The consensual view is that dividend cuts are going to increase within the UK equity market over the short to medium term given pay-out ratios have increased, earnings growth has been slowing and dividend cover has been falling. 
Most of these concerns have centred on commodity-related companies (which make up a large chunk of the UK index) as they have faced the clear headwind in the form of a severe plunge in the price of oil and iron ore.
However, given a number of other UK large-caps have challenged futures thanks to poor operational performance, growing macro headwinds and stretched balance sheets, certain industry commentators have said that dividend cuts will be widespread.
This is clearly frustrating news for investors: the demand for income has only increased over recent years as bond yields are so low, the population is ageing and there have been changes to pensions system.
Ben Willis, head of research at Whitechurch, says equity income will remain a popular asset class but investors need to think hard about which managers they should choose to protect their portfolios from future income reductions.
“Our preference for dividend-producing shares remains a core theme,” Willis (pictured) said.
“We see a UK interest rate rise unlikely this year, with rates remaining at a very low level for a considerable time given the fragility of the global economy, and this will be supportive for dividends. The key for equity income managers in 2016 will be avoiding the dividend cuts as we could see some high profile casualties.”
Therefore, in this article Willis highlights three UK equity income funds he and the team are backing in the hope they won’t be caught out by potential dividend cuts.
First up, Willis is a fan of the five crown-rated CF Miton UK Equity Income fund, which is co-managed by Gervais Williams and Martin Turner, thanks to its focus on the lower end of the market cap spectrum.
Willis points out that investors can find higher levels of dividend cover in the mid and small-cap space compared to large-caps and, given Williams and Turner’s experience in that part of the UK market, he sees the fund as a decent option going forward.
“The headline dividend cuts seem more likely to come from the large-cap space and while the Miton fund is a multi-cap portfolio, it is largely invested in mid-caps, small-caps and AIM stocks,” Willis said.
“While I’m not saying these areas are immune from dividend cuts, I think backing smaller companies gives you more of a cushion in that respect given the pressure has been on commodity companies and other large-caps.”
“I think Gervais Williams is an excellent manager and an expert in that part of the market, so we are confident he will be able to produce a growing income.”
Performance of fund versus sector and index since launch
Source: FE Analytics
According to FE Analytics, the £620m fund has been the best performing portfolio in the IA UK Equity Income sector since its launch in October 2011 with returns of 112.51 per cent. As a point of comparison, the FTSE All Share has made 40.01 per cent over that time.
The fund, which yields 3.86 per cent, holds 30.6 per cent in AIM-listed stocks, 19.8 per cent in the FTSE 250, 17.1 per cent in the FTSE Small Cap index and just 16 per cent in the FTSE 100. The managers also have put options on the FTSE 100.
Thanks largely to managers’ area of focus, CF Miton UK Multi Cap Income has been one the highest dividend paying portfolios in the sector since launch (paying out £2,552.48 on an initial £10,000 investment) and has increased its distribution in all but one calendar year since launch.
While it is fast becoming the most popular UK equity income portfolio, Willis says the now £8.4bn CF Woodford Equity Income fund is a very good option for those who want to avoid potential dividend cuts.
That being said, the fund – which is headed by star manager Neil Woodford – has received some negative press recently due to its low yield of 3.46 per cent and some fear that, if it continues to remain low, it may be forced to move out of the IA UK Equity Income sector due to the Investment Association’s yield requirements.
Nevertheless, Willis likes the fact the manager isn’t changing his process and taking overly risky bets.
“Though there have been concerns about the fund’s low yield and how it may be kicked out of the IA UK Equity Income sector because of it, I’m sure Neil Woodford doesn’t care as he won’t chase yield,” he said.
“He has enough money and support behind him so that he can stick to his views. One of his biggest bets is the pharmaceutical sector which could come under pressure in terms of future dividends, but due his strategy, he doesn’t hold banks or miners and no longer holds the major oil companies.”
He added: “We know we have a relatively safe pair of hands in Neil Woodford.”
Performance of fund versus sector and index since launch
Source: FE Analytics
Woodford has continued his stellar long-term track record from Invesco Perpetual at his new group as, since launch in June 2014, CF Woodford Equity Income has been the best performer in its peer group with gains of 18.42 per cent.
On the other hand, the FTSE All Share has lost money over the period.
It must be noted, however, that not only does the fund have one of the lowest yields in the sector, it was one of the lowest dividend payers in 2015. It paid out just £305 on £10,000 last year, which was some £110 less than the ‘average’ member of the peer group.
The final fund is another low yielder, but Willis is backing FE Alpha Manager Francis Brooke’s Trojan Income portfolio to continue its unbroken dividend track record.
Willis likes the fund – which weighs in at £2.5bn and carries five FE Crowns – due to its defensive characteristics and as the manager focuses on producing income growth. As the table below shows, Brooke has been successful in that respect given it has been one of the highest dividend payers in the sector since its launch in September 2004 and has never reduced its annual distributions.
Trojan Income’s dividend pay-outs in pence per unit over 10yrs
Source: FE Analytics
Brooke recently told FE Trustnet that he wasn’t bothered by his fund’s low yield (which stands at 3.72 per cent) either, as he says it just shows his holdings held up better than the market in 2015’s turbulent conditions.
Willis agrees, pointing out how he likes Brooke’s focus on prioritising capital by backing companies with sound balance sheets, low gearing and reliable earnings.
“This is a fund that has an exemplary dividend track record. The fund is very income-orientated and is plain vanilla in many ways as, thanks to their analysis at a stock level, the team won’t invest in those companies with challenged dividends.”
“Where Brooke has really earnt his stripes is his fund tends to hold up much better when the market is under stress and that is why it has been able to deliver its outperformance.”
Trojan Income has been a top decile performer in the sector, and beaten the FTSE All Share, over one, three, five and 10 years.
Thanks to its top decile performances in falling markets like 2008 and 2011, Trojan Income has had the second highest risk-adjusted returns, second lowest annualised volatility and lowest maximum drawdown in the sector over the past decade.
Brooke’s top 10 holdings include defensive large-caps such as Unilever, Imperial Tobacco and GlaxoSmithKline.
