The sector requires funds to deliver a yield which is 110 per cent that of the the FTSE All Share, which currently yields less than 3 per cent.
Given that the recent bull market in equities has forced dividend yields lower and lower, IBOSSs Chris Metcalfe has told FE Trustnet that equity income funds will have to take on a lot of risk to make sure that they are not kicked out of the sector.
This raises the question whether the highest yielding UK equity income funds are now too high risk.
The four highest yielding IMA UK Equity Income funds are Insight Equity Income Booster, Schroder Income Maximiser, Premier Optimum Income and Fidelity Enhanced Income.
Source: FE Analytics
On the face of it, these funds look like any other IMA UK Equity Income fund with all of them having high weightings to popular large-cap dividend payers such as GlaxoSmithKline, Vodafone and Royal Dutch Shell.
However, in order to generate a higher level of income all four the funds use derivates, such as call options. Though these funds do use alternative investment strategies to deliver that level of income, FE Research’s Rob Gleeson says that doesn’t necessarily make them more risky.
“A call option means that you agree to sell a stock at a given price, but you receive an income from that call option.”
“If that stock reaches that price, you are forced to sell. It means you can be putting a ceiling over your capital gain in exchange for a higher level of income. That’s what the risk is,” Gleeson said.
Gleeson says, however, this means these funds can perform well in a falling market, but then can lag in a strongly rising one.
That is because that when markets are in turmoil they are still generating good level of income from those call options, but during a period of positive sentiment they may be forced to sell more of their stocks at the call price and could possibly miss out on further returns.
He says that the £240m Fidelity Enhanced Income fund, which is headed up by Michael Clark and David Jehan, is a good example.
Our data shows in 2010, 2012 and 2013 when the IMA UK Equity Income sector and the FTSE All Share both delivered double digit returns, Fidelity Enhanced Income made money but was a bottom quartile performer.
However, in 2011 when the sector and index both lost around 3 per cent, the fund was a third best performing portfolio in the sector with returns of 6.36 per cent.
Performance of fund vs sector and index in 2011
Source: FE Analytics
Despite those returns, Gleeson says the fund’s performance in rising and falling markets could also be a function of the more cautious way in which Clark and Jehan manage money.
JOHCM UK Equity Income, Elite Charteris Premium Income and Jupiter Income are among the highest yielding long only UK equity income funds.
One of the major reasons why these funds have an above average yield is because they more concentrated than most in a few high-yielding stocks, with the concentration risk that brings. For instance, Clive Beagles and James Lowen’s £2bn JOHCM UK Equity Income fund has a yield of 4.6 per cent.
The managers will only invest in companies that have a prospective yield above that of the FTSE All Share and will sell immediately if that dividend yield falls below the market average.
The managers say that because of that strategy, they have been turning to the larger end of the market which has lagged behind in the recent rally.
For instance, their three largest individual holdings are Shell, BP and HSBC and the managers hold more than 20 per cent of their assets in those stocks.
This approach has helped the fund to outperform, however, as JOHCM UK Equity Income has been a top quartile performer over rolling three, five and seven year periods.
Elite Charteris Premium Income, which yields 4.55 per cent, has 30 per cent of its AUM tied up in its top five holdings while Jupiter Income, which has yield of 4.5 per cent, has 27 per cent in its top five. Another aspect these funds have in common is a high weighting to out of favour areas of the market, most specifically with the Elite Charteris and JOHCM funds’ allocation to mining and basic materials stocks.
According to FE Analytics, the FTSE 350 Mining index has lost more than 30 per cent over three years while the wider FTSE 350 has returned more than 20 per cent.
Performance of indices over 3yrs
Source: FE Analytics
While a number of managers have been upping their exposure to the likes of BHP Biliton and Rio Tinto because as the companies become more focused on returning cash to shareholders after a period of over-expansion and poor share price performance, Fidelity’s Michael Clark recently told FE Trustnet that he thought it was too riskier a sector for an income investor.
“Looking at it from an income perspective, the problem is that these companies mainly focus on iron ore production and they basically have one major customer, which is China. If the slowdown continues, then I think their price is at risk,” Clark said.
For instance, JOHCM UK Equity Income holds Rio Tinto and Glencore Xstrata as top 10 holdings.
Elite Charteris Premium Income has a much higher weighting. FE data shows that four of its five largest positions are mining related companies with the managers holding 6.2 per cent in Glencore, 6.1 per cent in BHP, 5.7 per cent in Rio Tinto and 5.9 per cent in Fresnillo, which is precious metals miner.
The high weighting to the commodities sector will have almost undoubtedly contributed to its bottom quartile returns over one, three and five years.
Gavin Haynes, managing director at Whitechurch, says that equity income funds make up the core of most of his portfolios and understands that investors will always want a decent yield, but he urges them to take a closer look under the bonnet before they decide to invest.
“It is really important to not get obsessed with headline yield,” Haynes said. “Just because a fund has one of the highest historical yields in the sector, it doesn’t mean that they are in the place to grow their income over the medium to long term. Income growth is just as important to us as the starting yield.”
Gleeson says, however, that investors can’t just assume a manager is taking on too much risk if he is willing to have a concentrated portfolio or is backing out of favour areas of the market, like miners.
“I don’t think you can make that call on individual funds like that,” Gleeson said. “Fund managers will make decisions based on where they see opportunities, they won’t hold a stock they don’t like just because it has a high yield.”
