The strong performance of mid and small-caps, relative to their mega-cap rivals, has meant yield compression has been rife across the UK’s smaller company’s indices.
Performance of indices over 5yrs
Source: FE Analytics
This has left certain managers in the IMA UK Equity Income sector in danger of missing the trade body’s sector guideline that says funds must yield 10 per cent more than the FTSE All Share, which currently yields 3.5 per cent.
Henderson, who has a high weighting to small and mid-caps, was one such manager.
His primary focus is finding a growing source of income and that usually revolves around identifying companies that have the ability to grow.He moved his fund into the IMA UK All Companies sector last year because he thinks the current guidelines are forcing investors into a value trap and he doesn’t want to have to change his strategy.
“To stay in the sector, it would have required a real move up the market cap and I think I would have given it [the fund] to someone else,” Henderson (pictured) said.
“There are only 70 companies in the FTSE 350 that yield above 3.5 per cent, so you are corralling yourself into just a few stocks. If I were to stay in the sector, it would have been a constant battle.”
The five-crown rated Henderson UK Equity Income & Growth fund currently yields 3 per cent, which some investors may see as unappealing. However, the manager says focusing on yield is a big mistake and instead his primary source of income is all about finding those companies that can grow their dividend.
“The idea is to grow the capital with an income discipline, that’s when you get genuine income. The philosophy is if you bleed the capital and take it as income, you end up with less capital and less income over time.”
“You’ve really got to grow the capital; you should never buy something that just has a high yield because you are just going down a cul-de-sac. Too many people are being corralled into too few big companies that aren’t really growing.”
Henderson is among a number of managers who have moved their fund out of the IMA UK Equity Income sector recently, with the five-crown rated Invesco Perpetual High Income and UK Strategic Income funds also making the switch.
Simon Moon, manager of the predominantly small-cap Unicorn UK Income fund, said that yield compression in smaller companies was such an issue at the start of the year that it was one of the main reasons why he, John McClure and Fraser Mackersie increased their weighting to the FTSE 100 to 15 per cent.
That weighting has since reduced following the sell-off in mid-caps this year, however.
Performance of indices in 2014
Source: FE Analytics
Nevertheless, a recent survey of leading fund-pickers at the FE Select 100 Equity Income Conference showed that close to 40 per cent think the IMA should do away with its 110 per cent yield target due to the complications it was creating.
FE Research’s Rob Gleeson has told FE Trustnet on numerous occasions about the dangers of judging income funds on their yield. He and his team have recently devised a new rating system for income funds as a result.
This analyses the stability of a fund’s dividends, its ability to protect capital on the downside and then its yield.
Henderson understands why some investors would prefer a higher starting yield; however he says that if investors aren’t more flexible they will just end up holding mega-caps that have little growth left.
“For me, there are few moments in investing where I suddenly learn something. One of them was in the early 1980s when I found an FT from 1932 and looked down at the FT Top 30, and it’s like ‘where are they now?’ They’ve all gone.”
“Today’s big company can be tomorrow’s big company, but more likely, it won’t be.”
“We’ve got no Tesco in the fund and 25 years ago Tesco was the young kid on the block. It was the one that was going to bash Sainsbury’s up and grow rapidly; and then it became big and the established blue-chip that people had to have in their portfolios.”
“I didn’t know it was going to go wrong like it has, but one thing I know is that the life cycles of companies are getting shorter; you’re not the top dog for long. People know whose prices are competitive faster now thanks to price comparison websites, there is nowhere to hide.”
This process has certainly worked for Henderson in the past. According to FE Analytics, his £570m UK Equity Income & Growth fund has returned 125.54 per cent since the manager took over in January 2005, beating the FTSE All Share by close to 50 percentage points.
It has comfortably beaten the IMA UK All Companies and UK Equity Income sectors over that time.
Performance of fund vs sectors and index since Jan 2005
Source: FE Analytics
It has significantly outperformed those two sectors and the index over one, three and five year periods.
Our data shows that investors would have earned £458.30 in income if they had bought £1,000 worth of units in Henderson’s fund when he took over. However, that means it would rank 46 out of 49 in the IMA UK Equity Income sector for its dividends paid out over that time.
While a number of experts commend Henderson for sticking to his investment approach and moving sectors, it has put certain investors in a difficult situation.
One of the major reasons why the IMA has its sector guidelines is to allow the underlying investor to fully understand what type of fund they are buying and to try and create better transparency.
While the manager says the fund will always have an income mandate, he has upped his exposure to non-dividend payers recently, which could come as a concern to some investors.
However, they only account for 10 per cent of the portfolio and the manager says his fund’s dividend growth will be 7 per cent this year.
Henderson also says that he has never really attracted fund-pickers who have tried to pigeon-hole his portfolio.
Neil Shillito, director at SG Wealth Management, is a fan of the fund, but he isn’t concerned about Henderson moving out of the sector as he likens the manager’s view on yield to choosing a manager who is benchmark agnostic.
Henderson UK Equity Income & Growth has an ongoing charges figure (OCF) of 0.84 per cent.
