The income recovery is still in its infancy, say experts

Income funds have had a renaissance in the past 18 months after the global pandemic sent funds and trusts tumbling.

In 2020 companies around the world conserved cash to combat the effects of lockdowns, such as shuttered airlines, deserted high streets and empty offices.

However, since then the recovery has been palpable. In the Investment Association universe, both the IA Global Equity Income and IA UK Equity Income sectors have beaten their respective all companies counterparts – IA Global and IA UK All Companies – over the past year.

Total return of sectors over 1yr

Source: FE Analytics

The same trend is true among investment trusts, where the UK and global income sectors have beaten the wider rivals. Here, however, there are also dedicated sectors for the Asia Pacific region, where income has also outperformed.

Total return of sectors over 1yr

Source: FE Analytics

There are a number of factors that have caused this swing from growth stocks to value – the latter of which are more commonly found in income portfolios.

Rob Burgeman, investment manager at wealth manager, Brewin Dolphin said the geopolitical risk and economic dislocation caused by the invasion of the Ukraine, has caused certain sectors to surge.

Spikes in the oil and broader commodity prices as well as rebounds in defensive sectors such as tobacco and pharmaceuticals have benefited these funds as they are all “stalwarts of the income sector”.

The second factor has been the “toxic combination” of surging inflation and rising interest rates, which has impacted “blue sky” growth companies whose profits lies many years in the future.

However, after such a strong run of fortune, have investors missed the boat on income, with the best relative performance already in the rear-view mirror?

Chris Metcalfe, investment and managing director at IBOSS, said that the turnaround in the relative fortunes of income funds was “still in its infancy” as many in the space have “underperformed their sexier growth peers” for most of the past decade.

“The pandemic created the ultimately poor market conditions for a significant number of sectors which provide most of the higher dividend payers such as banks. Not only were many companies’ business models under pressure but governments actually dictated that some companies couldn’t pay dividends,” he said.

“This is no longer the case and with an inflationary backdrop (which we never thought was transitory) and a rising rate environment, this looks like a positive backdrop for income funds across the globe.”

Burgeman agreed but said that investors should not throw all of their eggs into one basket. “A well-constructed portfolio will rarely be focussed 100% on one investment style,” he said.

For investors that wanted to add exposure to income funds, he suggested the Fidelity Global Quality Income UCITS ETF. This global equity tracker has more reach than a traditional UK income fund and uses an income overlay on the MSCI World index.

Kamal Warraich, investment analyst, Canaccord Genuity Wealth Management, said whether an investor buys into these income funds now will rely entirely on their timeframe and circumstance, such as being in retirement.

He noted that short-term forecasts are notoriously difficult but acknowledged that markets are moving into a challenging period, with inflation, interest rate rises and geopolitical risk all potentially negative for stocks.

“It suggests that the sharp re-rating of value and income stocks we experienced over the past 12 months is probably behind us. However, there is nothing to stop a broader and more gradual move upwards if earnings remain resilient,” he said.

Over the long term, dividends generate a significant portion of equity returns, and reinvesting your income is a very powerful compounding mechanism.

For those that wished to buy an active fund, he suggested the Fidelity Global Dividend portfolio. The fund has underperformed its peers over the past year as its zero weighting to energy stocks has hampered its progress.

However, the 22.5% allocation to financials should drive returns in the future if interest rates rise, while its 12.9% allocation to technology names (growth) and 15.5% to consumer staples (quality) broaden the portfolio across multiple styles.

Although short-term progress has been slow, the £2.5bn fund has been the third-best performer in the IA Global UK Equity Income sector over the past decade, returning 205.7%.

In the investment trust space, Warraich highlighted Law Debenture Investment Trust as another strong option. “Both have compelling dividend growth track records and are managed by credible teams who have delivered consistent returns over time,” he said.

The trust has a unique structure split between a traditional stock picking fund (managed by James Henderson) and an independent financial services business, which accounts for 17% of assets.

Over one, three, five and 10 years it has been either the best or second-best performer in the IT UK Equity Income sector, returning 209% over the decade.