The Investment Association (IA) has paved the way for an overhaul of the UK equity income fund sector by launching a consultation on its controversial yield requirements.
To qualify for the UK equity income sector under the current rules, a fund has to be invested at least 80% in UK equities and to achieve a yield in excess of 110% of the FTSE All Share index yield at the fund's year end.
However, this means that managers who grow the capital of their fund can be penalised. For example:
- Fund A starts the year at a price of £1 per unit and ends the year at £1.10 per unit, while producing an income of 5p over the year. The historic yield of the fund is therefore calculated as 4.55% (5p/110p).
- Fund B starts the year at a price of £1 per unit and ends the year at £0.90 per unit, producing an income of 5p over the year. The historic yield of the fund is calculated as 5.56% (5p/90p).
While the manager of fund A has done a good job of increasing the fund's capital, and hence its price, this has the effect of lowering the yield. This in turn means the fund is more likely to get kicked out of the sector.
£19 billion of income funds currently sit in the UK all companies sector, having been exiled from the UK equity income sector for not having produced sufficient income under the present rules of the IA.
Now, the IA has put forward three options for redrawing the definition of the sector.
The first option is to maintain the current definition. The second is to lower the bar and simply require funds to produce more income than the FTSE All-Share. The third is to require funds to produce more in-depth income statistics.
Laith Khalaf, senior analyst at Hargreaves Lansdown, comments: "The key to creating a rising dividend stream for investors is building capital, yet managers are being penalised for taking this long-term approach.
"We believe the best solution for the sector is to calculate a fund's yield based on its price at the start of the year, not at the end. That way managers are not hobbling themselves by boosting the fund's capital over the year."
While the consultation is a positive move to tackle the issue, Khalaf believes the proposals reported so far "either don't do enough to ensure investors are getting a premium income, or shove this industry hot potato onto the investor's plate, which simply isn't fair".
"Investors in UK equity income funds just want to know their fund is doing what it says on the tin."