The current market environment lends itself to shorter term, more tactical plays as opposed to long-term holdings in the UK equity income space, according to Ryan Hughes (pictured). 
The fund-of-funds manager, who co-runs a variety of portfolios for Apollo, only holds one fund in the IA UK Equity Income sector despite the fact it was the best-selling market area for ISAs and the second most-popular sector in March, according to the latest data from the Investment Association.
The hunt for income has intensified over recent months, given the fact that the unusually long market cycle has pushed asset prices up and yields down. This has been bolstered by increased nerves among investors following February’s sell-off and the market’s subsequent recovery which has resulted in a choppy and sideways market to-date.
Performance of indices in 2016
Source: FE Analytics
In an article published earlier this year, Hargreaves Lansdown’s Mark Dampier told FE Trustnet that equity income funds are suitable for a wide range of investors, but are particularly good investment vehicles for cautious investors to hold rather than absolute return funds.
“I just think with a low-risk fund you have to be even more cautious about what you’re saying to clients and I guess I’m a bit of a traditionalist in saying that’s why I like the equity income sector so much,” he explained.
“For 32 years it’s been a sector which is basically the essence of investing. It’s trying to buy out-of-focus stocks on high yields and sell them when they’ve re-rated.”
This view isn’t necessarily shared by everyone, however - the only fund Hughes is gaining his UK income exposure through is Montanaro UK Income, which doesn’t hold any stocks with a market cap of more than £10bn and therefore adopts a very different approach to most of its peers in the sector.
In fact, when taking a look at the IA UK Equity Income sector over three years, the five top-performing funds all hold significant weightings in small and mid-caps and are underweight large-caps relative to the FTSE All Share - these are Miton UK Multi Cap Income, Marlborough Multi Cap Income, Chelverton UK Equity Income, MFM Slater Income and Majedie UK Income.
Performance of funds vs sector over 3yrs
Source: FE Analytics
FE data shows that more small-cap biased funds have tended to deliver a lower volatility and maximum drawdown and their large-cap rivals over that time.
Hughes said: “Most people assume that small companies are focused on growth and therefore don’t generate much yield, but actually the reverse is very much true in that the largest number of companies that pay a yield are often found in the smaller end of the market.”
“Equally, you’ll have companies that will be fast-growing and paying some of their earnings out as income. In the smaller companies space, it’s quite possible to find those characteristics of growing income.”
The manager adds that his small exposure to the IA UK Equity Income sector is partially because he is shying away from the UK in light of the impending EU referendum.
Another reason the manager gives is that he is aiming to become more thematic and selective in his approach in order to navigate volatile market conditions.
“I think that equity income can work when it’s bought, held and left alone for long periods of time to allow that income to compound,” he continued.
“But equally, the fact that stock market returns have been quite dispersed over the last couple of years has meant there has been greater short-term stock-picking opportunities. For this reason, we’ve been more tactical over the last 18 months rather than buying and holding traditional equity income strategies.”
In an article published yesterday, Heartwood’s Jaisal Pastakia said that investors need to start turning to less obvious areas of the market to achieve attractive levels of income, due to most equities trading on historically high valuations and bonds offering low yields.
Like Hughes, he believes that the UK small-cap space is one area of the market that investors should be turning to if they’re looking for attractive and growing income streams.
“Small-cap stocks are typically less affected by global pressures, such as global deflation, China and commodities, given their domestic demand focus,” the investment director explained.
“This is an important consideration if investors take the view that the current low growth, low yield environment is likely to persist for some time yet.”
In contrast, Chase de Vere’s Patrick Connolly believes that more traditional UK equity income offerings still very much deserve a place in portfolios, although he emphasises the importance of holding these as part of a diversified portfolio.
“Retail investors in particular are looking for a steady and reliable income stream and it is more likely they’re going to get that from large, blue-chip secure companies that have been paying dividends year after year after year, whether that’s based in the UK or overseas. If you turn to a fund that holds smaller companies, these holdings won’t have that same track record,” he pointed out.
“With smaller companies, there is possibly more growth potential, there is very possibly greater likelihood that those dividends will increase, but the flipside of that is there is more risk on the capital side and there’s more risk that those dividends won’t be sustained.”
In terms of traditional, blue-chip income funds, the head of communications particularly likes Threadneedle UK Equity Income, which has been co-managed by Richard Colwell since 2010 and solely managed by him since September last year when Leigh Harrison decided to take a step back from managing money.
Over this time frame, it has provided a total return of 88.38 per cent, outperforming its sector average and benchmark by 23.99 and 40.54 percentage points respectively.
Performance of fund vs sector and benchmark under Colwell
Source: FE Analytics
The £3.2bn fund, which has a clean ongoing charges figure of 0.82 per cent, has a quality, large-cap bias and has a fairly concentrated portfolio of 50 holdings. It currently yields 4 per cent and, if an investor had put in £10,000 when Colwell first joined the fund as co-manager in 2010, they would have received an income pay-out of £3,137.65.
The fund is also favoured by the team at Brewin Dolphin, which also believes that the fund is being managed well has navigated challenging market conditions efficiently.
“[Colwell] introduces a contrarian element to the strategy which is working well for him this year given the value-versus-growth bounce,” fund analyst Tom Jemmett said.
“Although it lagged its peers last year, it’s snapped back this year and is doing a very good job. That is a core UK equity income fund with a contrarian element.”
He adds that some income investors could be nervous on the sector because of the dividend cuts that have been seen among UK blue-chips over the last year or so, although he believes that this shouldn’t deter investors from having exposure to the area.
“Clearly there have been a lot of dividend cuts already, so I think the stresses on the market dividend have eased somewhat relative to six months ago and that makes large-cap space more attractive,” Jemmett said.
“Then, through active management, managers can navigate through those issues anyway and we would expect them to.”
“In the small-cap space, people are looking towards that market for more dividend growth but it’s not without risk, given the run-up to the Brexit vote in June.”
