The Investment Association has been at the forefront of many investors’ minds over the last week, following the news that it has launched a consultation of qualification rules regarding the IA UK Equity Income sector.
This was followed by the announcement that Carl Stick’s five crown-rated Rathbone Income fund was to be ousted from the sector for failing to meet the current requirement, which is to yield in excess of 110 per cent of the FTSE All Share index over a rolling three-year period and not drop below 90 per cent of the index’s yield in any one year.
In an article published earlier this week, Hargreaves Lansdown’s Laith Khalaf said that the IA UK Equity Income sector as it stands rewards failure and punishes success.
“They lead to the absurd situation where an income manager can get kicked out of the sector because they have done a good job in growing investors’ capital,” he said.
“It’s high time the IA UK Equity Income sector definition was reviewed to stop good funds being expelled from the sector on a technicality.”
However, this isn’t an opinion that everybody shares. Last Tuesday editor Gary Jackson called for FE Trustnet readers to offer their thoughts on the sector and whether it is in need of an overhaul.
While some readers such as markS. believe that something needs to be done to prevent high-performing equity income funds from getting kicked out the sector, overall results were certainly mixed.
Jen points out that there are both pros and cons to the current sector requirements and says that, while a lower yield benchmark could discourage active stock selection, the bruised areas of the market are bumping up the yield of the index but are too high-octane for many managers.
Theo argues that income investors are looking for funds that can provide a comfortably higher yield than the benchmark and as such, the current requirements for the IA UK Equity Income sector highlight the investment vehicles that can generate truly desirable levels of income.
The latter sentiment is shared by FE Alpha Manager Stephen Bailey (pictured), who co-manages the Liontrust UK Macro Growth and Macro Equity Income portfolios alongside Jamie Clark and fellow FE Alpha Manager Jan Luthman. 
He says that he cannot see the rationale behind changing the requirements for funds to reside in the IA UK Equity Income sector, given that all managers have the same level of freedom in terms of how they position their portfolios.
“The Equity Income sector has been with us for quite an age now. Just because there are certain areas of the market that are unable to sustain dividends at their current levels, it shouldn’t affect the sector,” he said.
“There’s an all companies sector that’s more than able to accommodate funds that have more of a growth bias rather than an income bias.”
However, the manager says that it would be prudent for the Investment Association to provide clarification surrounding the fact that yields can demonstrate higher risk levels as well as how much underlying stocks are able to pay to shareholders.
He believes that, rather than working entirely from historic yields, there needs to be greater clarity regarding forecast yields and says that adherence to a target yield could perhaps better serve investors’ concerns.
One argument that supports the need for change within the IA UK Equity Income sector is that a significant weighting of the FTSE All Share index is in mining and financials, which are particularly precarious sectors at the moment and therefore provide very high dividend yields to compensate shareholders for the risk they’re taking.
“We’ve actually been able to comfortably generate 110 per cent of the dividend yield of the All Share – we’re in excess of 120 per cent - and yet we haven’t felt the need to be heavily exposed to the likes of HSBC, BP or Lloyds,” Bailey argued.
“There are opportunities away from those income stalwarts. Sadly there is a high concentration of assets within the sector and that’s not a new phenomenon – it’s been that way for a very long time.”
“If you look at the [IA UK Equity Income] sector currently, the funds that did exceptionally well last year were those that were exposed to small and mid-cap sectors and all credit to them because they actually went into a highly specialised area and benefitted from it. I think that’s an example of how the equity income sector can offer variety.”
Currently the manager is seeing the best income opportunities in the financials sector, although he steers clear from any of the larger incumbent banks because of regulatory and balance sheet headwinds.
Instead, he believes that the smaller competitor banks such as Virgin Money, Money Supermarket and Aldermore offer greater income opportunities as they have a greater ability to grow dividends.
“We have a global mandate now to minimise the systemic risk of big banks. We think there are going to be further regulatory calls for big banks to retain a high degree of earnings, increase their capital buffers and the result of that will be very disappointing for shareholders,” Bailey continued.
“If you dig deeper underneath the high yield of the likes of HSBC there are risks that haven’t been fully understood. The opportunities are with the smaller guys - Virgin Money has a dividend yield of about 1 per cent but it’s growing it in excess of 50 per cent per annum.”
“That’s the kind of business that we want to be exposed to - a company that has the ability to increase its dividend rather than one that’s actually struggling to maintain its current pay-outs.”
Other areas of the UK market that offer attractive income opportunities at the moment, according to the manager, are pharmaceuticals such as GlaxoSmithKline and AstraZeneca, and telecoms such as BT and Vodafone.
“We have a preference for the larger businesses currently and, if you look at telecommunications, one of the main attractions to us is the ownership of content,” he explained.
“The reason we don’t find the opportunities further down the cap scale is that the cost of contents becomes very prohibitive so it’s really only available to the very large telecommunication businesses”
“With pharma, people can read too much into Hilary Clinton tweets and when you’re examining it very closely, the idea that she can restrict price increases for drug majors just isn’t realistic, it’s not practical.”
“You’re looking at a wealth of politicians now that are exceptionally worried about health – we’re now looking at a sector that has a lot of political patronage.”
Bailey adds that these are long-term themes and sees no rationale for changing direction as he says that it is easy to get sucked into the mentality of momentum investing in the hunt for yield.
“With regards to income, there’s an awful lot that’s been said and written over the last few weeks about managers falling short of their income targets, they’re going to be disappointing investors by cutting dividends, and that hasn’t affected us at all,” he said.
“Our dividend this year will be 2 per cent higher than the previous year - it’s going to be 8.7p against 8.48p - and we see the opportunity to increase that again next year.”
Over the last decade, Liontrust Macro Equity Income has provided a total return of 80.96 per cent compared to its sector average’s return of 63 per cent.
Performance of fund vs sector and benchmark over 10yrs
Source: FE Analytics
The £521m fund has a clean ongoing charges figure of 0.88 per cent and yields 4.24 per cent.
