Today, FE Trustnet is hosting its Select event on UK equity income where top-rated managers Richard Colwell, Michael Clark and the Unicorn duo of Simon Moon and Fraser MacKersie will be discussing their outlooks and positioning with leading wealth managers and DFMs from around the country.
It looks like an ideal time to analyse UK equity income as well, given its continued popularity but also the challenges facing fund managers, investors and the Investment Association itself.
As such, here we will try to answer the question of what actually makes an equity income fund – something that has become increasingly prevalent over the past 12 months.
First and foremost, though, it is worth highlighting just how popular UK equity income funds are among investors – as shown by the recent survey we conducted in the build up to our event. According to the survey, some 56.33 per cent of you view it as your go-to asset class for income in the current environment.
Source: FE Trustnet
This isn’t too surprising. As we know, UK investors do (rightly or wrongly) tend to have a domestic bias within their portfolios which explains why UK equity income funds have proven to be more popular with our readers than their overseas counterparts. On top of that, fixed income yields are at all-time lows and alternative assets like property have faced major headwinds over recent months.
However, despite its clear popularity, it is clearly a troubled asset class.
Following a prolonged period of poor earnings growth and ever-increasing pay-out ratios, dividend cover across the UK equity market has taken a tumble. Indeed, a recent FE Trustnet article highlighted that dividend cover in the FTSE 350 has fallen to its lowest level since the global financial crisis.
Dwindling dividend cover tends to lead to dividend cuts and that is what has happened over recent times, with 14 FTSE 100 stocks having to reduce their pay-outs over the past 18 months or so and many expect more and more companies to join that list.
While many of those have been commodity-related stocks that have had to deal with a plunge in the price of oil and iron ore, there have been various warnings that this is a far more widespread phenomenon as earnings growth has generally been weak across the board.
Dividend cover in the FTSE 350
Source: The Share Centre
Sterling weakness has no doubt alleviated this issue over the short term given the UK market’s large proportion of international earners, yet the concentrated nature of the FTSE All Share (the fact that a significant amount of total dividends are paid by a handful of mega-caps with depleted levels of cover) only makes the matter worse.
As such, it comes as little surprise that half of FE Trustnet readers are either concerned or very concerned about the potential for more dividend cuts across the UK market while just 15 per cent are either relaxed or not bothered.
What is interesting, however, is how this market dynamic has affected UK equity income funds. 
Given the concentrated nature of the UK market and the fact that many of the companies with the most challenged dividends sit at the top end to the market-cap weighted index and therefore offer the highest yield, there now aren’t a huge number of companies within the FTSE All Share that actually yield more than FTSE All Share average yield.
As a result, the current IA UK Equity Income sector criteria (funds must produce a yield 10 per cent greater than the FTSE All Share over rolling three-year periods) has come under greater scrutiny as 17 funds have been removed from the peer group for failing to meet that target.
While it is by no means black and white, managers in the sector seemingly face two options: either buy those high yielding mega-caps, stay in the sector but risk capital and a potential dividend cut or buy the higher quality but lower yielding companies that should maintain or grow their dividends, but risk being booted out of the peer group.
The Investment Association has launched a consultation into the future of the sector – but opinion within the industry is very mixed.
On the one hand, some argue these equity income ‘exiles’ have been unfairly punished for backing the right companies and seeing their unit prices increase while others say that, at their current low yields, they offer very little value for investors who want to buy now.
I think the crux of the issue, however, is the relationship between yield and income – two metrics that are often used interchangeably within this industry – and this is why the question of what actually makes an equity income fund has become so prevalent.
Regular readers will know that the relationship between yield and income is a theme we have devoted a lot of time to over the years.
Indeed, we launched our campaign for greater transparency surrounding income in 2014.
The reasoning was mainly out of frustration with the fact that we live in a world where investors are constantly told they need to find a growing source of income (with a huge number of funds marketing themselves on being able to do just that) yet many funds would not make how much they have paid out to unitholders in the past readily available.
Therefore, in the absence of that information, many investors would have to rely on yield to judge how good an equity income fund was or has been.
