which delivered around 60 per cent of dividend income in 2022.
Given the current makeup of the FTSE 100, dividends tend to be derived from a small number of large sectors, including mining, banks and resources, which combined generated 39 per cent of dividend income in 2022.
This weighting worked relatively well for investors last year, with the FTSE 100 outperforming the more domestically focused FTSE 250 by a record amount.
Weaker sterling also provided a dividend and earnings tail wind for the significant proportion of dollar earners on the large-cap index.
This is in contrast to the strong level of long-term outperformance generated by the FTSE 250 over the long term, both capital and total return; since 1985 the FTSE 250 has beaten the FTSE 100 by 2.47 per cent and 1.86 per cent respectively on an annualised basis.
Despite a more challenging period for smaller quoted UK companies, the recent relative underperformance has created an interesting investment opportunity, particularly for income-seeking investors.
Outside the FTSE 100 there is an opportunity to identify high-quality small and medium-sized companies capable of delivering significant growth in profits and attractive levels of dividend income.
The markedly different sector weightings of the small and mid-cap indices also ensure significant sector diversification from popular large cap-focused income funds.
During the pandemic, companies of all sizes paused or cancelled dividends due the extreme uncertainty they were facing.
Dividends have subsequently resumed but generally remain well below pre-Covid-19 levels, as many companies that were overdistributing took the opportunity to rebase payments.
As a result of this slow dividend recovery the yield of the FTSE All-Share index remains relatively modest – at just 3.77 per cent.
The recent Link Dividend Monitor also predicted that headline payments are set to fall again in 2023 after recovering for the past two years since the pandemic.
The vast majority of funds within the IA UK Equity Income Sector are currently delivering a yield ahead of the FTSE All-Share, with more than a quarter of funds yielding in excess of the current base rate.
Within the group of higher-paying funds it is unsurprising to see those with a small and mid-cap bias feature prominently, given the current valuation opportunities within this area of the market.
Managing inflation
One of the biggest challenges for equity investors over the past 18 months has been managing the impact of rapidly rising inflation on portfolios.
With significant exposure to sectors that tend to perform well in this environment, large-caps have been a relatively good place to be.
However, with inflation now falling – albeit slower than we would like – the backdrop is turning more favourable for smaller companies, which tend to underperform when inflation is rising and outperform when inflation is falling.
We have seen significant yield opportunities emerge in the small and mid-cap space across a range of sectors, including unloved areas of the market like real estate investment trusts, industrials and financials.
With depressed valuations and relatively weak sterling, overseas buyers of high-quality UK assets remain very active as they try to take advantage of this "double discount" opportunity.
This has led to an increase in merger and acquisition activity in recent months. If UK markets are not willing to value companies correctly, there are clearly plenty of others that will.
This activity has provided some support for smaller quoted companies in recent months and looks like a trend that will continue.
Income-seeking investors should certainly consider the merits of investing further down the market-cap range in the current environment, where active managers are able to access attractive yields, provide sector diversification and exposure to an exciting selection of long-term growth opportunities.
While savings accounts now offer appealing levels of annual income, those investors looking for an attractive level of (growing) income alongside the opportunity for meaningful capital appreciation should not dismiss all income funds just yet.
In an environment where inflation and interest rates remain elevated, investments capable of providing a growing level of income, alongside capital growth, are a compelling proposition.
Fraser Mackersie and Simon Moon are co-managers of the Unicorn UK Income Fund
