Equity income funds buy companies that make regular payments – called dividends – to investors, with the amounts and the dates of payment determined by the company.
Investors have the option to keep that money or to reinvest it in the company or fund that has distributed it to them.
The income option is highly-prized by investors who are retired, or by those who want to supplement their earnings, but it is the power of reinvested dividends to grow capital that makes this asset class popular with investors with other objectives.
Data from FE Analytics shows the power of the compound growth that is available from reinvesting companies’ pay-outs.
With dividends reinvested, the FSE All Share has made 1100.06 per cent since January 1986, while when dividends are withdrawn this shrinks to just 345.66 per cent.
This means that investors holding all the shares in the index would more than triple their returns if they reinvested the money the companies pay out.
Performance of FTSE All Share since January 1986
Source: FE Analytics
Richard Troue, investment analyst at Hargreaves Lansdown, said: “Rising dividends is one of the best ways to grow your money over the mid to long term.”
“You could invest in more speculative companies and hope for higher gains, but I would suggest that dividends are a solid way of building your wealth in the long term.”
John McClure, FE Alpha Manager of the Unicorn UK Income fund, agreed: “Twelve years ago you could have invested in the tech boom and you would have ended up with no money. If you had invested in income-generators you would have outperformed.”
Troue says that the economic environment since the financial crash of 2008 has made investing in the asset class more attractive.
He said: “From our point of view equity income has been one of the most popular investments for thirty years or more, but it has been rising in prominence in recent years.”
“The key reason for that is that rates are so low that returns in cash are negative in real terms, so after accounting for inflation, finding a decent rate of investment is difficult.”
“If you are investing in corporate bonds, another alternative you have right now, while you may have the prospect of reasonable income you won’t have the same potential of rising income and capital growth.”
“Plus, once you are older and retired you can switch on your income tap and take the funds out.”
McClure says that the crisis has increased the attractiveness of equity income investing in a number of ways.
“Lehman’s collapse has been a godsend for us,” he said. “Most PLCs have tightened their balance sheets up. Therefore their dividend payment capacity is much larger than you think.”
Quantitative easing is increasing the case for equities, McClure says, while property – once a popular source of income – has suffered large falls in capital value.
“Basically I cannot see another asset class that has an equivalent investment opportunity. If you are very bearish you could buy gold, but it has already risen significantly, so you are taking a risk on events as to whether it will rise any more.”
Troue explains that some of the types of company that typically pay large dividends are those that hold up better in a difficult environment.
“Equity income funds often look for cash generative businesses that are defensive in nature and which will keep growing their earnings through difficult conditions.”
“This means you find consumer staples companies and tobacco companies for example, because they sell products that consumers cannot or will not stop buying.”
“However, some equity income funds will invest in more economically sensitive companies and even in lower yielding areas, looking for companies which are able to grow dividends over time, so they might be investing in younger businesses with potential,” he explained.
McClure says that investors should be very wary of investing in companies that don’t pay dividends.
“Paying dividends is absolutely critical to the investment case. If companies do not pay dividends, you have a fair chance they are duds, in other words that some of their accounts will not quite be what they say they are.”
“If you get a dividend, that’s a hard cash pay-out, it shows you the reality of the company’s cash flow,” he said.
Troue says that when building an equity income portfolio, investors might consider using a multimanager fund that creates a core of good equity income funds before adding to them with their own picks.
He adds that investors should consider when the payments on the different funds are made, as if all the funds pay out on the same two dates, this might not be convenient for the investor who is drawing down his income.
As far as risks go, some investors will be wary of investing in the stock market at all, Troue explained: “Obviously there’s the risk of capital fluctuation from the volatility of being invested in the market, but if you do not need to access the capital for five to ten years that should not be a problem.”
“The main risk for most investors is that in the stock market your capital is not secure; it can fluctuate and so you need a long term perspective,”
“You cannot go in with a one or two year view; at the company level there’s the risk of a company having to cut its dividend, as we saw with BP and the Gulf of Mexico disaster.”
“If you have a three to five year horizon this style of investing is very powerful and should provide you with strong capital growth.”