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Should income investors be wary of the highest-yielding funds?

08 September 2014

Investors looking for dividends are automatically attracted by the highest yielding funds, but this doesn’t mean the income they receive is sustainable.

By Joshua Ausden,

Editor, FE Trustnet

When measuring an income fund, dividend yield is one of the first things investors look at. Indeed, on a standard factsheet, it’s the only information investors have about the level of dividends that they have generated.

Rob Gleeson and his team at FE Research think looking at this figure alone is not particularly useful – indeed, in some cases they think that it can be misleading.

If you rely on dividends for everyday life, drawing your income at the end of every month or quarter, Gleeson says that dividend stability is far more important than yield.

“What income investors really care about is the money that is being paid every month or quarter, and this doesn’t have a direct relationship to yield. A fund’s yield could go down and the dividend payout could actually increase,” he explained.

It is for this reason that the FE Research team has developed a new system of rating income funds from purely a dividend-paying perspective, explained fully in an article last week.

In the first of a series of studies, FE Trustnet highlighted FE Alpha Manager Francis Brooke’s Trojan Income fund as the best UK equity fund for income investors, thanks not only to its strong yield but high dividend stability and downside protection from a capital growth point of view.

“These are exactly the three factors that we look at, so obviously we’re happy with the result,” said Brooke.

“The sustainability of the dividend is exactly what we’re aiming for. This is the way that income funds should be measured.”

ALT_TAG “The majority of investors in my fund are income investors, so this is very important.”

Brooke (pictured) confirmed that 82 per cent of investors in Trojan Income are invested in income shares, with the remaining 18 per cent in accumulation shares.

He scored top marks for capital protection – unsurprising given how much better he has fared in down markets compared to his peers and benchmark.

Capital growth performance of fund, sector and index since launch

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Source: FE Analytics


The manager says there’s a severe lack of information about dividends in the industry, which has contributed to the over-reliance on yield.

He suggests dividend growth rates should be published on fund factsheets, to help investors identify those that suit their requirements.

“If your dividend is all over the place, that’s not a lot of help to an investor who relies on income,” he added.

Brooke adds that funds which use derivatives to enhance their yield, including the likes of Fidelity Enhanced Income and Schroder Income Maximiser, may pay out a great deal in income overall, but the volatility of call-options means they find it difficult to maintain their payouts.

Indeed, many of these scored poorly from a dividend stability point of view over a three-year period in FE Research’s study, with the Fidelity fund scoring just 11/100 and the Schroder fund just 25/100.

Call options also sacrifice capital growth on the upside, though this is more of a concern from a total return rather than an income point of view.

John Blowers (pictured), head of Trustnet Direct, says the stability of a fund’s income is more important for some investors than others.

ALT_TAG “If you’re in accumulation shares then it isn’t a major issue. The importance of the dividend here is that you can reinvest it and grow your total pot of money, so one payment being more or less than another won’t directly impact the investor,” he explained.

“Those who draw their income have different priorities. Some will see their dividend payment as a bonus. It’s not the be-all and end-all, but is a welcomed pot of money at the end of the month or quarter.”

“For others it is much more important than that. Many in retirement rely on the income from their investments, and if at the very least dividends aren’t staying at the same level after inflation, then it can be a serious problem. It can be the difference between being comfortable and scratching around for cash at the end of the month.”

Gleeson points out that funds with a commitment to sustainable dividends also tend to be those that pay out the most in income overall.

“It always goes back to stability of the dividend. If a manager is committed to paying dividends and has a proven ability to maintain the payout, you’re looking in the right place,” he said.

The likes of Trojan Income, Invesco Perpetual High Income and Rathbone Income, which all scored more than 95/100 from a dividend stability point of view, are among the best-paying income funds in the sector over a three and five-year period.

While some of the highest yielding funds have excelled in dividend payments overall, including those that use call options, dividend stability is generally much lower.

As well as the Fidelity Enhanced Income, Schroder Income Maximiser, RWC Enhanced Income and Insight Equity Income Booster, high yielding funds such as Newton Higher Income and Premier Monthly Income scored 8/100 and 28/100 for dividend stability, respectively.

FE Trustnet will look at the best global equity funds for income in an article tomorrow.


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