Gleeson and his team score funds out of 300, depending on their performance in three key areas: the stability of their dividend, capital protection and finally dividend yield.
For investors who rely on income, a fund’s yield is the most popular differentiator, with a number of IMA sectors enforcing strict targets to ensure that funds remain committed to income investors.Gleeson (pictured) says that while yield should be considered, there are more important factors to take into account – particularly for investors who draw a regular income from their portfolios.
“The most important thing for an investor who relies on income is the stability of the dividend – not yield,” he said.
“The dividend yield has nothing to do with the dividend they receive. Some investors sell out of funds that dip below a yield, but it may be that a yield decreases because capital growth has been particularly strong. Similarly, a fund may be yielding 6 per cent because it’s just tumbled in share price terms.”
“What income investors really care about is the money that is being paid every month or quarter, and this doesn’t have a direct relationship to yield. A fund’s yield could go down and the dividend payout could actually increase.”
Gleeson says that a manager’s “commitment to the dividend” is the all-important factor.
While past performance is of course not a guide to the future, he says that looking at a fund’s ability to consistently grow or at least maintain its dividend payout is a key indication that the manager will continue to do so in the future.
FE Research has developed a way of ranking funds according to the stability of their income.
Funds are given a score of between 0 and 100, with those maintaining or growing their dividend payout every calendar year given the highest score.
“Investors who rely on income need their income to be stable – there’s no use getting a huge payout one year if it is significantly cut the next,” said Gleeson.
While dividends are the bread and butter for income investors, Gleeson says a manager’s ability to protect capital is also very important.
“If you’ve got a fund that’s growing its dividend every year that’s great, but if the remaining capital is eroded, investors have a problem,” he said.
“Investors who rely on income are typically cautious in their approach and don’t want a highly volatile fund with the potential for significant loss.”
To ensure funds are also committed to protecting on the downside, FE Research scores funds again on a scale between 0 and 100.
The funds with the lowest downside risk from a capital growth perspective on an annualised basis have the best score, while those that are susceptible to big drawdowns score poorly.
Gleeson accepts that yield does have a part to play for investors who are buying into a fund – particularly if you’re considering making a new investment.
Indeed, if a fund is a stable dividend payer but is only yielding 0.1 per cent, the payout is at least initially minimal for the end investor.
“If you invested in a fund many years ago, then you could still be getting a decent dividend even if a fund is yielding very little. If you’re buying it today however, the yield is obviously much more important,” he said.
To ensure funds have a decent dividend payout initially, FE Research scores funds from 0 to 100, purely taking into account yield.
The three scores out of 100 are then added up, with the best income funds awarded the highest score out of 300.
“Many investors look at the yield first, but it’s the last thing we look it. It’s a safety net,” Gleeson said.
“Interestingly, we’ve found that the funds with the most stable income stream have also been those that have paid out the most income overall.”
“It always goes back to stability of the dividend. If a manager is committed to paying dividends and has a proven ability to maintain the payout, you’re looking in the right place.”
Gleeson’s comments are particularly relevant in the context of the IMA UK Equity Income’s controversial yield target.
A number of funds have been forced to leave the sector in recent years as they have consistently failed to generate a yield 10 per cent higher than the FTSE All Share, as outlined by the IMA.
Invesco Perpetual High Income, Invesco Perpetual UK Strategic Income and Henderson UK Equity Income & Growth are among those that have recently joined IMA UK All Companies.
Interestingly, when looking at the best income-focused UK equity funds over a three-year horizon, Mark Barnett’s Invesco Perpetual High Income fund comes third, with a score of 275.
“It just goes to show why the yield target is flawed. It only takes into account one way of measuring the success of an income fund, and by no means the most important,” Gleeson added.
Under first Neil Woodford and much more recently Barnett, Invesco High Income has also been one of the best income-paying funds across the IMA UK Equity Income and IMA UK All Companies sectors over the past decade.
FE data shows that an initial investment of £10,000 10 years ago would have resulted in dividends of over £6,200 overall.
Income earned from initial £10,000 investment over 10yrs
Source: FE Analytics
Invesco Perpetual High Income is yielding 3.24 per cent - less than the FTSE All Share and the average UK equity income fund.
FE Research will highlight the best income funds across all major asset classes in an upcoming series on FE Trustnet, starting with the IMA UK Equity Income and IMA UK All Companies sectors later this week.
