A five year bull market in UK equities, declining fixed income coupons and paltry returns on cash held as savings has pushed and pulled the income hungry towards UK equity income funds.
Focusing on yield-paying stocks has become a popular strategy among UK investors recently, due in no small part to the fact that the average fund in the IMA UK Equity Income sector has outperformed the FTSE All Share by more than 10 percentage points over three years.
Performance of sector vs index over 3yrs
Source: FE Analytics
Capita Asset services predicted at the beginning of the year that 2014 would be a bumper year for dividends, predicting corporates would pay out £100bn to their shareholders over the course of the year.
According to Gordon Smith, fund analyst for Killik & co, the equity income space is a good place for income seekers.
“I would advise people to take a position in it as it will be an attractive place to be for some time to come,” he said.
However, Smith says that diversification is important in any portfolio but particularly for income investors who rely on the regularity of its performance than a growth investor, for example.
“From time to time in the equities markets you can see income shocks in large caps especially. So if you can diversify that risk away it can help to protect your income.”
Here we look at three ways income seekers can diversify away from UK equities.
Property
According to M&G’s Fiona Rowley income hungry investors should not overlook commercial property as a source of income.
“When we are looking at commercial property around 75 per cent of your total returns comes from income. It is an income generating asset class. We do get some capital growth but it is a lot about income,” she said.
“The tipping point for the market was April 2013 when we started to have some positive momentum and we also saw a very strong December.”
“As we went into 2014 better tenant demand and better rental growth boosted returns and I predict that will continue throughout the year.”
Rowley, who manages the £2.5bn M&G Property Portfolio, is upbeat that income growth will be driven by increased demand for office retail space particularly in central London and the south east.
The fund aims to maximise long-term total return through the combination of income and capital growth by investing in commercial property.
Over the past year the fund has returned 8.64 per cent, beating its sector average which returned 1.66 per cent.
However, over three years the fund has performed less competitively, returning 12.24 per cent compared to a sector average of 15.04 per cent.
Performance of fund vs sector over 3yrs
Source: FE Analytics
Neil Shillito says commercial property funds are great way for income seekers to diversify their portfolios, especially those geared toward commercial property.
“We are seeing quite significant resurgence on returns now on property and we think it’s a good asset class to hold,” he said.
“There is a nice and steady growth, with reasonably low risk with predictable income returns. It is one of the best alternatives to equity income.”
“The big attraction with fixed income is that you have a known yield and a reasonable chance of capital return at the end of it. Property is not a long way from that when you think about it.”
“It is unlikely, given a well-managed fund you will make a thumping loss, and in the meantime you will have a predictable return.”
Fixed income
Fixed income has been a testing place to be in past 12 month with many managers struggling to make returns.
However, Shillito says reports of its demise are overblown.
“The only reason fixed interest is out of favour is that other things are very much in favour,” he said. “It is purely that a 30 year bull market in fixed income has come to an end.”
“We have gone from interest rates in the early 90s of 11 per cent to virtually nothing today. So many people are predicting the death of fixed income, but that is total nonsense.”
“However, if you invest in fixed income you can only expect to clip the coupon and you’re not going to get anything else on top which is why we prefer property.”
Smith is also keen on the sector and recommends the TwentyFour Monument bond fund as a good way to fixed income play for income investors.
The £252m fund invests in European and Australian mortgage backed securities. It has performed well over the past year, beating the IMA Sterling Strategic Bond sector. It returned 5.49 per cent compared to the sector’s 3.31 per cent.
Performance of fund vs sector over 1yr
Source: FE Analytics
“The fund’s relatively small size allows it to invest in less liquid areas of the market which bigger players can’t, making it more nimble,” Smith said.
Infrastructure
Smith also recommends infrastructure funds as a way to find alternative sources of income but he says they should only form a small part of a portfolio.
He says the core parts of the infrastructure space are looking a bit expensive, especially those with a lot of Private Finance Initiative schemes within their portfolio.
He instead recommends the new part of the sector, more focused on environmental infrastructure which is trading at narrower premiums.
Smith also tips the newest fund to be launched in the space, the John Laing Environmental Assets Group, which will focus on green infrastructure projects.
“There are more attractions in the listed infrastructure space, the John Laing portfolio, for example, gives a broader focus on renewable infrastructure projects such as waste management.”
The trust was launched at the end of March 2014, raising £160m in its initial public offering.
Monica Tepes, senior fund analyst at Cantor Fitzgerald, says investors shouldn’t necessarily avoid these sectors even though many of the funds have high premiums and that they make a good alternative to bonds in an environment of very low interest rates.
