This is according to FE Alpha Manager James Henderson, whose £411m five crown-rated Henderson UK Equity Income fund has been booted from the sector by the IMA for failing to maintain a yield at least 10 per cent above that of the FTSE All Share.
However, the manager says he can better fulfil the requirements of his investors by looking for companies that have the ability to increase their dividend rather than those that pay a better headline yield.
"My fund has been moved into the All Companies sector because I haven’t really been rotating out of the sectors where there has been strong capital growth. The headline yield [on my fund] has fallen because of the capital appreciation of the shares."
Henderson points out that the payout on his fund grew by 15 per cent last year, but this wasn’t enough to satisfy the IMA thanks to the strong growth his holdings experienced.
The manager currently favours the industrial sector, saying it is the best bet for income investors. He adds that he doesn’t want to follow the crowd into areas that have a better yield but are riskier in the current troubled economic environment.
"The usual income strategy is to rotate sectors more but I think we are in that period in the market where challenged companies aren’t getting any improvement."
"For example, I don’t have any Marks & Spencer. I think the sector remains very difficult. There will be ups and downs in consumer spending. There’s structural change happening in retail with the move from offline to online – it’s going to be very difficult."
"Take the utilities – they are trading at well above their regular asset values. We know the authorities are worried about the price of gas and electricity going up too fast, so it’s a difficult environment to make strong returns."
"There will be downward pressure on the prices."
Henderson UK Equity Income is currently yielding 3.4 per cent, below the 3.94 per cent average for the sector.
Performance of fund vs sectors and index over 3yrs
Source: FE Analytics
However, in total return terms it has performed exceptionally well, returning 65.47 per cent over three years – top-decile returns in the All Companies sector. This number has been bettered by only two UK Equity Income funds.
The manager holds 37.3 per cent in industrials, his biggest sector weighting. He says this provides him with both growth and yield.
IMI is an example of a stock the manager says he would have to ditch to remain in the sector.
"In the 1990s it was a yield stock, it was a business that never performed that well, a conglomerate really, but then since 2000 when Martin Lamb became chief executive it thinned down and became more focused over the last 13 years."
"It has just sold two businesses to Warren Buffett for the whole market value of the company when he took over."
"It was an income stock and it has grown the dividend strongly. There was a point it fell below the yield on the All Share because of capital appreciation. I remember reducing it once, but I would be wrong from a capital and income growth perspective to do so again."
"With the sale of the businesses there will be £630m returned to shareholders, so although the yield is just 2 per cent, growth has been strong. It’s important to keep running with companies like that and not selling out to buy high-yielding shares."
"This has happened with quite a few shares."
The manager says that this sector represents a particularly strong element of the UK economy. He holds Senior, GKN and Hill & Smith in his top-10.
Data from FE Analytics shows that the FTSE 350 Industrials index has made 60.88 per cent over the last three years while the wider index has made just 32 per cent.
Performance of indices over 3yrs
Source: FE Analytics
"There has been survivorship bias in UK industrials," Henderson continued. "To have had growth over the last 10 years you need to have been a good business, to have had excellence in what you are doing."
"We have largely got rid of any low-margin commodity-intensive businesses, which have probably gone to the Far East."
"What you are left with is often higher-quality companies. For a long time, people have labelled these as cyclicals whereas there has been a big change in what these businesses can make."
"People said they could never make a double-figure margin but businesses are now different and a lot of margins have gone up further. You are seeing low-teen margins, top lines are growing and you will see further margin expansion."
"So rather than selling you should keep with companies that are good stocks in that area. They still haven’t got the ratings growth that should result from their long-term prospects."
The manager says that he is more cautious than the majority of his peers on the outlook for the UK economy.
"I don’t think the economy was as weak as some people were suggesting last year and in the spring, and I think it hasn’t completely moved around – there are still a lot of issues."
"The level of debt in the country is quite high and needs to come down. It has in the corporate sector but not elsewhere. I think the domestic economy remains difficult."
He adds that investors need to be wary of the housebuilding sector, which has done well of late. Housebuilders have done well from buying land cheaply after the 2007 bubble burst, but that this "low-hanging fruit" has now been picked.
Their margins will come under pressure now that the market rate for land is higher, he adds.
Henderson UK Equity Income requires a minimum initial investment of £1,000 and has ongoing charges of 1.75 per cent.
