Dividing UK equity funds into IA UK Equity Income and IA UK All Companies sectors could be encouraging managers to take on inappropriate levels of risk to hit yield requirements, according to Francis Brooke (pictured). 
The FE Alpha Manager, who heads up the five crown-rated Trojan Income fund, says that the Investment Association should instead combine both sectors so that investors can make their own decision as to how much risk they take and how much yield they require from the funds they choose.
The suggestion comes following the fact that Brooke, whose fund currently yields 3.6 per cent and has an unbroken dividend growth record, could be ousted from the equity income sector for failing to produce a yield that is 10 per cent more than the FTSE All Share over a rolling three-year period.
Brooke isn’t the only one to call into question the Investment Association’s criteria for being a member of the IA UK Equity Income sector.
Following high-profile UK equity income funds such as Mark Barnett’s Invesco Perpetual High Income, Carl Stick’s Rathbone Income and Henry Dixon’s Man GLG UK Income being moved into the IA UK All Companies sector over the last couple of years, a number of investment professionals have called for the Investment Association to reconsider the barriers to entry.
“The current IA UK Equity Income rules reward failure and punish success,” Hargreaves Lansdown’s Laith Khalaf said in an article published in April.
“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. 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.”
The Investment Association recently announced that they are considering changing the IA UK Equity Income requirements and, at the end of last month, said that they will conduct consumer research into how the sector should be dealt with.
Brooke, however, believes that the sector should be scrapped altogether in order to keep income funds with similar mandates all in the same place. Failing this, he believes that the yield requirements of the IA UK Equity Income sector should be set lower given current challenging macroeconomic conditions.
“I think the IA is in an invidious position. It’s a very difficult line to draw. We’ve made it pretty clear that we’re not going to change the way we run the fund and it does seem strange that funds which have done well – i.e, produced a good capital return as well as income – should be regarded as having somehow not fulfilled their obligations to investors as income funds,” he said.
“If you’ve outperformed the market as we have for quite some time and that has been a combination of capital and income, your yield will be significantly lower than if you’d have just moved in line with the market, for argument’s sake.”
Performance of fund vs sector and benchmark over 5yrs
Source: FE Analytics
“The denominator effect is important to recognise. Our view is that this is not a time to be pushing an equity fund to deliver yield at a level which could compromise capital. As far as we’re concerned the current requirements are arbitrary and, in certain conditions, inappropriate.”
The struggle for yield has been well-documented over the last year or so, given historically low interest rates, gilt yields at an all-time low and a large number of blue-chip companies warning of potential dividend cuts.
As such, many investors are either turning to expensive and defensive dividend-paying companies or ‘bond proxies’, or they are upping their risk threshold to buy into companies that have precarious balance sheets and high yields.
“There are quite a lot of income funds that have already been moved across into the IA UK All Companies sector when actually they are income funds and, in a low inflation environment where cash produces virtually nothing, 10-year gilt yields are now down to well below 1 per cent, getting between 3 and 4 per cent from an equity portfolio I would say is a very healthy income,” Brooke pointed out.
“With the perception of income, it has to be borne in mind as to what is appropriate for the conditions that we find ourselves in when you look across different asset classes. “
“By removing this arbitrary decision and basically leaving it to investors and intermediaries to make their own decisions about what is an appropriate income fund or an appropriate growth fund for their investors, to me would make more sense.”
However, the decision to merge IA UK Equity Income and IA UK All Companies into one sector isn’t clear-cut. For instance, high-growth, high-risk funds with highly cyclical holdings could be crowned the top-performing UK equity fund over a certain time frame, despite the fact that income funds have a different mandate and focus on dividend yields as well as capital appreciation.
“It’s true that there is no perfect world here. Personally, what I would rather was that all the genuine income funds – I think there are quite a few genuine income funds which yield less than the current IA requirement – they should all be together but at the moment they’re split already and that split is going to get greater,” Brooke continued.
“On the basis that you just have to look at all the yields on FE Trustnet and you can see that quite a few funds are running very, very close to the line.”
10 IA UK Equity Income funds with the lowest yields
Source: FE Analytics
“If you think that all funds yielding less than, say, 3.8 per cent are going to be moved out of the IA UK Equity Income sector, there isn’t going to be much within the sector certainly in terms of value because some of the biggest funds are going to come out.”
“The other side of the coin is, how representative is a UK equity income sector which only has high-yielding equity funds in it – how misleading is that to investors? That they’re told these are the income funds and the IA UK All Companies sector holds the growth funds when actually it will contain a lot of income managers with very good long-term track records. That’s not a very good outcome either.”
The FE Alpha Manager also points out that, when multinational firms are removed from the FTSE All Share index, it has a yield of 3.1 per cent. He says that this excludes stocks in high-yielding areas of the market where investors are most concerned about the likelihood of dividend cuts.
“That to me tells you that, to ask and expect investors to be generating yields between 3.5 and 4 per cent to be regarded as income funds, is probably not in the investor’s best interest,” he said.
“The nub of my argument is that, unless the yield requirement is lower and it keeps the genuine income funds together, you’d actually be better off having one sector.”
“In an ideal world the yield requirement would be dropped to what might be regarded as a sensible number which would allow funds that have genuinely committed to long-term income growth and a balance between capital return and income to remain in.”
“To split the sector and really push more and more funds out of what is an increasingly unrepresentative UK equity income sector I just don’t think is in the best interests of investors.”
Brooke’s £2.9bn Trojan Income fund is in the top quartile for its total returns over one, three, five and 10 years, having almost double the performance of its sector average and benchmark over the last decade.
Performance of fund vs sector and benchmark over 10yrs
Source: FE Analytics
If investors had put £10,000 in Brooke’s fund over the same time period, it would have provided an income of £4,774.29.
The fund has a clean ongoing charges figure of 1.02 per cent and yields 3.6 per cent.
