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."
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."
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.
The practice of locating your financial affairs (banking, savings, investments) in a country other than the one you’re a citizen of, usually a low-tax jurisdiction. The appeal of offshore is it offers the potential for tax efficiency, the convenience of easy international access and a safe haven for your money. However, offshore is governed by complex, ever-changing rules (such as 2005’s European Union Savings Directive) and, as such, is the exclusive province of the wealthy and high-net-worth individuals.
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
There are limits to how much you can invest in any tax year. For 2011/12, the limit is £10,680. Of that, the maximum you can invest in cash is £5,340 and the balance of £5,340 can be invested in shares (individual company shares or investment funds). If you don’t take the cash ISA allowance, you can invest up to £10,680 into a stocks and shares ISA.
The term is interchangeable with stock exchange, and is a market that deals in securities where market forces determine the price of securities traded. Stockmarket can refer to a specific exchange in a specific country (such as the London Stock Exchange) or the combined global stockmarkets as a single entity. The first stockmarket was established in Amsterdam in 1602 and the first British stock exchange was founded in 1698.
An individual employed by an institution to manage an investment fund (unit trust, investment trust, pension fund or hedge fund) to meet pre-determined objectives (usually to generate capital growth or maximise income) in prescribed geographic areas or investment sectors (such as UK smaller companies, technology or commodities). The manager also carries the responsibility for general fund supervision, as well as monitoring the daily trading activity and also developing investment strategies to manage the risk profile of the fund.
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
A market-weighted index of the 100 biggest companies by market capitalisation listed on the London Stock Exchange. It is often referred to as “The Footsie”. The index began on 3 January 1984 with a base level of 1000; the highest value reached to date is 6950.6, on 30 December 1999. The index is “weighted” by how the movements of each of the 100 constituents affect the index, so larger companies make more of a difference to the index than smaller ones. To ensure it is a true and accurate representation of the most highly capitalised companies in the UK, just like football’s Premier League, every three months the FTSE 100 “relegates” the bottom three companies in the 100 whose market capitalisation has fallen and “promotes” to the index the three companies whose market capitalisation has grown sufficiently to warrant inclusion. Around 80% of the companies listed on the London Stock Exchange are included in the FTSE 100.
If you own shares in a company, you’re entitled to a slice of the profits and these are paid as dividends on top of any capital growth in the shares’ value. The amount of the dividend is down to the board of directors (who can decide not to pay a dividend and reinvest any profits in the company) and they will be paid twice yearly (announced at the AGM and six months later as an interim). Dividends are always declared as a sum of money rather than a percentage of the share’s price. Although dividends automatically receive a 10% tax credit from HM Revenue & Customs (HMRC), which takes the company having already paid corporation tax on its profits into account. Dividends are classed as income and, as such, are liable for personal taxation and so shareholders have to declare them to HMRC.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.