This article is part of the Morningstar's Guide to Active vs Passive Investing. Click here for our edit on how the experts use the tools at their fingertips, finding out whether you prefer one to the other and examining how to blend active and passive investing for profit.
UK Equity Income Funds have once again topped the polls as the most popular actively managed open-end fund sector last month.
According to the latest statistics from the Investment Management Association (IMA) show that UK equity income funds recorded sales of £606 million in September – raking in more cash than any other sector for the fourth month in a row. In part this boost is down to the launch of star manager Neil Woodford’s equity income fund in June, but low cash rates and rock bottom gilt yields also contribute.
The popularity of the sector, even in a month where total investment across all sectors dropped to a 20 month low, proves UK investors are still primarily concerned with the hunt for yield.
Ever since Bank of England dropped the base interest rate to 0.5% in March 2009, the popularity of income paying assets – first bonds and then equities – soared. Investors have turned to experience fund managers to help boost their portfolio’s income, but passive funds can be just as effective.
During the global recession the number of companies in the FTSE 100 paying a dividend significantly fell. British banks, which had been the backbone of any income portfolio, cut their dividend entirely as they were tasked to sort out their books and build up cash reserves. But new players have emerged and the defensive sectors – including as tobacco, pharmaceuticals and utilities – are paying out double the rate of inflation.
This has helped boost the FTSE 100’s yield to 3.4% - pretty attractive when you consider that the current official rate of inflation in the UK is just 1.2%. With FTSE 100 yield nearly triple the rate of inflation, it is worth considering an exchange traded fund that gives you exposure to the whole index – but for a fraction of the cost of active management. The iShares FTSE 100 ETF (ISF) distributes dividends and has an ongoing charge of just 0.4%.
Fixed income ETFs are also offering income, but investors must be prepared to move up the risk scale as the bond market is still paying out historically low yields across the board.
The iShares $ High Yield Corporate Bond ETF (IHYU) has a four star rating, and pays out dividends twice a year. Pimco Short-Term HY Corp Bond Source ETF (STHY) pays out monthly.
Income Seekers Could be Smart to Choose Strategic Beta
Smart beta ETFs seek to enhance returns or minimise investment risks relative to a traditional market capitalisation-weighted benchmark. These ETFs, also known as strategic beta ETFs, are weighted by alternative variables such as dividend payments, volatility and earnings and exploit the same sources of return as active managers.
These funds are a kind of hybrid between active and passive management; passive strategies seeking to either improve their return profile or alter their risk profile relative to more traditional market benchmarks.
In a typical equity ETFs the size of the stock holding within the fund is determined by that company’s market cap. For example, within the FTSE 100, HSBC is the largest company and so it will be the largest holding within a FTSE 100 ETF.
Strategic beta ETFs instead weight the holdings in their fund portfolio by the size of the dividend – giving investors a better pay out.
“Income weighted ETFs by far the most popular in the strategic beta ETF marketplace in Europe,” said Morningstar passive fund analyst Jose Garcia Zarate. “It’s all to do with investors’ desire to enhance returns wherever possible in the current market conditions.”
ETF provider WisdomTree has recently launched four such funds, covering European and US equities that pay a dividend.
Luciano Siracusano, chief investment strategist for WisdomTree said that over time dividends are a key part of the total return generated by stocks.
“Dividend weighting equity markets has the opportunity to generate higher starting dividend yields - relative to comparable indices,” he said. “In a low yield environment dividend weighting equity markets have the opportunity to generate more income for investors.”
