The UK equity market has performed very well over since the period after the financial crash with the FTSE All Share delivering a return of more than 100 per cent over the last five years.
Performance of index over 5yrs
Source: FE Analytics
However, due to those high returns and as investors have turned to equities for income due to ultra-low interest rates and poor bond yields, dividend yields have come down substantially across the UK market. For instance, the All Share currently only yields 2.8 per cent.
Metcalfe says this is creating a real problem as it means managers in the IMA UK Equity Income sector will have to start taking on a lot of risk to meet the sector’s criteria of delivering an income which is 110 per cent greater than the FTSE All Share.
“I do not think that it is sensible to trying to find a fantastic relative yield at the moment,” Metcalfe said.
“A lot of these managers are going to have to start investing in some very poorly valued stocks to meet that target. The problem is, people are naturally inclined to want a yield, but these risks aren’t going to be apparent until a market sell-off.”
Metcalfe is very wary about investing in the IMA UK Equity Income sector. He has therefore sold his holdings in funds that sit within the sector and has spread his exposure across various funds in the IMA UK All Companies sector.
He admits that it is a difficult decision for investors to make because a lot them need that income, especially given that the outlook for bonds looks uncertain.
However, Metcalfe urges investors not to be too short-sighted because if a stock’s dividend yield is high, it tends to mean the market is wary whether investors will actually receive that income.
“I have had this discussion with our IFA clients on numerous occasions. However, I keep coming back to this valuation point because most of these income-orientated funds are carrying a lot of risk,” Metcalfe said.
“Yes, people are going to be happy with you if you put them into a high yielding fund now, but when the chickens come home to roost, so to speak, they won’t be very happy. The question is with these income-orientated managers, where are they going to go now?”
A number of groups have switched their income funds into the IMA All Companies sector recently.
For instance, FE Alpha Manager James Henderson’s Henderson UK Equity Income & Growth fund switched sectors last year as the manager wanted a higher degree of flexibility and to not be pushed into a yield trap.
Invesco Perpetual moved their highly popular High Income fund, which had been managed by Neil Woodford and his now run by Mark Barnett, last month as they say the strategy would not be able to hit the sector’s current rule set.
Metcalfe says that those funds, and ones which will likely follow them, should be applauded.
“I think it is absolutely right,” Metcalfe said. “The sector rules were written at a completely different time and yields are now at a completely different place. As I said before, people may be happy having a high yield now but won’t be happy after the event.”
“But there will be no point blaming the IMA because that won’t get your money back.”
Metcalfe says, however, that risks surrounding equity income funds aren’t just limited to the UK. He has, for instance, removed Jason Pidcock’s five crown rated Newton Asian Income fund from his buy list.
According to FE Trustnet, it sits firmly in the top quartile of the IMA Asia Pacific ex Japan sector since its launch in November 2005 with returns of 167.11 per cent and has beaten its benchmark – the FTSE Asia Pacific ex Japan index – by close to 40 percentage points.
Performance of fund vs sector and index since Nov 2005
Source: FE Analytics
The fund has underperformed recently, however, and has been one of the worst performing portfolios sector over the last 12 months.
Metcalfe says the major reason why he sold the fund was because of its size , which at £4.3bn, he feels is too big.
He says he has no hard evidence to suggest that size impacted on its performance, but like he has told FE Trustnet in the past, he doesn’t want to take the risk of waiting to find out.
“It has taken on a shed load of money recently and it comes back to our point that we have never found a fund that has performed better when it is much larger. There is a risk there that wasn’t there before.”
However, instead of moving that money into another income fund, he has switched into Matthew Dobbs’ Schroder Asian Alpha Plus fund.
Jonathan Pines, manager of the Hermes Asia ex Japan fund, recently told FE Trustnet that a bubble was developing in safe, reliable dividend Asian stocks as investors have wanted to maintain some exposure to the underperforming region without taking on too much perceived risk.
Pines says that has meant investors have been paying over the odds for quality, which means that many income funds will materially underperform over the coming years. Metcalfe fully agrees with that view.
“We spoke to Matthew Dobbs recently and he told us that he believed his Alpha Plus fund will outperform his income trust over the coming years because of where valuations are with dividend paying stocks,” Metcalfe said.
“The problem with income-orientated funds is that they are limited in where they invest, while a growth fund can invest anywhere without being forced to take risks.”
“Of course, if Dobbs finds opportunities in income stocks he can buy them, but he hasn’t got a yield targer and won’t ever be hassled about it.”
“It’s the same in the UK, though, if there are good value income stocks, managers in the IMA UK All Companies can buy them.”
Dobbs’ £474m Schroder Asian Alpha Plus fund was launched in November 2007.
Performance of fund vs sector and index since Nov 2007
Source: FE Analytics
Our data shows that over that time it has been the seventh best performing portfolio in its sector with returns of 64.3 per cent and has doubled the returns of its MSCI AC Far East ex Japan benchmark.
It has also been top quartile over rolling three and five year periods, but has slightly underperformed against in the sector and index over the last 12 months.
Its clean share class has an ongoing charges figure (OCF) of 0.95 per cent.
