The future of investing for income

In an ideal world, income-seeking investors would have their cake and eat it with equity income funds, which aim to offer a growing income alongside long-term capital growth.

The staple of this sector used to be UK-based funds, but these have suffered from stockmarket turbulence, with performance tables making unpleasant reading for investors.

Over the past year to summer 2008, the average UK equity income fund has fallen more than 8%, with Chelverton UK Equity Income and New Star Strategic Income the worst performers, down by 33% and 27% respectively. This will no doubt have been a shock to investors who saw these funds as the bedrock of their portfolios.

Despite this, the basic appeal of equity income funds remains because, over time, dividends account for the majority of the return from most shares. "Regardless of the prevailing climate for equities as a whole, dividend yield is always positive," explains Gavin Haynes, investment director at independent financial adviser Whitechurch Securities. "It’s the impact of this positive income stream being reinvested over the long term that has such a marked impact on returns."

For example, FTSE 100 returns over 20 years on a capital basis, compared with returns when dividends are reinvested makes the difference clear, as reinvesting dividends accounts for more than 300% of the total return.

One of the reasons many UK funds have suffered is because they are heavily invested in high-yielding stocks such as banks. As a result, they have been hit hard by the ongoing credit squeeze.

"The threat of higher interest rates followed by problems in the financial sector has caused severe underperformance in dividend-paying areas of the UK market, resulting in income funds underperforming and failing to make money after years of strong returns," says Haynes.

The sector has an array of established UK flagship funds on offer, such as Invesco Perpetual Equity Income and, until recently, was seen as the preserve of the UK market. However, there have been a handful of high-profile global fund launches in the past few years seeking attractive yields from Europe and Asia, to Latin America.

"This is good news, as a well-diversified portfolio is a must in these troubled times, and there is no getting away from the fact that equity exposure is vital for investors with the right risk appetite," says Darius McDermott, managing director at Chelsea Financial Services.

"Many asset allocation models state that you need both UK and global equity exposure and, by diverting away from the UK, you are reducing risk as you are not solely reliant on one economy to provide your returns."

Also, a hefty nine out of 10 stocks yielding more than the FTSE All Share Index are found outside the UK, says Meera Patel, senior investment analyst at Hargreaves Lansdown, the independent financial adviser. "So a global equity income fund makes sense."

The growth in the markets of Asia, Latin America and the mature markets of continental Europe has produced a wide range of high-yielding investment opportunities.

James Harries, manager of Newton Global Higher Income, the first global income fund to launch in December 2005, says: "Part of the fund’s great appeal for UK equity income investors is that only around 10% is allocated to UK assets, and it’s this diversity that has helped to drive returns."

Playing catch up

Companies across world economies are developing more efficient capital structures and are more willing to pay a dividend, although they have some way to go before catching up with the UK dividend culture.

"A stock’s yield is the key determinant for us, so the US market, where yields are generally far lower, only accounts for around 13% of the fund’s allocation; Japan is another major underweight," says Harries. "The remainder is shared between a 25% holding in euro-denominated assets, 30% in Asian holdings and around 10% in Latin America."

However, in the past decade, the number of companies listed within the FTSE World Index yielding more than 3% has risen from around 5% to just less than 30%. Crucially, well over 90% of the stocks in the FTSE World Index that yield more than 3% are outside the UK.

Aside from the Newton fund, a favourite of experts, there is a small range of other global income funds for investors to choose from. These include Schroder’s Global Equity Income, launched in August last year, and managed by Sonja Schemmann, who has a successful track record in running offshore global equity income funds. It favours Europe, UK, Asia Pacific (mainly Australia) and Emerging Markets and is underweight in North America and Japan.

Most recently, M&G joined the fray, with the launch in July of its Global Dividend Fund, managed by Stuart Rhodes. The fund had a starting portfolio of 50 global stocks with typical weightings of 1.5% to 3%. It invests in stocks such as Johnson & Johnson, which Rhodes believes is undervalued, as well as Kellogg’s and Nestle, because he sees great opportunities in the US market.

All these global funds provide increased opportunities to invest in economies with potential growth prospects.

"Global managers are likely to have opportunities that are not available to their UK counterparts and, as the UK economy suffers, there are likely to be more fund launches in this area," says McDermott.

Alex Robins, client portfolio manager of JPM Global Equity Income Fund, adds: "When we look outside the UK, we find many attractive dividend-paying companies across a broader range of sectors - income investing is now a truly global phenomenon and by searching globally this allows us to tap into growing sectors not represented in the UK."

Yet the most compelling case for global equity income investment is that you are diversifying assets away from a single market, says Patel. Certainly, retail investors are keen to take advantage of this, pouring more than £1 billion into global equity income funds over the past year, according to the Investment Management Association (IMA).

So how should you go about choosing a global equity income fund?

"Income is clearly key for many investors so the yield on these funds will be important," says Patel. "But investors should not buy these funds based on their yields alone as they will be variable, and should focus on funds that look to grow the dividend over time."

Risk profile

Another factor to consider is your risk profile. While some fund managers will choose mainly small and mid-cap stocks, others are more focused on larger companies so it’s vital to know what you’re buying into.

Some of the markets can also be volatile. Asia and emerging markets offer higher potential for capital growth than the UK but they are more risky, says McDermott.

Also, investing overseas in equity income funds does carry risks on your income and capital. These funds must be viewed as medium to long-term investments. The currency markets can be volatile.

Yet, even taking into account these factors, choosing an overseas income fund can be difficult - most have such short track records, with many being open for less than a year. Yet the case for adding one to your portfolio remains fairly strong, claim advisers.

Haynes says: "Dividend yield will continue to be an important part of the total return equation and, with the UK economic prospects looking fairly bleak, these funds will provide increased opportunities to invest in economies with good growth prospects."

"Uninspiring" performance

However, the performance of global income funds over the past year, like UK equity income, has been uninspiring. "All these funds which have invested in financials have come under pressure so performance thus far does not look inspiring," says Patel.

However, the basic arguments in favour of equity income remain intact. The discipline of investing for income means that managers have to look for companies that generate cash and distribute it in dividends, and there are opportunities in the current climate, some claim.

"We subscribe to the contrarian view that there are opportunities for active fund managers in out-of-favour areas that are now trading at distressed valuations and offer strong recovery potential, such as house builders," says Haynes.

If you are considering using your ISA allowance to invest in a UK equity income fund, remember that those with a defensive positioning should be able to ride out the current storm.

For example, Neil Woodford, manager of the Invesco Perpetual UK Equity Income fund, has steered clear of banking stock and has exposure to defensive stocks like tobacco and utilities, which should be able to produce dividends in a difficult environment.

"Higher yielding shares have performed badly," says Simon Gergel, fund manager of Allianz RCM UK Equity Income. "But these are the sort of conditions that build up potential opportunities - and there are still companies with strong balance sheets, such as those operating abroad, like GlaxoSmithKline."

A further benefit of the dividend-driven approach is that it prevents managers from getting too attached to a stock because they are compelled to sell when the yield falls below an acceptable level.

Overall, equity income funds, whether global or UK-based, have a lot going for them but recent market shocks have provided investors with a reminder that they should only form part of a diversified investment portfolio.