While clearly a very popular area of the market, UK equity income has and will continue to face its challenges. 
In the build up to our most recent FE Trustnet Select Event, we surveyed our readers to see how they view UK equity income funds in the current market and how they are positioning for the future.
In articles later this morning, we will be hearing where the three management teams who presented at the event – Columbia Threadneedle, Fidelity and Unicorn – are seeing opportunities, but first here is how you view the current market.
The major headwind investors have had to deal with over recent months has been the fallout of the EU referendum.
Uncertainty was rife in the months prior to the vote and once Brexit became a reality in late June, markets reacted negatively with UK equities posting significant drawdowns. However, since then (due to various issues such as sterling weakness and action from the Bank of England) the index has delivered decent gains.
Performance of sector versus index since Brexit vote
Source: FE Analytics
According to FE Analytics, the FTSE All Share has returned 6.49 per cent since the UK voted to quit the EU. However, due to a structural overweight position in mid-caps (which tend to be more domestically-orientated relative to FTSE 100 stocks and have therefore struggled) compared to the commonly used benchmark in the peer group, the average IA UK Equity Income fund has lagged the index over that time.
Not only has the sector average returned 4.33 per cent over that time, but just 17.5 per cent of the peer group are actually outperforming the index since the referendum.
Those funds tend to be those with a high weighting to UK-listed large-cap multinationals (such as Investec UK Equity Income and F&C UK Equity Income) or a significant chunk in companies listed outside of the UK (like CF Woodford Equity Income and Newton UK Income) and have therefore benefitted from sterling’s drop in value against the dollar and euro.
This is further shown by the make-up of the 14 IA UK Equity Income funds that have outperformed since Brexit.
While the average weighting to the UK across the sector is 90.78 per cent, the average weighting across the list of outperformers is 88.7 per cent. On top of that, 36 per cent of stocks that are top 10 holdings in those funds are listed overseas.
Furthermore, the most popular holdings across those funds are all UK companies that derive the majority of their earnings from overseas or report in non-sterling currencies such as GlaxoSmithKline, AstraZeneca, British American Tobacco and Unilever.
Most popular stocks with outperforming IA UK Equity Income funds since Brexit
Source: FE Analytics
Despite this, it seems FE Trustnet readers aren’t phased by the Brexit-induced uncertainty and the performance many UK equity income funds have delivered as a result.
According to our survey, not only do 56.33 per cent of you view UK equity income as your go-to asset class for income, but only 11.94 per cent of readers have been selling their funds in the space since the Brexit uncertainty.
On top of that, 65.81 per cent have done nothing while 22.26 per cent have been upping their exposure to UK equity income funds over recent months.
Source: FE Analytics
This goes against the consensual view, especially when it comes to fund flows.
Reports from the Investment Association show that most investors have been dumping UK equities over recent months and have turned to far more defensive areas of the market such as the IA Targeted Absolute Return, the IA Sterling Strategic Bond and even the IA Short Term Money Market sector.
Interestingly, though, it seems FE Trustnet readers haven’t been focusing their attention on those international facing large-cap funds (which have therefore outperformed) since Brexit became a reality.
Our survey shows that only 41.85 per cent of FE Trustnet readers believe large-caps offer the best income opportunities in the current market, with the remaining 58.15 per cent preferring mid and small-caps.
Source: FE Analytics
As the chart above shows, it has been mid-caps (which are 50 per cent exposed to the UK economy, rather than 80 per cent exposed in the FTSE 100) which have proven to be the most popular with readers as 43.77 per cent view them as the best area for income opportunities.
There are a number of reasons why this may be the case.
Though investors can find the highest yields right at the top end of the FTSE 100, this is due to the fact that it is this part of the market that carries the largest risk of potential dividend cuts (an issue only 15 per cent of you are relaxed or not bothered about, according to our survey).
This is because earnings have been slowing in mega-cap land for a number of years, with scarce levels of dividend cover among FTSE 100 blue-chips meaning many are paying their current dividend out of debt. Unless the macroeconomic conditions improve or underlying earnings take a turn for the positive, many expect more companies to join the list of recent dividend cutters.
That is in the large-cap area of the market though and, as the graph below shows, dividend cover in the mid-cap space has gradually been improving suggesting the FTSE 250 offers the better opportunities for dividend growth.
Dividend cover on the FTSE 100 and FTSE 250
Source: Thompson Reuters/Standard Life Investments
Indeed, while FTSE 100 dividend cover is below 1 times, it is only slightly below 2 times across the FTSE 250.
Therefore, though funds with a high weighting to mid-caps have struggled of late, FE Trustnet readers seem willing to stomach the lacklustre returns in the hope that these types of funds can deliver good capital and income growth going forward.
Some of the worst performing IA UK Equity Income funds since Brexit include Marlborough Multi Cap Income (29.1 per cent in mid-caps), Majedie UK Income (33 per cent in mid-caps) and TB Saracen UK Income (41.2 per cent in mid-caps).
Given the popularity of mid-cap stocks among income seeking FE Trustnet readers, later today we will take a closer look at a selection of IA UK Equity Income funds with an overweight position in the FTSE 250.