Options, overseas stocks and a focus on mid-caps are some of the ways that the best performing income funds coping with a shrinking pool of dividend paying stocks. 
With government bonds now more expensive and low interest rates having forced savers to look for new homes for their cash, income has become increasingly hard to come by.
Over the past 18 months, UK gilts have outperformed the FTSE 100, returning 10.70 per cent while the UK’s large cap index has produced 9.73 per cent.
Performance of government bonds and UK equities over 18months
Source: FE Analytics
The search for yield has become an obsession for some investors in recent years as the low rate environment has forced them into other risky areas.
Companies paying an income have been in high demand as their as their solid (if unspectacular) earnings potential and incremental dividend increases have been valued higher than ever before.
However, with bank stocks as well as some miners and supermarkets cutting or scrapping dividends in recent years, the number of opportunities to choose from has drastically reduced.
FE Alpha Manager Christopher Metcalfe (pictured), who runs the Newton UK Income, said: “In my early days as an income manager half the companies in the index yielded more than the index and half would yield less. Now only about 20 per cent yield more than the index.
“So yes there is a smaller pool of large income payers and it has certainly been the very large companies that have been the highest of them.”
Therefore, below we look at three different income offerings and how each manager is combatting a shrinking dividend pool to generate returns.
Use your overseas allocation
Metcalfe says a smaller dividend pool makes it difficult for funds using different styles to remain in the IA UK Equity Income sector, particularly given its controversial yield requirements.
To be included in the sector, you have to outperform the FTSE All Share index by 110 per cent over a rolling three-year period.
Additionally, in any one year you are also allowed to drop to 90 per cent of the index’s returns but no lower.
“We try to remain in the [IA UK Equity] Income sector and to do so you have to produce an income of more than 10 per cent above the FTSE All Share over that rolling three-year base,” he said.
“You have to fish to some extent in that pool in order produce our income total of 110 per cent of the All Share, but what we do is then supplement that with areas where we see value for example the large US tech firms in San Francisco – we quite like those situations.”
The £1.6bn fund includes the likes of UK large caps Diageo, Shell and British American Tobacco, but pairs these with companies including IT services company Wolters-Kluwer, as well as a 6 per cent weighting to North American equities.
Performance of fund vs sector and benchmark over 3yrs
Source: FE Analytics
As the above graph shows, the fund has beaten the IA UK Equity Income sector and FTSE All Share over three years by 5.48 and 4.21 percentage points respectively.
“It is undoubtedly a challenging time to be an income manager. We try and make sure that everything in the portfolio makes a contribution to that income but not all of them yield more than 110 per cent of the All Share so we blend them in order to come up with that amount,” Metcalfe said.
The fund currently yields 4.17 per cent and has a clean ongoing charges figure of 0.79 per cent.
Making use of all the options available
Rupert Rucker, client portfolio manager at Schroders, takes a different approach to generating yield – using call options to boost the yield of the £1bn Schroder Income Maximiser fund.
The fund, which uses the portfolio of its sister Income fund and adds options, is run by Kevin Murphy, Nick Kirrage and Mike Hodgson.
It aims to provide a yield of around 7 per cent (currently 6.96 per cent), however, Rucker says there is a trade-off when targeting such a high return.
“This is where I come back to the trade-off - there’s one trade-off in getting to 7 per cent which is we are invested in equities – so that is riskier obviously than any other asset class.
“The other trade-off is with buying options and you do give up some future returns to receive that income up front.
“Now when markets have been very strong that hasn’t necessarily been the right decision.”
He says there is so much uncertainty in the world now that and perfection “based in the markets” the expectation is for these options to become more and more attractive.
“I could have said this last year or the year before but I think it is different this year,” explained Rucker. “If you look at the current levels of any developed market really around the world they are pricing in a very smooth Brexit, a very smooth Trump presidency.
“It may not be such a stupid idea to take some of that future return potential and crystallise it now – which is what Maximiser does.”
While using this method does mean the fund gives up some returns in a rising market, he is quick to note that the fund does not give up all of the future returns.
“This has been an experience of Maximiser since we launched in 2005 that on average we’ve still given back around 85 per cent participation in markets,” he said.
As a result of this method, the fund is not hamstrung by only owning the top yielding funds in the FTSE All Share.
Additionally its value-biased approach (the fund holds a high weighting to banks and miners as well as under loved stocks such as Tesco) means it benefitted last year as the style came back into favour, even though many of the stocks are not current dividend payers.
Performance of fund vs sector and benchmark in 2016
Source: FE Analytics
As the above graph shows, the fund returned 20.67 per cent last year against the index’s 16.75 per cent. The IA UK Equity Income sector returned an average of 8.85 per cent.
Look further down the market
The third option for investors comes courtesy of FE Alpha Manager Siddarth Chand Lall, who uses the full market spectrum when trying to find income streams.
“It’s such a big market that, for us, rather than choose from 90 stocks that can qualify to pay the dividend, we have 600 or 700 stocks we can choose from, so it’s a very wide opportunity set,” he said.
He runs the £1.5bn Marlborough Multi Cap Income fund, which currently yields 5.43 per cent and has a 32.7 per cent weighting in mid-caps and 39.5 per cent holding in smaller companies.
“I’m not here to put any other type of strategy down,” he said. “It is so easy to point fingers and I’m not here to say you can’t buy large-caps for income because we do hold a lot of large-caps as well. We have close to £150m invested in them.
“It’s just we think that, as a portfolio approach – and especially given this remit to outperform the FTSE All Share yield – there is a more interesting angle by having a bias towards small- and mid-caps.”
Last year, he says large caps outperformed given the currency boost, but mid-caps such as Victrex, Tate and Lyle and PhotoMe all have some foreign earnings that investors would have missed out on had they only focused on the top end of the market.