This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here, Michael Clark, portfolio manager of the Fidelity MoneyBuilder Dividend and Fidelity Enhanced Income funds says income seekers should do their homework before investing
Many investors will be familiar with the attractions of the equity income sector and the compounding effects of dividends. Indeed, one only needs to look at how dividends have accounted for two thirds of long-term total returns. Moreover, as well as providing the potential to enhance returns or to provide an income stream, dividend stocks typically provide a lower-risk way to access the equity market.
With an array of attractive features, it therefore comes as a little surprise that equity income funds are increasingly being viewed as a core holding throughout the cycle for many investors’ portfolios. Testament to this how the UK Equity Income sector has been steadily growing in popularity for over 10 years now, with assets having grown by over 219% in the last decade.
While the sector continues to go from strength to strength it should be pointed out that not all UK equity income funds are created equal and funds can behave very differently from one another due to the way they are structured and managed. As a result, it is worth taking a thorough look under the bonnet of any fund sitting in the UK equity income universe to understand how it might perform.
Based on our analysis we have identified that there are broadly three ways that funds within the UK equity income sector are managed.
At one end of the spectrum there are those managers who filter stocks on yield. To be classified within the IMA UK Equity Income sector, funds need to provide a distributable income in excess of 110% of the FTSE All Share yield. To achieve this, some managers may choose to only consider stocks that provide an income above (and sometimes significantly above) 110% of this threshold. When a stock’s yield drops below this mark, this normally acts as the trigger for the stock to be sold.
While selecting stocks purely on yield within an equity income strategy can help achieve a certain level of distributable income, this approach has its dangers. For example, a high yield could be an indication that the company is under stress, specifically when a fall in its share price is artificially pushing up the estimated yield.
At the opposite end of the scale is an approach whereby a manager will buy a high percentage of capital growth stocks which offer very little in terms of yield. To boost the fund’s income, the manager will also buy and hold a selection of bonds or very high yielding stocks. This is commonly known as a ‘barbell’ strategy. This strategy can lead to increased volatility given that the underlying holdings tend to be predominantly growth stocks.
It will come as little surprise that this style generally proved to be successful last year, given that cyclical stocks out-performed defensives and small/mid cap stocks delivered strong returns. The flipside though, is that this approach is likely to underperform during less bullish markets due to the make-up of the portfolio.
The third strategy is to invest in stocks that deliver safe and growing dividends. The approach typically focuses on identifying solid stocks based on an assessment of the company’s earnings and dividend pay-out. Rather than investing solely on the basis of a stock’s yield, this approach places greater importance on the concept of sustainability of income which I believe should form the cornerstone of any equity income portfolio. A focus on the sustainability of earnings and dividends across the cycle will help a portfolio to avoid investing in value traps. Furthermore this strategy tends to place an emphasis on stocks with the potential for dividend growth which gives investors a better opportunity to keep up with inflation. However, the downside of this approach is that it tends to underperform during strong bull markets.
Knowing what type of equity income fund you are investing is therefore essential. Whilst there is nothing wrong with a high beta approach or yield focussed approach, we believe that in the current economic environment, which continues to look fragile, delivering safe and growing dividends makes the most sense for income investing.
