Why UK Equity Income Funds Are Suffering

VIDEO: Income funds may be unpopular but there are opportunities to be found, Morningstar's Michael Born explains

Sunniva Kolostyak 16 May, 2023 | 6:43AM
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Sunniva Kolostyak: UK equity income is one of the most unpopular fund categories, but how bad can it really be? Today in the studio, we have Michael Born from the manager research team, who's done some digging into these funds. Michael, thanks for being here. Why are these funds struggling to see inflows?

Michael Born: So it's fair to say that this has been a terrible time to be a UK equity fund manager over these past 10 years and particularly in the equity income category, we've seen loads of money out. So Morningstar data shows that since Brexit UK equity income managers have had about £33 billion of of outflows versus about £18 billion for UK large caps. And it's worth bearing in mind that we're talking about a £60 billion category versus £160 billion. So yeah, pretty bad time overall.

Kolostyak: So how have we ended up here, if we look at the the flows first.

Born: Yeah, sure. So equity income as a strategy and I guess the UK kind of overall is quite value biased and since the GFC, we've really seen growth stocks leading the way, increased adoption of technology but also record buybacks and largely deflationary macro has really benefited those growth names. It's also worth mentioning that since Brexit, the UK has really been out of favor for investors. And then also a lot of these traditional equity income stocks in industries like tobacco and energy and and banks, they've really been out of favor on fundamental, but also in some cases ESG grounds, which has kind of made them higher beta and therefore riskier parts of the market.

Kolostyak: Okay. So you've mentioned Brexit. If you look at kind of the broader economic environment. What's that been like for these kinds of stocks?

Born: Yeah, sure. So, more to the current where we are right now value stocks they had a really excellent 2022. So that combination of higher oil prices and higher interest rates really kind of caused rerating of many of these beaten up stocks and also kind of the funds in that UK equity income category they offer a dividend yield of 4% on average, which is actually forecast to rise in aggregate over 2023. It's also worth mentioning that as a result of these higher rates, cash and risk free investments, they actually offer a competitive yield to equities. However, these forgotten stocks, these value names are really exceptionally cheap and the price to earnings ratio of the Morningstar UK index was around 12 times at the end of April, which is just under the 30th percentile on a 20 year view. And in terms of its discount to the Morningstar Global Stock Index, this is around at the 10th percentile. And I suppose more to the point, if you look historically when equity valuations are at these sorts of levels, they have almost always outperformed bonds and cash over the successive 10 years. So you're kind of likely to get rewarded when stocks are at these sorts of valuations.

Kolostyak: Okay, so if you look at the category then and the composition, which funds can investors expect to see?

Born: Yeah, sure. So, the majority of funds in this category are really invested into the large cap names, which are already paying a high yield. But what you also see is some funds which are more into their small caps and and also looking for more kind of dividend growth stories rather than those already paying a high yield. And although there's nothing wrong with holding kind of the latter type of fund. In fact, some of the strategies we rate really highly are in this category, but for investors who might have a longer time horizon really want to benefit more from having higher dividends over time, they might prefer some of these larger cap funds which are also they generally have a less volatile performance profile. So, some of the funds which we kind of rate in this category include the Artemis Income Fund, J O Hambro UK Equity Income and Troy Trojan Income which are all rated as Silver by Morningstar analysts.

Kolostyak: You also briefly mentioned kind of the valuations, so with this – these stocks being not really in favor, does that mean the investor has some opportunities at their hands?

Born: So I suppose that is one of the main buying points for this category, but then also the fact that these stocks are paying a decent yield. And then that's kind of forecasted to grow. But I think it's also worth saying that the outlook is likely to remain volatile. And there are some valid risks which might cause some of these pricing of stocks, but certainly they look optically cheap. So on that basis, I think they do look fairly attractive.

Kolostyak: Well, Michael, thank you very much for being here today.

Born: Thank you.

Kolostyak: For Morningstar, I'm Sunniva Kolostyak.

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Sunniva Kolostyak

Sunniva Kolostyak  is data journalist for Morningstar.co.uk

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