Benchmarking UK equity income funds against each other is like comparing ‘apples with pears’ given the wide range of strategies now available, according to Insight Investments’ Tim Rees.
Rees, manager of the £111.5m Insight Equity Income Booster fund, said the recent study into benchmarking by the Financial Conduct Authority has thrown up numerous questions for the sector.
According to data from FE Analytics, 10 of the funds in the 86-strong IA UK Equity Income sector use their peer group or another similar one as a benchmark.
While the objective for IA UK Equity Income funds is to deliver a yield in excess of the FTSE All Share index at the year-end and on a rolling three-year basis, there are a number of ways this can be achieved.
“As a house, we're deciding for income funds on whether it should be the FTSE All Share or the IA UK Equity Income sector,” he said. “You might think that ‘Equity Income sector or FTSE All Share, there's not a lot in it’, but there is a heck of a lot in it on a calendar basis.
“There is a very big difference between the equity income sector as a median return, and the All Share. What I try to do is to remove the extremes of those factors and therefore prefer to be more focused on the All Share or FTSE 100 performances.
“This volatility comes because a lot of income funds tend to be more cyclical, [the style] tends to lend itself to certain sectors and tends to keep you out of others,” he said.
Annual relative performance of IA UK Equity Income sector vs FTSE All Share since 1991
Source: FE Analytics
While some funds will aim to meet sector yield requirements through investing in the FTSE All Share or FTSE 100 (which makes up around 98 per cent of the market capitalisation of the former), others might hunt further down the market cap scale. This, however, can lead them to wilder swings in performance.
“There are funds in here which are effectively small cap funds and they can have wildly strong, and at times rather weaker, performance,” he said. “So, it's not really [comparing] apples and apples, it’s more like apples and pears.
He added: “I'm looking for performance that is much more steady. But it doesn't mean that I'm immune.”
Rees’ enhanced equity income strategy focuses on UK large-cap stocks, making it sit “somewhere between the FTSE 100 and the All Share”. The Insight Equity Income Booster fund invests in a portfolio of 40 to 60 dividend-paying stocks, using a call option overlay to deliver a target yield of 7.2 per cent. Premiums received from writing the option are used to boost the dividend income, which is paid out monthly.
Given the call option overlay, Rees (pictured) tends not to take big risks on special situation-type stocks “that would serve no purpose whatsoever” to the portfolio.
“The simple reason is that we have this systematic option overlay and if I found a stock that I think is going to be the ‘bees knees’ and the next great thing, I’m only going to receive a premium based on what the market thinks about it,” he said. “If I’m proved right and it goes to the moon, it’s the options holder that benefits, not the fund, so it doesn’t pay to take great risks.”
Nevertheless, Rees said it is not a defensive or “cowardly” fund, with the manager willing to take positions in unfashionable areas of the market.
“To be quite honest, this last few months is probably the weakest performance I've had in terms of capital returns in probably 20 years,” he said. “I go back to when I was bravely fighting the tech bubble as an income investor, believing that nonsense was prevailing across the world. And you know, we just had to sort of hang in there.”
As such, the Insight manager said that the fund has a very low turnover and has a ‘hold and learn discipline’, preferring to wait rather than act rashly.
“I'm an optimist in terms of the global economy,” he added. “I think there are huge geopolitical pressures being developed at the moment and that is what the American president Donald Trump is effectively reflecting.
“It may not just be populism, as it is described, it may be more than that. You need to put a portfolio together that sort of copes with all of [that].”
While some have argued that the UK equity market has become a harder place to invest with the threat of Brexit hanging over it, Rees said that he remains positive on the outlook for the domestic economy.
“I look at the UK economy and hear people saying ‘oh, well, you know, the UK might recover very strongly if we can get rid of Brexit, Brexit's been holding us back’. But it hasn't been holding the consumer back.
“If you look at the savings ratio in this country, the Anglo-American consumer, bless them, will not stop spending unless you hit them very hard and play whack-a-mole with interest rates. And we clearly do not have the central bank structure to play whack-a-mole.
“So they're quite happy consumers and understandably spending all they've got and more if they're given half a chance,” he said.
The Insight manager added: “I don't see that there's any great recovery in the UK consumer because it just hasn't been constrained in any way.”
One area that Rees does like is banks, which are more balanced than their US and European counterparts, having resolved the issues of the credit crisis.
In 2007/2008, UK retail banks had attempted to look as “racy and sexy” as investments banks, which prompted them to raise money on the wholesale market to lend more to customers.
“You had a situation where Northern Rock went under because it lent 300 per cent of its deposit base,” he said, while other banks such as Royal Bank of Scotland, HBOS and Lloyds were forced to seek government help.
While wholesale funding helped boost lending prior to the credit crunch, however, the size of the mortgage market has barely grown since then.
“Banks are being run much more prudently in terms of the amounts that they're lending, they are lending roughly what they have in actual deposits,” said Rees.
“So, in that sense, I think the banks are unquestionably on much firmer ground. The problem, if there is one, is that actually large chunks of the mortgage market and housing market have seen very big increases.
“Effectively, you've got the mortgage availability being concentrated into fewer and fewer properties. And we have, I think, a disjointed, dislocated housing market.
“And to me, this is a risk demographically, but ultimately, there is a banking system that's being run much more prudently but an expectation that somehow £1.3 to 1.4trn of lending is somehow going to be able to transfer £6 to 7trn in property ownership to the next generation.”
Performance of fund vs sector & benchmark since launch
Source: FE Analytics
Since launch in March 2009, the Insight Equity Income Booster has made a return of 171.35 per cent compared with 203.65 per cent for the FTSE All Share index and 188.8 per cent for its average IA UK Equity Income peer.
The fund has a yield of 7.8 per cent and an ongoing charges figure of 0.84 per cent.
“It’s a ‘steady Eddie’ fund that is trying to allow the investors who don’t want to go into bonds where you only get about 1 to 2 per cent [yield] and worry about the eroding features of inflation over the next 20 to 30 years,” Rees concluded.