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Equity income investing: looking beyond the headline numbers

29 July 2018

Darius McDermott, managing director, FundCalibre takes a look at this ever popular sector – both when investing at home and globally.

It’s natural for investors to have a home bias, especially UK investors looking for income. The UK has one the best cultures in terms of returning money to shareholders. And with the average fund in the IA UK Equity Income sector (not including dividend-enhancing strategies) currently yielding 4.05%*, why look elsewhere? Especially as the average fund in the IA Global Equity Income sector (again, not including enhanced strategies of sector-specific funds) yields 2.99%*.

UK equity income funds have also held their own in recent rising markets. The average fund in the sector has returned 52.64%* over five years, compared with 56.89%* for the UK All Companies sector.

Global equity income funds, on the other hand, have struggled to keep pace with the wider global universe in total return terms, principally due to the lack of income-paying tech stocks (which have rallied in recent years) and the performance gap is far more pronounced. The sector average is 58.04%* over the last five years, compared with 73.66%* for the IA Global sector.

Looking beyond the numbers

Whether you are sticking with the home market or looking to diversify abroad, there are a few important factors that could impact the way an equity income portfolio is constructed.

1. Starting yield matters: Part A

On the one hand,  it makes sense to take advantage of yield compression by focusing efforts on identifying stocks with elevated dividend yields, that have the potential to compress as the market observes their positive change in fundamentals.

Two funds I like that aren’t afraid to do this are Standard Life Investments UK Equity Income Unconstrained and Schroder Income. The former invests in companies of all sizes, but with a bias towards mid caps and its manager, Thomas Moore, looks for non-consensus companies and often avoids the traditional income-payers.

Schroder Income is a concentrated, deep value fund. The managers aren’t afraid to hold companies which may not ever return to their glory days, but are not terminally impaired. This allows them to find stocks which are compensating for risk-taking with attractive dividend yields.

2. Starting yield matters: Part B

Another way of looking at this is that a lower dividend with good potential for growth, can also benefit over the longer-term. If you take an income it can be keeping pace with inflation and if you are reinvesting the income compounding will increase exponentially. Rathbone Income, for example, has a slightly lower headline yield at 3.98%**, but has one of the best – if not the best – track record among open-ended funds for paying dividends, having increased its payments during 24 out of the last 25 years.

While the average yield among global equity income funds is lower than that of the UK, there are exciting things happening elsewhere in the world in terms of increasing dividends. Janus Henderson’s Global Dividend Index in February this year*** noted that globally, dividends have risen by some 75% since 2009, with 11 out of 41 countries breaking records in 2017. Underlying growth is strong at 6.8% and every region of the world has seen dividends rise.

The M&G Global Dividend fund perfectly demonstrates the importance of dividend growth. While it has a historic yield of 2.8%**, investors who had bought in at launch would be receiving a personal yield of 6% because it has regularly raised its dividends over time.

3. The number of UK equity income funds is shrinking

There has been a lot of change in the IA UK Equity Income fund sector since 2009. The most striking of which has been the reduction in the number of funds surviving in the sector: down from a peak of 103 in 2009 to 87 today.

One would hope that some of the laggards in the UK sector have gone by the wayside, leaving the better options, but there is still quite a lot of overlap among many underlying holdings, especially the larger companies. Iif you own more than one UK equity Income fund, there is the danger that you are simply doubling up, rather than diversifying.

Dividend cover for the FTSE 100 was under some pressure prior to the Brexit referendum, but rebounded thanks to the drop in sterling and recover of earnings in large cap sectors such as oils, mining and banks. But the FTSE 250 dividend cover still remains higher today as does its earnings growth and dividend growth forecasts for this year. So if you are sticking to the UK, fishing further down the cap pool fells like a better bet on a medium-long term view.

Marlborough Multi Cap Income, for example, has 34%** invested in mid caps and 30%** in small caps. The afore-mentioned SLI UK Equity Income Unconstrained has 43%** in FTSE 250 companies.

4. Giving global a chance

Given the demand for income from investors, it is perhaps surprising there are fewer UK equity income funds today– until you look at the IA Global Equity Income sector. Launched in 2011, there are already 55 constituents. So asset managers, at least, believe there is both an investment case and the all-important investor demand.

And while there will still be the risk that there is some overlap of holdings as the UK is such a prominent market, there are good funds out there that avoid this. Artemis Global Income, for example, has just 4.6%** invested in the UK stock market.

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Darius’s views are his own and do not constitute financial advice.

*Source: FE Analytics, total returns in sterling, as at 25 June 2018.

**Source: Fund Fact sheets, 31 May 2018.

***Source: Janus Henderson Global Dividend Index, February 2018.

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