UK Equity Income funds have lagged the FTSE All Share in the first half of 2016. This is unlike the last six calendar years, when it has consistently outperformed the index. Why has the sector underperformed this year?
Market Capitalisation
Much of this performance difference can be attributed to the market cap profile. The Morningstar UK Equity Income category average fund, which aggregates all the holdings in each fund within the category to form a hypothetical portfolio, shows a significantly lower weighting to giant-caps and a higher weighting to mid and small-caps relative to the index.
Mid-caps have outperformed the FTSE All Share in four of the last five calendar years, while small-caps have outperformed in three. With a greater emphasis on small- and mid-caps, the category average fund tends to benefit when they outperform large-caps, and vice versa when they underperform. With mid- and small-caps strongly underperforming large-caps in the first half of this year, it is therefore no surprise that the category average is lagging the market. This does not paint the whole picture however.
Sector Allocation and Stock Selection
The search for a higher than average yield and sustainable dividend has seen equity income managers prefer certain sectors over others. Most meaningfully, the category average fund was underweight materials and energy, the two poorest performing sectors, in 2015.
While historically these sectors have proved to be a typical hunting ground for income-seeking managers due to their higher yields, the threat of dividend cuts in the face of tumbling commodity prices saw an increased level of caution. Stock selection was also an important influence on returns, as illustrated by financials exposure. The average fund’s exposure to the sector was broadly in line with the index, but it managed to add alpha through underweighting banks and overweighting select names within insurance and consumer finance.
This positioning also contributed to the category average fund’s underperformance in the first six months of 2016, as those areas that struggled in 2015 rebounded – energy and materials were both among the top performing sectors. Again, stock selection proved positive overall. Notably, the average equity income manager managed to add value in within financials sector through the underweight to banks, which suffered badly in the immediate aftermath of the Brexit vote.
Style and Variation within the Category
Investment style has also had an impact, with growth stocks outperforming their value counterparts through 2015 and vice versa in 2016 to date. Two funds that nicely illustrate this trend, and the variation in products available within the equity income space, are the SLI UK Equity Income Unconstrained fund and the Schroder Income fund.
The SLI fund returned 12.1% in 2015, while the Schroder fund lost 6.94%. In the first half of 2016 this trend was reversed, with the Schroder fund returning 4.7% against a loss of 14.6% for the SLI fund.
When we look at the different style profiles of each fund, we find the context of such extreme performance variations. The SLI fund has a clear focus on dividend growth and hence a tilt further down the cap scale, while the Schroder product follows a deep value approach that has seen the fund more heavily invested in large-caps.
We rate both funds positively, and while they have illustrated the ability to outperform peers over the long term, we highlight the potential for short term performance volatility relative to peers and the benchmark.
Concentration of UK Dividend Yield Remains an Issue
The ten largest dividend providers, all giant-cap companies, create over 50% of the market’s dividend, while the FTSE 100’s dividend cover has been on a downward trend since 2012. It is therefore no surprise that UK equity income managers have been looking further down the cap-scale to find their investment ideas as they try to avoid concentration risk. That said, with less than 25% of all companies in the index actually yielding a dividend at a premium to the market, investing in equities for a higher than market yield is still tricky.
Overseas Stocks
Fund managers have also continued to look overseas to diversify their source of yield. As at the end of May 2016, the category average fund held just over 9% in non-UK listed companies, the sector allows up to 20%. This figure has gradually increased over the years, perhaps underlining the concentration/reliability issue in the UK – four years ago the category average held just under 5%.
