After an “unusual” year for equity income funds, Columbia Threadneedle’s head of UK equities Richard Colwell remains confident that the process he has in place will continue to deliver in 2017.
The five crown-rated £3.5bn Threadneedle UK Equity Income fund Colwell has managed since 2010 underperformed the FTSE All Share for only the second year of the past decade in 2016.
However, while the fund didn’t beat the FTSE All Share last year, it was in the top quartile of the IA UK Equity Income sector as many of its peers also struggled to beat the index.
To understand the reason for this, investors need to go back to 2015, says Colwell.
Performance of fund vs sector and benchmark in 2016
Source: FE Analytics
He explained: “In calendar 2015 you had a very unusual situation where if you ranked all of income and growth active funds in a league table together then the FTSE index was in the bottom decile.
“The last time the FTSE performed in relative terms so badly was 2007 before the financial crisis.
“You knew going into 2016 that active funds had had a pretty unusual situation and that the likelihood was that the elastic had got a bit too stretched.”
The manager said: “In 2016 it’s been the revenge of the index and in particular the mega-caps. I think about 4 per cent of income and growth funds outperformed the index.
“The main reason is that although you had the likes of BP and HSBC rally from very depressed levels, and both have big yields so maybe income funds might own them, other leaders of the index were more mining related which some funds will have owned but not many.
“What’s interesting if you look over two years the income funds that did particularly poorly in 2015 had a stellar 2016 and vice versa.”
Source: FE Analytics
Indeed, as the above table shows, the top five performers in 2015 struggled in 2016 while the same was true for the top five outperformers in 2016.
Colwell says the Threadneedle Equity Income fund, which was fifteenth among all funds in the sector last year, made its returns without relying on commodity plays or banks, making the performance more impressive.
“Although we weren’t able to match the index last year we were top quartile in our peer group without having any mining stocks or BP or HSBC,” he said.
Two of the top performing sectors in 2016 were miners and financials, although mining stocks outperformed by a staggering 92.28 percentage points compared to the more modest 2.75 percentage point gain for the banks.
Performance of indices over in 2016
Source: FE Analytics
Despite its modest growth the financial sector’s largest constituent and one of the biggest dividend payers, HSBC, rose by 32.11 per cent in 2016.
“Half of the banks’ market weighting is in HSBC which is something like 5 per cent of the index. If that goes up 30 per cent I have got to find performance the equivalent of that going up,” Colwell said.
“It’s the opportunity cost because in a 50-stock fund you are going to have zero weighting to some of these stocks and its more about having enough – whether its Unilever, AstraZeneca, RSA, et cetera – rather than having a little bit of HSBC because it is a big part of the index.”
He added: “Although they [HSBC management] have made good progress in simplifying the business there is still the problem of diseconomies of scale in such a huge and complex organisation.
“And because it is 5 per cent of the index I would never own just a little bit like 2 per cent. If I were going to own it, I would buy 5 or 7 per cent and I’d rather have that elsewhere.”
The other sector member becoming more popular is Lloyds Banking Group. Despite a down year in 2016, it has become more attractive to managers now the UK government has sold its stake.
“I am still very comfortable not owning Lloyds Bank even though it is a popular share; the management are trying to be on the front foot by saying they are well-capitalised and can grow dividends,” he said.
“I still think their ability to grow the dividends could disappoint because I think they need to build up more capital still because the risk-weighting against their big mortgage book is very low.”
When it comes to the miners, Colwell (pictured) says many equity income funds bought into the sector after the majority had come off the dividend-paying roster in 2015 as a value play. 
“Most of them bought after the dividend cuts and bought them as a value-contrarian trade and have owned them without a dividend in the expectation of good capital growth which certainly came through in the last year,” he explained.
“I would say well done to them but from a risk-return point of view I suspect most of those guys will have been taking profits.
“There is a huge amount of speculation that has driven some of those commodity prices and therefore those cashflows, which now look very healthy in the mining stocks, are not necessarily as resilient as the market is now thinking.”
He added: “We’ve gone from one extreme of emotion and fear to maybe too much complacency. I am quite happy not owning mining stocks even though it was a headwind in terms of capital growth and I’m not bothered about it from a dividend perspective either.”
As such, investors should not expect to see miners or banks in the portfolio anytime soon, though Colwell tends to have a value bias.
“We are trying to deliver an attractive total return of which income is a key component but we don’t want to choke off capital growth opportunities or overreach for yield,” he said.
“We own about 50 holdings so it is quite a focused fund and within the 50 there is not a rigid criteria on yield. Some of the stocks will have a higher yield but not a lot of dividend growth, while some will have a lower yield but quite attractive dividend growth; one or two will have no dividend at all.
“Newer positions or those that I am building up materially will tend to be contrarian-value situations where I’m trying to assess if the valuation absorbs quite a lot of the fears that the market has."
Colwell added: “I am not buying when there is evidence of any operational improvement or when the sky is blue, I am trying to wrestle with the issues and be a patient investor and build up holdings.
“If I get more of those right than wrong then they can come through and migrate to become the next generation of cashflow compounders.
“I am not clever enough to buy just on the hockey stick as things start to improve but you can afford to have a handful of these stocks that you are wrestling with whilst other stocks come through.”
Performance of fund vs sector and benchmark over 10yrs
Source: FE Analytics
This approach, he says, should allow the fund to outperform over the long-term, which it has done. Over the last 10 years the fund has outperformed in eight calendar years and beaten the FTSE All Share and IA UK Equity Income sector by 46.61 and 52.36 percentage points respectively.