Cholwill, who runs the £448m Royal London UK Equity Income fund, says mid caps offer the best capital and dividend growth opportunities at the moment, which giant equity income funds will struggle to get access to due to their liquidity constraints. He adds that because he looks for companies with a sustainable dividend that can grow in an anaemic economy, he holds 40 per cent of his fund in FTSE 250-listed stocks.
"I am looking for opportunities outside of the normal areas, as the UK equity income market is dominated by just a few names," he said.
"The top-20 dividend-paying companies make up 60 per cent of the market, but there are a lot of opportunities outside the mega cap stocks.The key component of my fund is that it isn’t too big like some of the others in the sector."
"They have been victims of their own success in many ways as they have attracted a lot of inflows, but those portfolios are now dominated by mega cap stocks. There is a liquidity issue for all investors, but it is more of an issue for the bigger funds."
"We are in an environment of very anaemic growth, so these very big companies which have dominant market positions will struggle to buck the trend and grow above average," he added.
The manager gave an example of why these larger funds will suffer over the coming years.
"I have bought defence company Cobham recently. The shares had fallen sharply so I bought it, as it has a dividend yield of 4.5 per cent, which the board says can grow at 10 per cent per annum, which is great news."
"As a result, I bought myself a 2 per cent holding, which was about £6m to £8m. But if you are running a fund that is £3bn to £4bn and they wanted a similar holding, they would have to invest 10 times that much and would own a large part of the company."
"If they wanted to invest the same amount as I did [in cash terms], it would be a much smaller holding, which would hardly contribute to the fund’s performance," he explained.
Cholwill did not highlight any funds in particular. However some of the largest funds in the IMA UK Equity Income sector include Neil Woodford’s Invesco Perpetual High Income and Invesco Perpetual Income funds, which both have more than £10bn in assets under management (AUM), as well as the £5bn Artemis Income fund.
Funds as large as these, he says, have become victims of their own success, and should have soft-closed by now. He says he is keeping a watchful eye on inflows to ensure his fund does not go down the same route.
"If you’re running a fund, it is important that it doesn’t become too big," he said.
"You have to keep an eye on the size of the fund as it will ultimately impact on performance. I think at £450m we have a lot of headroom and we would wait until it gets to at least £1bn before we reviewed it."
"The key for us is to not let it get too big, but who knows, by that time market liquidity could become much better. However, for the big equity income funds it is a bit late for them."
According to FE Analytics, Royal London UK Equity Income is a top-quartile performer in the IMA UK Equity Income sector over one, three and six months, and one, three, five and 10 years.
Cholwill took over the fund in March 2005 and since then it has returned 99.77 per cent, compared with 66.76 per cent and 78.79 per cent from the sector and FTSE All Share respectively.
Performance of fund vs sector and index since Mar 2005
Source: FE Analytics
Royal London UK Equity Income has a headline yield of 3.66 per cent and is the only one in the IMA UK Equity Income sector to have outperformed the average fund in each of the past six calendar years.
Cholwill says he is by no means prejudiced against large cap stocks, and counts the likes of GlaxoSmithKline, HSBC and AstraZeneca as top-10 holdings. However, he has upped his exposure to mid caps as he has found a number of interesting opportunities in this area of the market.
He says these opportunities do not just revolve around a growing dividend, however, and that the companies he is interested in could well benefit from increased M&A (merger and acquisition) activity.
"That is because instead of growing slowly these mega caps may look to buy smaller growing firms. They may have strong balance sheets and good cash-flow, but they have an issue with growth."
"Therefore they may look to buy attractive GDP-plus growth-type businesses and these tend to be the companies that have sustainable dividend growth," he added.
Royal London UK Equity Income has an ongoing charges figure (OCF) of 1.3 per cent and requires a minimum investment of £1,000.
