Consistently positive returns are a major goal of any fund manager but many equity income fund managers are failing to produce this, according to Royal London Asset Management’s Martin Cholwill. 
Cholwill (pictured), manager of the £2bn Royal London UK Equity Income fund, said that consistency is a “rare phenomenon” among the peer group, highlighting several high-profile blow-ups during the past year
This lack of consistency within the equity income space has been down to several key mistakes, according to the manager, which can lead to a “recipe for disaster”.
The first mistake equity income managers are often guilty of is possessing a lack of discipline in following through on their word and process.
“Many fund managers say the right things, but their investment decisions defy their words,” said the Royal London manager.
“Ultimately, this comes down to discipline. Managers can fail to live up to their proclaimed strategies at the first signs of trouble.”
Cholwill said consistency is not about every single investment decision being a success but applying a repeatable investment process.
In addition, the investment process should also correspond with the objective of reducing volatility.
As such, there should be no place for unquoted stocks in an income fund “because they are at the wrong stage of development to pay regular dividends and are more likely to make cash calls”.
He explained: “Their lack of liquidity renders their prices unstable, dependent upon the subjective evaluations of a limited number of buyers and sellers.
“This makes them particularly vulnerable in times of market stress.”
The topic of unquoted stock holdings and liquidity has gained more attention recently following the gating and announced winding-up of Neil Woodford’s flagship LF Woodford UK Equity Income fund.
Woodford launched the fund in 2014 following his departure from Invesco. But this year he came under considerable criticism and concern about the fund’s performance, particularly around his illiquid holdings in unlisted companies.
“Income fund managers that include unquoted stocks in their portfolios are often forced to purchase extremely high dividend yielders to meet their income requirements, as part of a barbell strategy,” said Cholwill.
UK dividend growth by yield versus dividend group since 1990
Source: Royal London Asset Management
“This sets them up for value traps, with the above chart showing that, on average, higher dividend yields have lower growth prospects.
“Thus, the strategy often combines a lack of yield from unquoted stocks with an excess of risk from high yielding ones. In our view, this is no formula for consistency.”
Another way that fund managers can “poison” their portfolios, according to the Royal London UK Equity Income manager, is by making the wrong macroeconomic calls.
“There are certainly a number of fund managers with long track records of making money through asset allocation,” he explained. “As equity income investors, however, our skill is in picking stocks, rather than making big macro calls.
“The problems emerge when managers step outside of their circle of competence, thereby undermining what they actually do well.”
Whilst Cholwill admits that nobody can pick stocks in a vacuum, equity income managers should not try to position for any particular macro outcomes.
“Of our four, more recent, top-performing stocks, two are domestically exposed and two are internationally exposed,” he said. “Our contrarian decision not to shy away from the UK due to Brexit fears unravelled some fantastic opportunities.
“The companies have strong market positions, cashflow-backed dividends and robust balance sheets, and so we believe should prosper in any environment.”
Royal London UK Equity Income fund is a “traditional” equity income strategy, according to Cholwill who seeks out quality companies when they are out of favour and ensures every stock can stand on its own and contribute to the yield of the fund.
The fund manager said he focuses on the underlying fundamentals of companies and how they change over time.
“Fundamentals are far less volatile than stock prices due to the widespread obsession with short-term earnings forecasts,” he explained. “Rather than earnings, we are concerned about cash flows, which determine dividend sustainability.”
Its bias to large and mid-cap quality stocks, he said prevents some of the “rollercoaster returns” experienced by other managers.
Top holdings include Royal Dutch Shell, which represents 5.9 per cent of the portfolio, AstraZeneca, GlaxoSmithKline and BP.
Performance of fund vs sector & benchmark over 3yrs
Source: FE Analytics
Royal London UK Equity Income has made a 16.66 per cent total return over the past three years, compared with a 17.64 per cent return for the FTSE All Share benchmark and 12.77 per cent gain for the average IA UK Equity Income peer. The fund has a yield of 4.41 per cent and runs an ongoing charges figure (OCF) of 0.72 per cent.