The future of the IA UK Equity Income sector has been one of the major talking points within the fund management industry of late. 
At this point in time, funds have to yield 110 per cent of the FTSE All Share over rolling three-year periods and can never drop below a 90 per cent yield of the index to be a part of the peer group – a criteria which has remained in place for a number of years.
However, that may be about to change as the Investment Association has launched a consultation into that definition following close to 20 funds being booted out of the peer group over the past three years for failing to meet that yield requirement.
Those who argue the sector’s criteria should be changed point to a very odd dynamic in the UK equity market, as companies with safe reliable dividends have seen their yields fall due to share price increases at a time when the index’s yield has risen due to the fact that some of its largest constituents (mining, oil, etc) have seen their share price’s decline and the chance of dividend cuts increase.
Indeed, the major tagline of these ‘exile’ funds is that they have been punished for protecting capital and outperforming.
However, FE data shows that when looking at the 17 funds that have been (or soon will be in the case of Evenlode Income and Montanaro UK Income) kicked out of the sector, they have consistently yielded less than the sector average and have generally paid out less in total dividends over the past five calendar years.
Yield and income performance equity income ‘exiles’ versus sector
Source: FE Analytics *figures based on a £100 investment in Jan 2011
On the other hand, the average IA UK Equity Income exile fund has outperformed the sector average (from a total return point of view) over the past five years by 10 percentage points and has done so with lower volatility and drawdowns.
We will leave the question of what will and should happen to the sector for another day, however, and instead in this article we take a closer look at how the exile funds stack up from a total income, income growth, capital growth and yield perspective.
Total income pay-outs
According to FE Analytics, the average dividend pay-out within the IA UK Equity Income sector on £100 between 2011 and 2015 was £23.26 while the average exile fund paid out £20.98.
Even if you remove the five IA UK Equity Income funds that use covered call options to boost their income, though, the average pay-out in the sector was still higher than the amount paid by the exile.
This is shown on the charts above.
Taking a closer look at the 17 exile funds in question and only one has managed to distribute more than the sector average over that time – Henderson Global Care UK Income (which was booted out in 2014) with a pay-out of £23.88.
Highest income paying IA UK Equity Income exiles
Source: FE Analytics *figures based on a £100 investment in Jan 2011
However, four more funds have paid out more than the sector average of you were to remove the booster funds over that time. They are Invesco Perpetual UK Strategic Income (£23.88), Invesco Perpetual Income & Growth (£23.14), Schroder Income (£23.06) and Evenlode Income (£22.79).
Nevertheless, one of major reasons why issues surrounding the sector have caused such a furore is because of how different investors judge an income fund.
For example, many put much more emphasis on other aspects rather than just total dividends – so have how these funds stacked up using other metrics?
Dividend growth
Open-ended funds are at an immediate disadvantage when it comes to delivering smooth dividend growth given they have to pay out all their earnings (rather than withholding up to 15 per cent each year in the closed-ended space).
Interestingly, however, there are a higher proportion of exile funds that have grown their dividends in each of the last five years (41.2 per cent) than in the IA UK Equity Income sector itself (31.8 per cent).
FE data shows that seven exile funds have achieved this feat.
Exile funds that have grown their dividend over 5yrs
Source: FE Analytics *figures based on a £100 investment in Jan 2011
As the table above shows, these tend to be the portfolios that have paid out the most in total dividends.
This group includes FE Alpha Manager Mark Barnett’s Invesco Perpetual UK Strategic Income fund, Schroder Income and the soon-to-be booted Evenlode Income.
However, it also includes the likes of Montanaro UK Income – which has paid out significantly less in total dividends than the IA UK Equity Income sector average (£18.17 on £100). That being said, for part of the last five years it was a member of the IA European Smaller Companies sector and has only recently changed its mandate.
Capital growth
Dividends and dividend growth are only one piece of the income puzzle, however.
Another vital piece is whether or not a fund has been able to protect and grow an income investor’s original investment, as there is little point drawing income from a pot of capital which is diminishing in size.
For this exercise, we have analysed how the income share classes of each exile fund have performed from a price point of view (again on an £100 investment made in January 2011). It therefore shows the outcome of an investors who was drawing income from each of the fund’s dividend payments rather than reinvesting into their original lump sum.
Best performing exile funds on £100 since January 2011
Source: FE Analytics *figures based on a £100 investment in Jan 2011
Again, it is Mark Barnett’s UK Strategic Income fund which has delivered the greatest return as an initial investment of £100 would have since grown to £157.20 in capital terms. His Invesco Perpetual Income fund, which he took over from Neil Woodford just months before it was ejected from the sector, is second on the list having grown £100 to £148.33.
The large majority of exile funds have (to a varying degree) grown their unit price of the past five or so years as well.
The exception, however, is Webb Capital Smaller Companies Income & Growth. Not only has it been one of the worst members of the mini-sector for income growth and total dividends, but a £100 initial investment in the portfolio would have since fallen to £94.56 in value.
Yield
Though FE Trustnet has written on many occasions how yield can be a poor indicator of future income pay-outs, it is true that it is an important metric to study when first buying a fund.
That because it can be a very useful figure to gauge the ‘value’ of a portfolio relative to its income stream.
Yield has been the reason why all 17 of these funds no longer find themselves in the IA UK Equity Income sector, but given it is largely a reflection of price movements, some are now hitting the peer group’s criteria.
The FTSE All Share currently yields 3.73 per cent (110 per cent of that being 4.10 per cent). FE data shows that eight of the 17 funds are currently yielding more than the index, three are yielding 110 per cent of it and two (Schroder Income and Man GLG UK Income at 4.46 per cent and 4.37 per cent, respectively) are yielding more than the IA UK Equity Income sector average.
Highest yielding exile funds
Source: FE Analytics
Both are value-orientated funds, but the experience of the Schroder Income fund – with its deep value bias – is worth pointing out given the recent debate surrounding the sector.
It has paid out more in income than the average ‘traditional’ IA UK Equity Income fund over the last five calendar years, increased its dividend in each of those years and outperformed from a total return point of view since January 2011, but was moved from the sector last year because of that unit price appreciation.
However, it is now eligible to re-join the sector from a yield perspective thanks to the fact managers Kevin Murphy and Nick Kirrage’s deep value approach has been out of favour which has led to a 10 per cent fall in total return terms (and a 14.32 per cent fall in price terms) over the past 12 months.