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Spotlight on 3 Funds Seeking Income in UK Equities

The UK Equity Income fund sector remains highly competitive but investors must be aware of the different styles and strategies adopted within the available offerings

Simon Molica 8 November, 2012 | 12:46AM

The search for income from equities remains a key focus for investors, which is of little surprise given the extent to which the zero interest rate environment is forcing investors to walk the gangplank of risk in search of return and attractive yields. 

Growth of the UK Equity Income Seekers
A raft of new equity income fund launches reflects this thirst for income. These new funds invest in regions beyond the historically-strong traditional dividend markets, such as that of the UK. This thirst is further manifested by the Investment Management Association (IMA) specifically launching a Global Equity Income category earlier this year.  However, the UK continues to dominate the income landscape, due in part to its heritage. The IMA UK Equity Income sector accounts for 8.5% of the total assets under management within the IMA sectors, while global equity income accounts for less than 1%. 

Further signs of the IMA UK Equity Income sector’s continued evolution are present in the increasing number of funds now investing further down the market cap scale, reaching into small-caps and even AIM-listed stocks. We broadly think of equity income funds as falling into one of three categories: those that specifically target a high income; those that are equally-focused on the need to pay an above-average income and to grow the fund’s income over time; and those that adopt a total return approach. However, all funds are required to produce an income which generates 110% of the FTSE All Share index yield in order to be included within the IMA’s UK Equity Income sector. 

Risk vs. Return
Interestingly, in the last 11 years, UK Equity Income has been one of the few equity areas in which the average fund has consistently been able to add value over the FTSE All Share index, and not only by outperforming in periods of market weakness. Indeed, since 2001 the average UK Equity Income fund has outperformed the FTSE All Share index in seven of the 11 years, compared to the average UK All Companies fund, which has only outperformed the index in four of those years. 

That said, investors would be well advised to remember the relative risks that typically feature within income-oriented equities in the UK. The highest yielding stocks are typically defensive in nature and among those with the largest market capitalisation. Consequently, they have tended to lag the market during risk-on rallies that typically favour names lower down the market-cap scale and that have more cyclicality. There are also large parts of the market that don’t pay dividends and income-oriented funds are unlikely to build large exposures to these areas. As such, income funds tend to be overweight in the healthcare, telecommunication, tobacco and utility sectors while underweight in the mining sector and domestic UK banking stocks. This can result in many funds running with high relative risk positions.  

Handful of Funds Attract Investor Money
The UK Equity Income sector currently comprises around 100 funds with assets under management of around £57.8 billion at the end of August 2012. This 100-strong group is still dominated by a small number of funds, however, with the top ten funds comprising almost 70% of the sector’s AUM. Indeed, Neil Woodford’s Invesco Perpetual Income and Invesco Perpetual High Income funds account for 38% of the sector’s AUM. Both funds are rated Gold by Morningstar OBSR analysts.

Highlighted Funds
The Newton Higher Income fund is a proposition that we would highlight as seeking to deliver one of the highest incomes within the sector. The fund has been managed since April 2004 by Tineke Frikkee, who invests in high yielding equities with strong cash flow and dividend growth. The manager will invest only in companies yielding at least 115% of the FTSE All Share index yield at purchase and any position within the fund that yields below that of the index will automatically be sold. This ensures a higher-than-average yield, while still aiming to achieve capital growth through investment in companies with good cash flow and strength in balance sheets and management. In contrast to many peers, the manager did not cut the fund’s dividend in 2009. The dividend level was rebased in late 2011, however, as management felt the opportunity set was significantly diminished, thus compromising the fund’s ability to also meet its long-term capital growth objective. Newton Higher Income has a large-cap value tilt, which generally leads it to underperform cyclical rallies driven by the lowest yielding stocks. The fund is run with a disciplined process and has a Bronze Morningstar OBSR Analyst Rating.

The Fidelity Moneybuilder Dividend fund’s objective is to consistently grow the income payout to investors on an annual basis. The fund has been managed by Michael Clark since July 2008. Clarke’s starting point is to assess the sustainability of a company’s dividend in difficult economic circumstances, focusing on balance sheet strength; he then considers to what extent the company can cover its dividend payment; and lastly he focuses on valuation. Investors should be aware that the fund is very concentrated, with the top 10 holdings accounting for almost half the fund’s assets. The fund has performed well over the three years to end-September and has recently been awarded a Bronze Rating by Morningstar OBSR.

The Threadneedle UK Equity Income fund adopts more of a total return approach and aims to achieve an above-average level of income combined with sound prospects for capital growth. This translates into a desire to outperform the benchmark as well as to deliver a healthy income, and results in the fund being managed pragmatically. The fund is managed by Leigh Harrison and Richard Colwell. They use a combination of top-down and bottom-up strategies, and seek to identify medium- to long-term investment themes within the UK and global economies. The fund will typically hold between 45 and 60 stocks and will be well diversified as the managers seek to manage risk at both the stock level and through portfolio construction. The fund has a Silver Morningstar OBSR Analyst Rating.

Final Words
In summary, we believe the UK Equity Income sector to be highly competitive, with some good funds run by very capable management teams, but investors should be aware of the risks involved when focusing on high yield equity investing. We advocate that investors should always gain a thorough understanding of the fund’s investment mandate before deciding on a suitable fund, owing to the differentiated nature of funds within the sector.  

A version of this article was published in Professional Adviser.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author Simon Molica

Simon Molica  is a fund analyst with Morningstar OBSR.