Strong stock market performance since the financial crisis has seen yields close across the board and many experts – including star manager Mark Barnett – believe that investors should expect less in the way of capital growth in the coming years.
FE Research analyst Charles Younes thinks there is a problem in the equity income sector, as there is little growth potential coming from the large cap dividend payers with an above-average yield, which prove particularly popular with managers.
"If you look at the large cap dividend-payers, they’re sitting on huge heaps of cash and they’re not using it," he said.
"There’s very limited growth coming out of them, and though they can pay out a special dividend now and again, unless they put that cash to work they’re not going to give investors much in the way of returns."
Rob Gleeson, who heads up the FE Research team, says considering equity income funds that are not constrained by yield could offer a solution to the problem.
Funds in the IMA Global Equity Income and UK Equity Income sectors must target a yield in excess of 110 per cent of the FTSE World and FTSE All Share, respectively. However, there are some income-focused funds that are not constrained by such strict guidelines, which may be of interest to investors who are concerned by the lack of capital growth potential in the market.
"Sometimes it’s the funds that aren’t in one of the assigned equity income sectors that do best, because they have greater flexibility to invest in the stocks where they see the most opportunity," he said.
"You get a decent yield, but you also get a better chance of doing well from a capital growth point of view. If the manager thinks there isn’t a lot of value in the high yield market, they can look elsewhere without having to worry they are hitting a specific yield target."
Here are five examples.
Henderson UK Equity Income
FE Alpha Manager James Henderson’s Henderson UK Equity Income fund is perhaps the best example of a flexible UK equity income fund.
The £473m vehicle was previously a constituent of the IMA UK Equity Income sector, but had to leave earlier this year as it consistently failed to keep up with the 110 per cent yield required of it. Henderson (pictured) explained in an interview with FE Trustnet that he hadn’t been rotating out of the sectors where there has been strong capital growth, which led to the fund’s yield dropping below the required level.
He says that he is more worried about total return than headline yield, which is why he refused to change his ways.
At 3.3 per cent the fund is currently yielding more than a number of high-profile funds in the IMA UK Equity Income sector, such as John McClure’s Unicorn UK Income fund, which is paying out 2.98 per cent, and the £1.4bn Schroder Income fund, which is currently yielding 3.17 per cent.
It is when looking at total return that the fund really comes into its own though; our data shows Henderson UK Equity Income has returned 184.02 per cent over a five-year period, putting it well ahead of its FTSE All Share benchmark, as well as the IMA UK All Companies and IMA UK Equity Income sectors.
Performance of fund vs sector and index over 5yrs
Source: FE Analytics
The fund is also ahead of all three performance measures over one and three years and since Henderson took over the fund in January 2005. It has tended to be more volatile than its peers, though.
FE Research rates Henderson’s fund highly, including it in the FE Select 100 even after news that it had to leave the IMA UK Equity Income sector.
"The manager places a strong emphasis on dividend growth when analysing a company, and does not hesitate to stray away from the typical large UK companies paying high and sustainable dividends," the analysts on the team said.
"This riskier approach also means the fund’s income policy is less stable than that of its peers, but it also helps him to invest in under-researched areas, typically UK smaller companies."
"This fund could therefore be viewed as a complementary product to some of the popular choices in the UK Equity Income sector," they added.
Top-10 holdings for Henderson include industrial company Senior, construction company Interserve and chemicals business Elementis. All are FTSE 250 companies.
His fund requires a minimum investment of £1,000 and has ongoing charges of 1.75 per cent.
M&G Global Dividend
FE Alpha Manager Stuart Rhodes’ M&G Global Dividend fund has been one of the best sellers in the IMA universe in recent years, pushing assets under management (AUM) to over £8bn.
In spite of its name, the fund sits in the IMA Global sector as Rhodes does not want to be restricted by the yield target.
He regards capital growth and dividend growth as more important than headline yield, as the FE Research team explains: "The dividend yield is not the primary concern for stock selection and this is reflected in the fund’s price appreciation, which is stronger than that of its benchmark and sector," it said.
"This demonstrates a robust process that identifies the right growing companies. He prefers to buy companies with a low yield as this suggests they are under less pressure and have room to increase their income payout."
M&G Global Dividend is currently yielding 3.05 per cent, which is well below average for a fund in the IMA Global Equity Income sector. However, since its launch in July 2008 it has shown its peer group and benchmark a clean pair of heels from a total return point of view.
Our data shows that the fund has made 91.82 per cent over the period, compared with 47.77 per cent from the IMA Global sector average, 60.46 per cent from the IMA Global Equity Income sector average, and 59.1 per cent from the MSCI AC World index.
Performance of fund vs sectors and index since launch
Source: FE Analytics
The fund is also ahead over one, three and five years, with around the same volatility as its benchmark.
The manager is backing the US as his biggest regional bet, which currently has a 51 per cent weighting. Europe and the UK are a distant second and third, at 18 and 16 per cent, respectively.
Most of the 50 companies in the portfolio are large caps, which is hardly surprising given the size. Microsoft, Prudential and Bank of Montreal are all top-10 holdings.
M&G Global Dividend requires a minimum investment of £500 and has ongoing charges of 1.66 per cent. It is a member of the FE Select 100.
Keystone IT
UK and global equity income trusts aren’t under the same strict guidelines as their rivals in the open-ended universe. Although the IT UK Growth & Income and IT Global Growth & Income sector definitions state that constituents typically yield in excess of 10 per cent above the index, they are not required to do so.
Numis’ Charles Cade explains that the decision to omit a trust sits with a committee, which he is currently on.
"In theory there is a classification, but the criteria is not as strict," he explained.
"The requirement looks at portfolio yield, which gives managers a bit more flexibility. You had the situation earlier this year when Henderson UK Equity Income had to leave its sector, but Henderson’s Lowland trust didn’t have that problem."
"When it comes to deciding whether a trust should be thrown out, as long as the committee is satisfied the trust is still looking for growth and income, it tends to stay in, which has been the case with Lowland and Finsbury Growth & Income. If something has completely changed in the strategy, obviously that’s a different story."
Regardless, there are a number of income-focused portfolios in the IT UK Growth sector that have no limits put on them whatsoever.
FE Alpha Manager Mark Barnett’s Keystone IT is a good example. The vehicle is essentially a higher conviction version of the Perpetual Income & Growth trust – which sits in the IT UK Growth & Income sector – and simply targets "long-term growth of capital".
Due to Barnett’s bias towards solid dividend-paying companies, the trust is likely to always have a competitive yield, but the manager can shift his focus towards capital growth if he sees fit.
Keystone is currently yielding 2.9 per cent – a touch below Perpetual Income & Growth, which is yielding 3.2 per cent.
Stripping out the impact of discount volatility, Perpetual Income & Growth has actually done marginally better than Keystone over the last decade, but both are well ahead of their FTSE All Share benchmark.
NAV performance of trusts over 10yrs
Source: FE Analytics
The £267m Keystone IT is currently on a 0.3 per cent discount, and is 9 per cent geared. It has ongoing charges of 0.96 per cent, excluding performance fee.
To read more about how Barnett is positioning his equity income portfolios at the moment, click here.
