With dividend yields across large parts of the FTSE All Share falling considerably in recent years due to rallying share prices, a number of IMA UK Equity Income funds have taken the decision to leave the sector in favour of IMA UK All Companies.
FE Alpha Managers James Henderson and Mark Barnett have moved their Henderson UK Equity Income & Growth and Invesco Perpetual High Income funds out of IMA UK Equity Income over the past year. Both argue that they would have had to have changed their investment approach if they were to meet the sector requirement of delivering a historic yield of 110 per cent in excess of the FTSE All Share. Neither was prepared to do so.
Clark (pictured) says that investors should expect more funds to switch to the UK All Companies sector over the next year, especially those with a mid or small cap bias.
“The starting point is that, apart from 2014, the index has delivered very strong returns from its deep lows after the crash,” Clark said. “However, those returns have been quite concentrated, with small and mid caps vastly outperforming. In fact, the FTSE All Share’s yield is higher than many would expect it to be and that’s because the highest-yielding stocks are all concentrated at the top end of the FTSE 100.”
“I’m talking about the likes of the oil twins [Royal Dutch Shell and BP], GlaxoSmithKline and HSBC. That’s where the yield is, with some of them yielding more than 5 per cent.”
“However, in order for managers to achieve the 110 per cent yield target, they have to be invested in those stocks. If they aren’t, they won’t achieve it. If you are going to maintain a mid cap focused fund, you will have to drop out of the sector.”
He added: “That’s why you are seeing so many funds move across to the IMA UK All Companies sector.”
According to FE Analytics, the FTSE 250 and FTSE Small Cap indices have returned 137.95 per cent and 121.51 per cent respectively over the past five years, compared with 85.98 per cent from the FTSE 100.
Performance of indices over 5yrs
Source: FE Analytics
The FTSE All Share currently yields 3 per cent. While the FTSE 100 yields slightly more than this, the small and mid cap indices pay out slightly less.
Although Clark didn’t mention any funds in particular, some of the ones with a high weighting to the lower constituents of the FTSE All Share – and that have next to no exposure to mega caps – include the likes of PFS Chelverton UK Equity Income, Marlborough Multi Cap Income and CF Miton UK Multi Cap Income.
Our data shows that all three of these funds are top-decile performers over two years.
Although Clark says that funds that do not buy mega caps aren’t putting their investors’ money at risk, he warns that it will put fund selectors in a very difficult situation.
“It’s not necessarily a problem, but it comes down to a matter of choice,” Clark said. “Of course, there are lots of very good All Companies funds, but one of our major selling points is that yield is taken very seriously. The question is: what do you want from your fund?”
Clark has managed the £780m Fidelity MoneyBuilder Dividend fund since July 2008.
According to FE Analytics, it is a top quartile performer over that time with returns of 82.7 per cent, beating its FTSE All Share benchmark by more than 20 percentage points.
Performance of fund vs sector and index since July 2008
Source: FE Analytics
Clark has primarily invested in large caps throughout his time as manager. While this has meant the fund has underperformed during fast-rising markets, it has also allowed it to outperform during periods of market stress.
Our data shows the fund beat the sector and index in 2008 and 2011 and is currently top-decile so far in 2014.
Clark holds roughly 70 per cent of his MoneyBuilder Dividend fund in the FTSE 100. The portfolio currently yields 4.08 per cent.
Ben Willis, head of research at Whitechurch, agrees that because mid and small caps have performed so well over recent years, income investors are facing a conundrum.
“He has a very good point,” Willis said.
“You have the likes of Barnett and Woodford who have come out and said: 'I’m not going to chase yield and hold stocks that I don’t like and if my yield drops below the target, so be it'. It’s slightly different, but you have funds like Unicorn UK Income, which has always been small cap focused, buying large caps for the purposes of liquidity and because of the yield.”
As Willis points out, a number of funds in the UK Equity Income sector that previously had a high weighting to mid and small caps have recently rotated into mega caps on valuation grounds.
Unicorn UK Income, which is headed up by FE Alpha Manager John McClure, is one of the prime examples. McClure told FE Trustnet recently that he had bought a number of FTSE 100 stocks to make sure he hit the yield requirement, despite the fact that his fund has consistently outperformed as a small cap focused portfolio.
Performance of fund vs sector over 10yrs
Source: FE Analytics
The likes of Standard Life UK Equity Income Unconstrained, Schroder UK Alpha Income and JOHCM UK Equity Income have all sold down their mid cap exposure in favour of mega cap stocks over recent months.
Willis says that managers within the sector are fully within their rights to chop and change their portfolios in order to find value and therefore yield. However, he warns that some managers may have to change their historical strategy in the hunt for yield.
“If you have bought a small or mid cap fund that then has to invest in mega caps, which may not be the manager’s area of expertise, then that is something you need to be aware of because it isn’t going to be the fund you originally bought it for.”
At the same time, Willis says that if investors who need income stick with a fund that drops out of the sector, they may have to accept that the yield they receive could well drop as the manager will no longer have to hit a target.
However, he says that investors should realise that fund managers have to work within the market conditions that are presented to them and if their preferred area has a low yield, then there isn’t much they can do about it.
He says he would prefer a manager to stick to his area of expertise instead of chasing yield, or falling into a potential yield trap, as he will at least know how the fund should perform in certain market conditions.
Willis also points out that if markets were to correct significantly over the summer, as a number of experts expect, then this issue is likely to disappear as yields would rise, especially in perceived higher risk areas such as small and mid caps.
