Investors seeking diversification in the IMA UK Equity Income sector need to look at funds that focus further down the market cap spectrum, according to Chelverton’s David Taylor.

"There’s no point in holding three or four traditional UK Equity Income funds because they just do the same thing," said the manager of the PFS Chelverton UK Equity Income portfolio.

"I certainly think there is a place for these types of funds – I think the likes of Neil Woodford and Adrian Frost are exceptional fund managers."

"However, if you want true diversification in the UK equity market, a small cap-focused fund like ours or Unicorn UK Income to go alongside one of the big boys is far more effective than just another run-of-the-mill portfolio."

"The vast majority of these funds generate their income from just a handful of companies, which is a big risk if one has to cut its dividend."

Taylor says the BP crisis in 2010 highlighted the importance of diversified UK equity exposure.

"The oil spill taught us two big things: one, that large companies can also be risky, and two, that there is little income diversification among UK funds, because so many had to cut their dividend," he explained.

"All of our stocks contribute and none make up more than 5 per cent of the total dividend."

PFS Chelverton UK Equity Income currently has a one-year historic yield of 6.43 per cent – one of the highest in the entire sector.

Taking a chance on these small cap portfolios has paid off handsomely in recent years; according to FE data, PFS Chelverton UK Equity Income and Unicorn UK Income are the two best-performing funds in the entire sector over three years, with returns of 70.21 and 90.05 per cent respectively.

Performance of funds vs sector over 3-yrs



Source: FE Analytics

Unicorn UK Income is also top of the tree over five years, but a poor 2008 has resulted in third-quartile performance for the Chelverton fund over this period.

The small cap focus of Taylor’s portfolio means that it is significantly more volatile than its peer group, and susceptible to big losses during market sell-offs.

In recent years, a handful of smaller cap-focused portfolios have been launched into the UK Equity Income sector, including Marlborough Multi Cap Income and MFM Slater Income, but Taylor doesn’t think there will be many more in the near future.

"The big fund houses aren’t really interested in these kinds of funds because they can’t grow to a massive level," he explained.

"I’ve always said, I will soft-close this fund when it gets to £250m because I wouldn’t be able to run the same mandate."

"I categorically will not hold a FTSE 100 company, because it goes against everything this fund stands for," he added.

Asked why other funds don’t have more small cap exposure, Taylor replied: "Our expertise is in the small and mid cap market which is rare for an income manager. Moreover, the majority of managers are terrified of straying too far away from their benchmark."

Taylor says he targets 'dull but worthy' companies that have a yield of at least 4 per cent, with the potential for capital growth.

He commented: "The stocks we hold aren’t necessarily the most exciting, but I think this is a strength. They’re not the sort of companies that are suddenly going to blow up – they’ve got a lot of cash on their balance sheets, look to grow their dividends and on average have a price-to-earnings ratio of 10 per cent, which is relatively cheap."

"Take Diploma, for example – a company that has recently increased its dividend by 20 per cent, following an increase of around 30 per cent in each of the two years previous."

The manager says the team is determined to keep its level of income above average, which obviously comes with its risks – two of the fund’s holdings are currently yielding more than 10 per cent.

"We’re very wary of value traps, so of prime importance is determining both the ability and propensity that the company has in paying its dividend," Taylor said.

"We make sure the board understands why income is important to shareholders, and we’re very quick to meet new management and make sure they’re on board."