Income investors will often turn to a large-cap equity income fund for their core exposure due to the perceived safety of FTSE 100 stocks and because of the index’s robust dividend culture.
This means that the likes of Invesco Perpetual High Income, Artemis Income and Trojan Income have been the portfolios of choice for most given their long and enviable track records, which have been created by focusing on the UK’s highest quality large-cap companies.
Outside of those core equity income names, an increasingly popular trend is to buy more ‘satellite’ areas of the market either through global equity income funds or yielding small and mid-cap funds for diversification purposes.
Allocating to these UK ‘multi-cap’ funds has also proved to be a very successful strategy in recent years as quantitative easing from the world’s central banks, bombed out valuations after the financial crisis, improving economic growth and increased appetite for risk all meant small and mid-caps have performed phenomenally well over the medium term.
FE data shows, for example, that the likes of Unicorn UK Income and PFS Chelverton UK Equity Income, which are predominantly invested in the lower end of the FTSE All Share, have been the best performing IA UK Equity Income funds from a total return perspective over the last five years – delivering returns which are twice that of the wider UK equity market.
Performance of funds versus sector and index over 5yrs
Source: FE Analytics
Nevertheless, investors still see the Unicorns and Chelvertons – along with similar lower cap income funds run by Miton and Marlborough – of this world as merely higher risk options to sit alongside their core large-cap equity income funds.
However, according to FE Analytics, lower-cap income funds have been a genuine dividend-seeking investor’s best bet over recent years.
As the table below shows, aside from the likes of Premier Optimum Income, Insight Equity Income Booster and Schroder Income Maximiser (which use covered call options to boost their income), the Chelverton and Unicorn funds have been two of the best funds in the sector for income generation over that time as well.
Source: FE Analytics
Not only have they paid out more than the sector average, but their dividends have been substantially greater than those of Invesco Perpetual High Income (£2,507 on an initial £10,000), Trojan Income (£2,891 on £10,000) and Artemis Income (£2,452 on £10,000) over the last five years.
Of course, small-caps carry their own risks such as illiquidity and the increased possibility of share price volatility, but Gervais Williams, managing director at Miton, says investors need to have a drastic rethink about generating income. 
He says investors can no longer use large-caps as their primary source of dividends as companies at the top-end of the All Share are facing increased pressures in terms of their future income payments.
All in all, he thinks investors need to be savvier in the way they judge income funds.
“I think this is a very relevant factor as it is all very well and good looking at yield, but it doesn’t mean much if you haven’t got the dividend growth there and you won’t get dividend growth if there isn’t dividend cover,” Williams (pictured) said.
“We are seeing pressure on dividends and over the next six to 12 months bigger companies will continue to see increased pressure on margins. At the end of the day, unless we see earnings growth we are not going to get dividend growth so it is becoming really tough for larger companies to grow their dividends.”
A number of commentators have warned about the dividend outlook for UK large-caps recently.
Franklin’s Colin Morton told FE Trustnet that highly popular income stocks such as GlaxoSmithKline, Vodafone, BP and Shell all face possible dividend cuts if the operational side of their businesses or the industries they operate in don’t improve.
“What is scary about those four companies – BP, Shell, GlaxoSmithKline and Vodafone – is when you put them together, they make up around 25 to 30 per cent of all the dividends the UK market pays,” Morton said.
“We [UK investors] basically have 30 per cent of our pension funds’ dividend payments in these four companies which, arguably, have dividends that are challenged.”
On top of that, FE Alpha Manager George Godber noted that five FTSE 100 stocks had already cut their dividends in 2015 – Centrica, Morrisons, Tullow Oil, Tesco and Severn Trent – as well as Sainsbury’s which cut earlier this week.
Godber’s major concern is that not only is the FTSE 100 now expensive, but that many companies don’t have the financial stability to maintain their dividend at current levels. He expects further dividend cuts over the next year and says that utilities, oil and mining companies are now at most risk.
“We are not anti-large cap at all but few shares meet our strict valuation and financial strength criteria in the FTSE 100,” Godber said.
“Whilst the prognosis at the larger end is somewhat bleak, we have overall been a net new buyer of shares in the quarter. Further down the market cap spectrum valuations are better and we are finding many rock solid balance sheets to go with it.”
Williams says the tell-tale sign that large-cap equity income funds may be at risk is because dividend cover has fallen substantially over recent years. The graph shows the historical dividend cover on the FTSE All Share, which is roughly 80 per cent weighted to the FTSE 100.
Dividend cover within the UK equity market
Source: Miton
However, Williams points out that investors can find much higher levels of dividend cover – a stepping stone for dividend growth – within the land of smaller companies.
This was demonstrated in a graph put together by the team at Montanaro, which while slightly out of date, shows that dividend cover in the Numis Smaller Companies ex IT index is far higher than the FTSE All Share’s.
Indices’ dividend cover
Source: Montanaro/Numis
Nevertheless, there will be income investors who will always want to generate the majority of their income from large-caps, rather than small-caps, and that is because smaller companies tend to be more volatile.
Certainly, dividend growth of, say, 5 per cent doesn’t mean much to an investor if the amount they originally invested were to sharply fall by 20 per cent; as can often be the case in the small and mid-cap indices.
On top of that, given the growing macroeconomic concerns, high equity valuations and political uncertainty in the UK, investors have understandably gravitated towards large-caps for their perceived safety at the expense of smaller companies.
However, Williams says investors are making a mistake if they have that view.
“The Buffett view is that risk isn’t volatility, but an outcome that you weren’t expecting,” Williams said.
“However, I think the bigger issue is that you can find a better margin of safety in small-caps. You can find better balance sheets, better dividend cover and the valuation gap between small and large-caps is now very wide.”
He added: “This is going to be a very big issue in the UK market.”
