Equity income has been a popular with investors for quite some time but recent warnings about its future direction have prompted questions over whether better opportunities will soon exist elsewhere. 
One of the factors that has driven the strong returns of dividend-paying stocks has been the huge quantitative easing programmes and low interest rates used by central banks in the aftermath of the financial crisis, which pushed them from bonds to equities.
However, with the prospect of interest rates rising in the US and the UK at some point firmly in investors’ minds, there are worries that equity income will be hit hard as investors in dividend-paying stalwarts – often known as ‘bond proxies’ – move back to fixed income when rates are higher.
FE Alpha Manager Steve Russell, who heads up the Ruffer Investment Company, recently told FE Trustnet that he believes a crash in defensive income stocks could be on the cards.
He said: “We are as fearful as ever – we are acutely aware that the hunt for yield across all markets has driven prices higher, but it won’t last forever. We don’t know when it will come, but it will.”
“Equity income is an especially dangerous area as it has an aura of safety, but in our opinion in some cases high yield stocks are just as dangerous as a biotech stock given the prices they’ve been bid up to.”
“We have been increasingly moving out of high income stocks which we now view as extremely dangerous, because it seems that many owners of them see them as risk free. It will all end in tears.”
Others including Margett’s Toby Ricketts, Investment Quorum’s Peter Lowman and City Financial’s Mark Harris have also warned investors to think tactically and focus on growth and value in order to protect their portfolios this year.
Figures from the Investment Association show that UK growth funds have been distinctly out of favour, with the IA UK All Companies sector being hit with net retail outflows for 11 of the past 12 months. IA UK Equity Income funds have benefited from strong net inflows over this time.
Still, a poll of discretionary fund managers and fund of fund managers at the FE UK Growth event held in April found that more than 70 per cent of participants believe the IA UK All Companies sector is due a revival.
Performance of indices in 2015
Source: FE Analytics
While income remains a popular choice for retail investors, do the high valuations in some parts of the market and the risk of interest rates rises means these funds – especially those with a high weighting to so-called bond proxies – mean this space is best avoided for now?
David Coombs, head of multi-asset investments at Rathbones, has been reducing the weighting to income funds in his multi-manager portfolios and buying those with more of a growth style, which is why he’s currently overweight technology and healthcare.
“I’ve incrementally been doing that over several months and even in recent weeks I’ve been selling income funds,” he said.
“I’ve been slowly re-setting the portfolios. Fundamentally it’s on valuation grounds but I also think in a rising interest rate environment that you want to buy growth stocks. If you have rising interest rates, the cost of capital increases and you want to buy quality companies that are not heavily indebted and can grow their top and bottom line. What you don’t want in rising interest rates is long-duration assets.”
“I’d rather have lower yielding stocks with more growth than higher yielding stocks ex growth, so I want lower yielding funds not higher.”
However, fund managers are able to make these changes because they can afford to take a more tactical approach.
For retail investors who are investing for the long haul, is it wise to sell out of the likes of long-term investors such as Neil Woodford and Mark Barnett simply to avoid a period of potential underperformance?
Premier’s Simon Evan-Cook doesn’t think they should and has not reduced his exposure to equity income funds either.
“If you’re backing a manager like Mark Barnett or Neil Woodford you should expect to be with them for the long term. Trying to guess when they’re about to underperform or outperform normally ends in tears, so with those types of managers I think they’re buy and hold,” he said.
“Potentially, you could even argue that we’re late in the cycle and that actually valuations across just about everything are quite high, which means that being in a fund such as Woodford’s fund or Barnett’s fund, which are typically quite defensive, might actually turn out to be in a very reasonable place to be compared to some higher growth mandates.”
“I would caution against the strategy of trying to call what’s going to happen to a particular fund. It’s very difficult to time that type of thing.”
Hargreaves Lansdown’s Mark Dampier agrees and remains perplexed as to why people would even consider altering their portfolios to accommodate the potential macroeconomic headwinds facing equity income funds.
“Bond rates aren’t expected to rise that much, it’s just the normal talk – I just think it’s a mug’s game,” he said.
“The truth of the matter is, of course, your portfolio style should be one of inactivity most of the time – it’s not one that’s very popular because people think you should be buying and selling like dervishes. Actually, that secures you and just because everyone says it’s a bond proxy, it’s not really a bond proxy at all. These dividends actually rise, bonds don’t see their dividends rise and they’re incredibly low, so I don’t even completely buy the story.”
“To some extent, some of those stocks have been up a bit more, but they’re still giving you a rising income and, as I’m going to be holding for 10 years or so, am I really going to try and trade nuances which may or may not come about?”
What’s more, Parmenion’s Meera Hearnden pointed out that, over 10 years the FTSE 350 Lower Yield index has outperformed the higher yield index by almost double, delivering a total return of 151.02 per cent to date.
Performance of indices over 10yrs
Source: FE Analytics
The underperformance of high-yielding stocks to low yielding ones suggests to Hearnden that there could be some value in equity income styles. Furthermore, she says investors have a range of options to choose from when it comes to equity income funds, so they need not drop the asset class entirely.
“Investors should maintain well-diversified portfolios and this means equity income can form a core element of many portfolios come rain or shine,” she pointed out.
“If an investor feels that some equity income funds might roll over after a good period of performance, the sector is home to many other funds with different styles and market cap biases and diversification can be achieved by investing in equity income funds with complementary styles, so that good performance can be achieved in a variety of markets.”
“There will be periods when equity income funds falls out of favour, but this should not automatically trigger a sell. As long as the long-term fundamentals remain sound, the skilled managers within the equity income sector should be able to demonstrate that periods of underperformance are more than made up for in outperformance over the longer term.”