A large share of the funds within the IA UK Equity Income sector are currently yielding less than the peer group’s yield target, according to research by FE Trustnet, thanks to a record gap between the companies at risk of cutting their dividend and ‘safer’ holdings.
At the end of January 2016 the yield on the FTSE All Share stood at 3.83 per cent, although UK equity income managers have argued that this disguises a difficult situation where the market’s yield is being pushed up by a handful of dominant dividend payers that investors think will be forced to reduce to their payouts.
Problems for IA UK Equity Income funds emerge because of the sector’s yield requirement: in order to stay in the peer group, members have to produce a yield that is 10 per cent higher than the FTSE All Share’s. At current levels, this would mean a fund needs to yield 4.2 per cent in order to remain compliant, but to achieve this it might need to hold stocks with large question marks over their income outlooks.
Our data shows that the average yield in the sector is currently above the target at 4.45 per cent, although this does include the yields of the ‘enhanced’ income funds that use covered call options to boost the payouts generated by their portfolios. When these are stripped out of the data, the sector’s average yield falls to 4.26 per cent.
Furthermore, 31 non-enhanced funds of the 71 fund that we hold yield information on are below the 4.2 per cent yield that the sector demands. The below table shows the 10 lowest yielding members of the peer group.
Source: FE Analytics
It’s important to note that this does not mean this funds will be ejected from the sector; the yield target is only looked at upon the fund’s year end and is considered over rolling three-year periods to prevent funds being overly penalised for one weak year.
However, any fund yielding less than 90 per cent of the FTSE All Share in any year can be removed from the sector. At the moment this equates to a yield of 3.5 per cent.
As the table above shows, three funds – Investec UK Equity Income, Henderson UK Strategic Income and CF Woodford Equity Income – are currently below this (but as the Investment Association rounds yields to one decimal place, the Woodford fund would meet the 90 per cent requirement).
Recent talk about the UK income market has revolved around the risk of dividend cuts. A number of names have already reduced payouts to shareholders – including Glencore, Tullow Oil, Standard Chartered, Centrica and Tesco announced cuts in 2015 – and this is expected to continue this year.
This week has seen BHP Billiton slash its dividend for the first time in 15 years, announcing a 75 per cent cut, and adopted a 50 per cent dividend payout ratio as part of a new “transparent capital allocation framework”. The strong falls in the prices of many commodities and the effect this has had on natural resources companies’ profits means that the sector is being closely watched by investors for further dividend cuts.
This clouded outlook for dividends from some of the market’s biggest payers has pushed down their share price, but this has caused yields in certain areas like oil and mining to spike, which has lifted the index’s yield and made it harder for equity income funds to achieve the required yield without exposing investors to companies that might cut payouts, managers argue.
Eric Moore (pictured), manager of the FP Miton Income fund, said: “It makes it harder [to hit the yield target], perversely, because the yield in the market keeps going up. The yield is going up, but it’s mainly because of things like Shell that have dragged the index’s yield up.”
“When you look at the yield on a median, rather than mean, basis it has gone down but the sector requirements work on the mean not the median. The median yield in the market is about 3.4 per cent and the mean is about 4 per cent – that’s quite a big gap.”
“Income has always been quite skewed towards bigger stocks. People point out that income in the UK market is concentrated in just a few names, but that’s nothing new. What is new is that some of those big guys now yield something like 8 per cent when the median has been dragged down.”
FP Miton Income is currently yielding 4.20 per cent and has paid out £3,000 on an initial investment of £10,000 made at launch in April 2007.
Income earned on £10,000 since launch
Source: FE Analytics
Nick Kirrage, co-manager of the Schroder Income fund, highlights the “weirdness” of the UK income-paying market, where two-thirds of dividends are paid by just 20 business. He notes that many of these dominant firms, such as HSBC, Shell, BP, Rio Tinto and BHP Billiton, are yielding more than 8 per cent and in some cases are into double-digits.
At the same time, the yields on companies without a negative income outlook have been forced ever lower and investors flocked to them in the search for yield and relative safety during the QE-fuelled market recovery.
“It looks like the market is yielding about 4 per cent still but that is a counterweight between 20 enormous companies that the market is telling you are unsustainable and a huge number of companies that have yields that are much, much lower,” he said.
“We’re now at the lowest level in history when it comes to the percentage of companies that are actually yielding more than the market. I think that’s a very telling stat.”
The IA UK Equity Income sector’s yield requirement is a controversial subject and has led to a number of funds – including Invesco Perpetual Income, Schroder Income and Henderson UK Equity Income – departing the peer group in recent years.
But in the sector’s rules, there is the provision for an adjustment to the yield target to be considered in the event of “extraordinary market factors”, should half the peer group’s members by number or 80 per cent by assets request it.
FE Trustnet understands that a number of fund groups have approached the trade body with this request but when asked, the Investment Association could not confirm if this was the case.
“The Investment Association is always open to discussions on how to improve the fund sectors. The current equity income methodology has been agreed by the sectors committee, which comprises members and data providers,” a spokesperson said. “We have an ongoing dialogue with sector users and members to ensure that sector definitions remain fit for purpose as the external environment changes.”
In the meantime, UK equity income funds face a difficult choice – run the risk of failing short the yield target in the hope it can be clawed back over the rest of the rolling three-year period on which they are judged or look at add yield through companies that market fears may cut its dividend.
Some groups, however, are embracing the fact that their yield is low, given the state of the market. Troy Asset Management chief executive Sebastian Lyon holds the view that the high yields found in some parts of the market is “a health warning of further dividend cuts to come” and reassures that Francis Brooke’s Trojan Income fund – which is yielding 3.82 per cent – will not be chasing this.
Performance of fund vs sector and index since launch
Source: FE Analytics
“It is notable that the yield on the Trojan Income fund is now below the UK market’s yield. This should reassure Trojan Income fund investors. The same occurred in 2008 prior to a rash of dividend cuts, mainly from the banking sector. Funds with premium income may be reaching for excess income, putting capital at risk,” Lyon said.
“Looking at potential cuts over the next few years, we estimate the genuine market yield may be as much as 1 per cent lower than the stated historical level. That still includes many companies that have increased their payout ratio this cycle. If we were to adjust their payments to the 10-year average ratio, yields fall to 2.4 per cent. Hardly a bargain.”
