Is equity income too good to be true?

6 October 2009

Equity income funds continue to appeal to those who need to live off their investments because, despite recent problems, they still offer the best chance of combining worthwhile immediate returns with growth of capital and income over the medium term.


However, you should think twice about how much of your investment income you spend. A lot of the long-term returns on equities come from dividends; if you don't plough those dividends back into the investment you'll considerably reduce the amount available to earn future returns.

Also, a lot of equity income funds keep their yields up by charging the running costs to capital rather than income. That means spending all your dividend income will eat into your core investment even more.
There is an increasing number of overseas equity income funds, but UK equities remain the favourite, with over £10 billion under management.
The sector has recently been divided in two, making it easier to select a suitable fund. Funds in the UK Equity Income sector must aim for a yield at least 10% higher than the FTSE All-Share index, whereas UK Equity Income & Growth funds must aim for a yield of at least 90% of the All-Share.

So, the former should pay out around 20% more and focus on income preservation, whereas the latter may pay out less now in return for better income and capital growth prospects.
Both sectors have produced very similar average returns over the last year, but the UK Equity Income & Growth sector has produced better five-year and 10-year average returns, with an average total return of 138%, against 121%. So going for the highest yield may not be the most sensible move.

For instance, the above-average yield on Newton Higher Income fund helps explain why it's one of the largest funds in the sector, but its performance does not compare particularly well with the other funds and the value of its units has fallen slightly over the last five years.
The fund's relatively lacklustre returns can be partly attributed to the fact that manager Tineke Frikkee is only allowed to invest in companies yielding at least 15% more than the All-Share at the time of purchase, and must sell any holdings whose yield falls below the All-Share.

This has been a handicap over the last six months, when the market's upward charge has been led by companies whose dividends were slashed after they were trashed in last year's setback.

Newton Higher Income has only been above-average in three of the last seven years, two of which witnessed very weak markets. So it looks a better choice for those who think the market rally is at an end, rather than those who expect further gains over the next year or two.

Schroder Income is a better choice for the optimists. Managers Nick Purves and Ian Lance have produced above-average returns in most conditions, and the fund has performed strongly over the last six months. The payoff for these returns has been a contraction in income.

Schroders has warned that after years of rising payouts it will have to cut this year's distributions by a fifth or more, reducing the yield to less than 4.5%. But Lance expects this to be offset by further capital gains on low-yielding shares such as Barclays and Rentokil. "We're very excited about our medium- to long-term prospects," he says.
Artemis Income fund is less constricted than the Newton fund, and less bullish than the Schroder's fund. Its returns have been above-average in four of the last five years, and its yield middle-of-the-road.

Manager Adrian Frost has been wary of this year's strong rally in banks and other cyclicals, although he invested in bank bonds. "A lot of companies that went into hibernation are defrosting, so things are getting better, but the acid test will come in six months' time.

"Are there any fresh green shoots, and are they actually growing?"

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