Now, while some of you have suggested we have some sort of vendetta against yield, it isn’t the case. The point we have been arguing is that yield (given it is the previous year’s dividend divided by the current unit price) isn’t the best indicator of future income pay-outs.
Instead, we believe yield is just one part of the income puzzle – and this has been borne out in our research over the years.
We start with the equity income exiles (or the 17 funds that have been removed from the IA UK Equity Income sector)
Income/yield performance
Source: FE Analytics
The charts above show the yield of the average equity income exile versus the sector over the past five years as well as the average income pay-out from the exiles and the current sector. As you can see, the exiles have not only consistently yielded less than average, but they have also paid out less in total dividends over that time frame.
While that does seemingly go against our argument, I think this shows that there have been a number of funds that have been removed from the sector for a very good reason – they are not equity income funds and shouldn’t be marketed as such.
However, when you delve deeper in the data, interesting trends emerge.
For example, without naming any names, this is one of the funds that is no longer in the sector.
Fund’s yield, income pay-outs and capital growth on £10,000 versus sector average over 3yrs
Source: FE Analytics
While this fund has consistently yielded less than the sector over the past three years, it has been a top-quartile performer for its income pay-outs over that time. On top of that, investors who bought £10,000 worth of income units in this portfolio would have also seen their capital grow far larger than the average fund in the sector.
So, just because that fund hasn’t yielded much, has that been a bad income fund?
Then, there is this fund that – under current sector guidelines – is an IA UK Equity Income fund.
Fund’s yield, income pay-outs and capital growth on £10,000 versus sector average over 3yrs
Source: FE Analytics
Yes, it has consistently yielded more than the sector, but its income pay-outs have been lower and what’s worse, that initial investment has fallen in value from £10,000 to £8,613 over three years suggesting that yield has been generated at the expense of capital.
So, just because it has yielded a lot, has that been a good income fund?
Of course, those are just two examples (and two fairly extreme ones at that). As mentioned earlier in relation to the equity income exiles taken on average, over the shorter term, there has been a correlation between high yields and larger income pay-outs.
However, over the longer term, that relationship all but breaks down.
The table below is taken from an article we wrote on this subject a number of years ago and it highlights the largest income paying members of the IA UK Equity Income sector on £100 over the seven years between 2007 and 2014 as well as their starting yields in January 2007.
Yes, Schroder Income Maximiser was the biggest income payer and also had the highest starting yield, but it uses covered call options extensively to boost its income and yield credentials (and is the only one on that list to use the strategy).
Looking down the list and four of the top 10 income payers had a lower than average yield at the start of the study.
The top 10 income paying funds on £1,000 between January 2007 and January 2014
Source: FE Analytics
As such, it isn’t surprising that the IA has come under pressure to amend its UK Equity Income sector guidelines with 63 per cent of those surveyed believing a change is required.
However, despite what I have said so far, I have real sympathy with the IA on this and I certainly don’t envy whoever has to make the final decision on what to do with the sector. It really is a minefield and there is no way you can please everyone on this subject.
As we know, the IA has drawn up three potential options for the sector. Firstly, make no change. Secondly, lower the yield target. Thirdly, scrap the yield target and force groups to publish more information about their income credentials.
Although all three have their pros and cons, we believe there are certainly merits to the third option – and this is something that many of you agree with as well.
Indeed, only 5 per cent of you think groups should only publish yield on their factsheets while more than 50 per cent would like to see fund’s dividend histories, underlying portfolio dividend cover or capital performance made more readily available.
Yes, there is certainly the argument that by throwing heaps of information at retail investors, the situation would only become more confusing than it already is.
However, not only would retail investors have more of the necessary information they need to make investment decisions if groups were more forthcoming with greater levels of income data, but it would also help advisers, wealth managers and DFMs better communicate their decisions to clients.
While many investors won’t pick funds depending on what sectors they reside in, given the importance of income in today’s world of an ageing population and ultra-low interest rates, there does need to be greater transparency surrounding the yield/income relationship.
Let’s be honest, this would mean the question of what actually makes an equity income fund is far easier to answer as – given where they are in their investment journey and what they want from their portfolio – equity income funds mean different things to different investors.
In essence, this would mean more investors would be able to answer the question of what an equity income fund actually means to them.