Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, Tineke Frikkee, manager of the Smith & Williamson UK Equity Income Fund, asks should the Investment Association change its 110% dividend yield hurdle for the UK Equity Income sector?
The constraints imposed by the Investment Association (IA) on UK equity income funds – specifically the one that states that such funds must generate a yield of 110% of the FTSE All-Share’s yield – have become a very hot topic in recent weeks. The debate has become such a big issue that it has been front page news in some trade publications and has also been picked up by the personal finance sections of the national press.
Dividend cuts tend to come in cycles and skilled fund managers should be able to avoid them
Why has there been such a furore? It is perhaps worth remembering why the IA developed sector classifications in the first place. Its web site says:
‘There is a huge variety of funds on sale in the UK. The Investment Association sectors provide a way of dividing around 3,000 of these funds into broad groups. Investors and their advisers can then compare funds in one or more sectors before looking in detail at individual funds.’
Like the IA, we think that grouping funds into sectors is helpful for investors and advisers. There are thousands of funds available for sale; retail investors who don’t use an intermediary are unlikely to search across sectors to find out which funds have an income objective and which do not.
We believe that stating a defined targeted income level is helpful for investors, given that interest rates are close to zero in the UK, which has left investors starved of income from cash or bonds. More importantly, given that most people in the UK need to save more to have a reasonable chance of a comfortable retirement, we believe it is important that the investment industry makes the process of investing easier and not harder. Classifying funds into sectors and giving them clear objectives is one way of doing that.
A High Hurdle to Clear
The 110% hurdle seems to have attracted the most criticism and we agree that it is an arbitrary target. We would argue however that a yield target is an important differentiator for investors because dividend yield is an indicator of the income return as well as potentially lower volatility of total returns. Equity income strategies historically have been less volatile than investment approaches that rely solely on earnings growth or valuation re-ratings to generate returns, because dividends and dividend growth have been less volatile. Management teams are usually reluctant to cut them.
While the yield target is a differentiator, it cannot be denied that the rules for UK Equity Income funds are much more prescriptive than those for the UK All Companies sector. Mainstream UK equity funds only have to have 80% in UK equities and seek to generate capital growth. By contrast, income funds have to invest at least 80% of their assets in UK equities and achieve a historic yield on the distributable income in excess of 110% of the FTSE All Share yield, measured at the fund's year end.
Given the looseness of the UK All Companies definition, there is an argument that the target for the income sector could be redefined as producing a dividend yield above that of the FTSE All Share, and abolishing the 110% and year end measurement constraints. This would address the current concerns that some managers are being punished for generating too much capital growth.
Although the rules for income funds are tougher than for the UK All Companies sector, some of the reasons cited for funds being unable to meet the target appear to be spurious. For example, if the issue is that a lot of large companies are cutting their dividends, the FTSE’s yield will fall and so will 10% premium hurdle rate. Dividend cuts tend to come in cycles and skilled fund managers should be able to avoid them.
For example, in 2003 some of the life companies were forced to cut dividends because of the slump in equity markets; post the global financial crisis, banks had to cut their dividends; and today mining dividends are under pressure. Skilled income investors appreciate that the number and size of dividend cuts in the UK has varied over time and will continue to rise and fall relative to changes in company cash flows and absolute levels of debt, amongst other things.
Concentration of Dividend Payments is Nothing New
Perhaps most importantly, the concentrated nature of UK dividends is nothing new – income managers have been dealing with this challenge for years. Since 2007, the top 15 dividend payers in the UK have generated an average of 60% of the total market dividend. The contribution of the top 15 payers has varied between 55% in 2015 and 67% in 2009, since 2007 according to Capita.
Based on our forecasts, the contribution from the top 15 dividend payers could fall to around 52% in 2016. If that is correct, one could argue that dividend concentration risk is falling, not increasing. In 2014, the top 15 accounted for 63% of total dividends. The lack of FTSE 100 high yield names is generally only an issue for funds investing in mega or large caps and/or which have high stock-level yield hurdle; they will only buy a stock if it yields more than 4% at purchase.
The focus on large-cap names is often a deliberate investment strategy or a result of the fact that large income funds are forced to have large-cap exposure because of their size, which precludes investment in mid, small and microcap stocks.
The debate about what constitutes an ‘income fund’ and whether there should be a separate ‘income & growth’ category is likely to rumble on – particularly given the size and importance of the income sector. There are unlikely to be any quick solutions that please everyone. As a starting point, we think it would be worthwhile for all equity income funds to publish the net income that they actually pay in pounds sterling amounts, in addition to publishing their headline dividend yields. This would at least allow investors to monitor historic growth in distributions.
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