The removal of the Schroder Income fund from the IA UK Equity Income peer group has brought the sector’s yield target back into the spotlight, with some industry members calling for the Investment Association to scrap the tough rule.
Numerous portfolios – including high-profile names such as Invesco Perpetual’s Income and UK Strategic Income funds – have left the sector over recent years because they failed the yield requirement, leading to the rule being seen as somewhat controversial.
In order to qualify for membership of the sector, UK equity income funds have to achieve a historic yield on the distributable income in excess of 110 per cent of the FTSE All Share’s yield at the fund’s year end. Those that fail to meet this target leave the sector – often to the IA UK All Companies peer group but some have gone into IA Unclassified.
The latest fund to be removed from the sector is the £1.6bn Schroder Income fund, which is headed up by the FE Alpha Manager duo of Kevin Murphy and Nick Kirrage. The five FE Crown-rated fund currently has a yield of 3.43 per cent, while the FTSE All Share is yielding 3.46 per cent.
On the back of this, Schroders called for the Investment Association to review how it determines what a UK equity income fund actually is, arguing that looking at headline yield alone may not lead to the best outcome for investors.
Robin Stoakley, managing director of UK intermediary at Schroders, said: “We are disappointed with the Investment Association’s decision to remove the Schroder Income fund from the IA UK Equity Income sector.”
“We believe that the methodology used by the IA to calculate the yield requirement is outdated and that end consumers are seeing a sector that is not a true representation of UK equity income funds. We are concerned with the direction that the sector is taking and believe the IA needs to rethink its calculations.”
Source: FE Trustnet
As the above graph shows, it’s hard to argue that Schroder Income has performed poorly from an income point of view. Between the start of 2007 and the end of 2015’s first quarter, the fund paid out a total of £3,657 on an initial investment of £10,000.
Of the funds remaining in the IA UK Equity Income sector, 56 have a track record spanning back to the beginning of 2007 and Schroder Income is ranked second for total income paid. It’s only been beaten by Schroder Income Maximiser – which is the same underlying portfolio, with call options used to boost income.
Another interesting point from the income history graph is that the fund has significantly lifted its income payout in every year since 2010 – which is when Kirrage and Murphy were handed the portfolio. Many investors want to have a growing source of income, rather than a high starting yield.
Schroder Income has also performed well from a total return point of view, gaining 91.34 per cent over the managers’ tenure against a 71.74 per cent return from its average peer and a 57.66 per cent rise in the FTSE All Share.
Performance of fund vs sector and index over managers’ tenure
Source: FE Analytics
For its part, the Investment Association says it is “always open” to discussing how to improve its sector classifications.
The trade body said: “The current methodology has been agreed by the sectors committee, which comprises members and data providers.”
“Schroders’ ideas have merit and will be considered by the sectors committee as the Investment Association continues dialogue with sector users and members to ensure that sector definitions remain fit for purpose as the external environment changes.”
Of course, if investors prioritise income payments over total return then few of the 14 funds that have left sector over recent years are likely to completely meet their needs.
The average income payout of the remaining IA UK Equity Income funds between the start of 2007 and the first quarter of 2015 was £3,502 on an initial £10,000 while it stands at just £3,022 for the average sector refugee.
Only Schroder Income has beaten the average income. However, those that haven’t have still beaten some of the remaining funds in the sector – after all, it’s impossible to have every member delivering higher than average income.
Adrian Lowcock, head of investing at Axa Wealth, says that as the hunt for income continues, it is becoming harder for equity income funds to achieve the sector’s yield target and is wary of managers who do anything they can just to stay in a sector.
“For equity income, the last thing I would like to see is a manager chasing yield just to stay in a sector. Chasing yield for yield’s sake can be dangerous and not in the best interest of investors over the medium and longer term,” he explained.
“Fund managers who are good in this space look for companies that do not necessarily have high yields but are able to grow their dividends over time. To do this, income managers sometimes need to be more flexible than a sector’s rules require and therefore might not meet the criteria required to be included.”
“Investors, therefore, should use the sectors as a starting point or guide to identify the right funds, but not as the only place to look. They can provide a good source of information and performance comparison but ultimately any investor will have to do a little bit more work to identify the right funds and make sure they are suitable for them.”
Our data shows that the typical fund to have been kicked out of the IA UK Equity Income sector has performed marginally better than the average fund still in the peer group when it comes to total return. Both sets have beaten the average IA UK All Companies fund and the FTSE All Share.
If you’re investing in equity income for the compounding power of dividends rather than the income earned from your funds, this could suggest funds that leave the sector are still a valid choice despite the view of some that they aren’t ‘proper’ UK equity income funds.
Performance of sub-sectors vs sector and index over 5yrs
Source: FE Analytics
Martin Bamford, chartered financial planner at Informed Choice, has some sympathy for funds that have been removed from the sector, but argues that the rules are clear and portfolios should have to adapt to them, not vice versa. However, he agrees that finding a good equity income fund is about more than yield and sector placement.
“The definition is clear. If achieving at least 110 per cent of the FTSE All Share yield is unachievable, then it suggests the aim of the fund needs to change or managers need to place a greater emphasis on yield, perhaps at the expense of capital preservation,” he said.
“Investors should be careful about using IA sectors to compare funds, especially on performance terms, as increasing the sectors can contain a real mix of fund types. The Unclassified sector, for example, is next to no use for any relative comparison purposes and IA Property contains everything from ‘real’ property funds to overseas property share funds, so comparisons are difficult to make on fair terms.”
“When selecting a UK equity income fund, investors should be looking at historic yield, capital preservation, volatility, consistency, risk-adjusted returns and cost. It’s never enough to simply look at relative performance and yield, and pick a fund based on those simple measures.”
