The UK Equity Income sector has long been a favourite place for investors to stash their cash – it offers the investment holy grail of growth and income. But as finding income has become increasingly difficult in recent years, the sector’s numbers have dwindled.
Some 22 funds have been booted out of the sector because they have failed to meet the yield requirements, reducing the total number of funds in the sector by a fifth.
Among their number are the £1.3 billion Rathbone Income fund, the £1.7 billion Schroder Income fund and the Invesco Perpetual Income and High Income funds, which together hold more than £16.5 billion of investors’ money.
But many of these could now be set for a triumphant return after the Investment Association changed the requirements for the group. Currently funds must produce at least 110% of the yield of the FTSE All-Share over a three-year rolling period to make the grade. At the moment that means producing a meaty income of around 4%.
But the trade body has now slashed that yield requirement, meaning from April 3 funds will only have to match the index yield over a three-year rolling period rather than beat it. If a fund falls to 90% of the index yield over a 12-month period it will be relegated out of the sector.
What the Sector Promotion Means to Funds
Funds which were moved to the UK All Companies and other sectors will now be able to apply to rejoin the UK Equity Income sector. With more than a quarter of the typical DIY investor’s cash is in UK Income funds – some £57 billion – the change will make a real difference.
Income funds not in an income sector may be overlooked by investors looking for yield – and it’s far more difficult to compare funds with similar objectives if they are sitting in different sectors.
Reducing the income requirement also reduces the pressure on managers to invest in higher yielding stocks which they might otherwise not back – fewer than 30% of UK companies currently yield more than the market.
Yet, while some funds have already committed to applying to rejoin the sector, others are still to decide. The Evenlode Income fund, which currently yields 3.2%, was relegated from the sector in May 2016. The managers have not yet confirmed whether or not they will look to rejoin. Experts still recommend the fund, which has a five star performance rating from Morningstar.
Ben Yearsley, investment director at Wealth Club, says: “This is a really interesting fund. The companies the managers like tend to be high quality, stable businesses with low debt, which can grow sustainably. They don’t invest in banks and have firms including Microsoft, Johnson & Johnson, and Procter & Gamble in their top ten holdings.”
The Schroder Income fund is also still yet to confirm. A spokesman said: “Our early assessment of this review is that it contains some very sensible recommendations, although it is too early for a more detailed view.”
The fund, which yields 3.45%, has a Morningstar Analyst Bronze Rating and a four-star performance rating.
Morningstar analyst Peter Brunt says the managers’ approach continues to impress. With a value focus, they are willing to invest in stocks which have cut their dividend if they think they are trading at a discount to their fair value. Currently the portfolio is overweight banks and food retailers.
While the value approach of the fund means performance can be “erratic”, Brunt says: “For investors that can tolerate this extra volatility, the managers' resolute adherence to the strategy has seen them rewarded over the long term.”
One fund which does plan to return to the Equity Income sector is Rathbones Income.
David Holloway, marketing director at Rathbones, says: “Reducing the dividend yield measure to 100% of the market yield does at least give us a more sensible starting point.”
The fund has a Morningstar Analyst Bronze Rating and four star performance rating. It yields 3.4%.
Brunt says the fund is a solid choice for capital growth and a rising income.
He says: “Our conviction is growing in this fund. We like its cheap ongoing charge, long-standing manager, disciplined approach, and performance profile.”
Manager Carl Stick runs a relatively concentrated portfolio of 40 to 50 stocks, aiming to pick quality companies which can grow their dividend each year.
Reducing Target Not the Answer
But some managers are concerned that lowering the yield requirement for the sector is missing the point. By reducing the target, there is the worry that investors will start accepting less from their funds and may not be able to produce enough income for retirement.
Managers including Robin Geffen of the Neptune Income fund and Richard Colwell of the Columbia Threadneedle UK Equity Income fund have promised to continue aiming to beat the original yield target of 110% of the index.
Geffen says: “In today’s low yielding environment a high and diversified income stream from equity income funds is a huge help to investors. I have long prioritised a high and rising income and will continue to do so.”
Others think the change simplifies the problem too much; that equity income funds should not just be judged against an arbitrary yield target but the total return they produce including capital growth.
Laith Khalaf, senior investment analyst at Hargreaves Lansdown, says: “The sector definition is only a very loose indication of what a fund does. If you really want to understand what a fund is about you need to take a look at its specific objective and how it has performed against that target.”
