We at FE Trustnet have often written why genuine income investors shouldn’t obsess over a fund’s yield when building their portfolio.
That is because, despite the low interest rate environment, an ageing population and the recent changes to the pensions system, there is still an unfortunate lack of transparency surrounding income and therefore many investors will choose an income fund based around how high its published yield is.
The issue with that, however, is yield is simply a fund’s dividend per unit divided by its unit price and therefore its published yield could fall because its unit price has risen, not because the actual amount of income it has paid out has diminished.
Indeed, misunderstanding and a lack of transparency was the basis for our well-supported income campaign. The data also backs up this view, as there was little correlation between the funds that paid out the most in dividends between 2007 and 2014 and their starting yields – as the table below shows.
Source: FE Analytics
While some of the highest yielders did indeed go on to pay out the highest amounts in income, funds such as Santander Equity Income distributed more than PFS Chelverton UK Equity Income, despite the fact it yielded less than half than the Chelverton offering in January 2007.
However, while yield has seemingly had little impact on a fund’s distributed dividends, our data suggests that it does play an important part for investors who are more concerned about growth and total return, rather than income.
The reason for that, as mentioned earlier, is that it can be a good indicator of value. While a high yield can often suggest a dividend cut is on the cards, it can also mean that a fund’s underlying holdings are undervalued.
It is often said that the greatest risk to an investment is the price you pay for it and FE data shows that the highest yielding funds have tended to outperform there lower yielding rivals.
For this study, we used the highly popular IA UK Equity Income sector again and the results showed that an equally weighted portfolio of the 10 highest yielding funds five years ago has gone on to outperform a similarly weighted portfolio of the 10 lowest yielders in the peer group by 10 percentage points since.
Performance of composite portfolios versus sector
Source: FE Analytics
While both portfolios have outperformed the sector average, the portfolio of low yielding funds has only narrowly done so.
It must be noted that we have excluded funds within the sector which ‘boost’ their income via call options (like Schroder Income Maximiser and Fidelity Enhanced Income) and have instead opted for traditional equity income portfolios.
When you look closer at the two portfolios, that outperformance becomes more understandable. The list of highest yielders, for example, includes small-cap orientated funds which many investors were avoiding due to the uncertain backdrop they were faced with in September 2010 as the financial crisis was still fresh in the memory.
However, those include Unicorn UK Income and PFS Chelverton UK Equity Income (which both yielded more than 5 per cent at the time) and they occupy first and second in the sector rankings over the past half a decade thanks to the phenomenal outperformance of mid and small-caps relative to FTSE 100 companies.
The lowest yielding funds, on the other hand, include large-cap orientate portfolios like JPM UK Higher Income, Insight Equity Income and BlackRock UK Income.
Of course, investors should never look to buy an equity fund for 12-month horizon and as we know the past is no guide to the future, but there has also been a clear correlation between yield and performance on an annual basis.
In fact, the highest yielding funds in January 2012 went onto outperform their lowest yielding rivals that year. The same is true in 2013 and 2014, as the table below shows. Each portfolio listed below differs though, as it shows the 10 highest and lowest yielding funds at the start of each of those years.
Performance of highest and lowest yielding funds versus sector
Source: FE Analytics
The portfolio of highest yielding funds in 2012 and 2013 again was largely made up of small and mid-cap income funds which positively flourished in the risk-on environments which characterised those markets, while the lowest yielders were funds that were mainly invested in the FTSE 100.
The portfolios of 2014 were completely reversed though, as the lowest yielders included R&M UK Equity Income, Webb Capital Smaller Companies Growth & Income and Unicorn UK Income which had all returned 30 per cent or more in 2013.
The highest yielders, on the other hand, was made up of large-cap funds like Evenlode Income and BlackRock Income.
As we know now, the FTSE 100 outperformed the FTSE 250 and FTSE Small Cap indices by 3 percentage points that year as investors became concerned about growing macroeconomic headwinds and small and mid-caps stellar gains the year before.
Ben Conway, fund manager at Hawksmoor, says the results show that yield can be a good indicator of value. However he warns that, certainly in the current environment, investors who want either growth or income should never purely focus on a fund’s yield.
“You just have to be very, very careful. You can’t just blindly pick funds because of their yield, you need to compare to a whole host of other metrics,” Conway said.
Conway says this is particularly prevalent for genuine income investors. He says that he and his team never look just at yield when picking income funds for their funds of funds, as there is always the risk that a high yield is generated by exposing the underlying investor to too much risk.
Certainly, while high yielding funds have outperformed their lower yielding rivals on a consistent basis over recent years, it hasn’t always been the case.
This year is a good example, as the portfolio of highest yielding funds at the start of 2015 is underperforming the lowest yielders by 0.2 percentage points year to date.
Performance of highest and lowest yielding funds versus sector in 2015
Source: FE Analytics
The list of highest yielding funds in January 2015 was again dominated by funds which have a bias towards the lower end of the FTSE All Share such as Unicorn UK Income and Marlborough Multi Cap Income, which sit in the top quartile.
However, the portfolio has underperformed against the lowest yielding funds due to the performance of Elite Charteris Premium Income. The fund had a high yield of 4.5 per cent at the start of the year, but also had a very high weighting to cheap mining stocks which have fallen a long way this year due to China’s slowdown.
FE data shows it is third worst performing fund in the sector this year (and still holds Fresnillo and Randgold Resources as top 10 holdings) with losses of 6.83 per cent, compared to a 1.2 per cent gain from the sector average.
