Many income investors are at risk of disappointment in the coming years and must think long and hard about whether or not their equity income fund is giving them what they need, according to Neptune Investment Management’s Robin Geffen. 
Earlier this year, asset manager trade body the Investment Association (IA) lowered the yield threshold for funds in the IA UK Equity Income sector from 110 per cent of the FTSE All Share to 100 per cent.
Ben Willis, head of research at Whitechurch Securities, said the change enabled managers of large funds not to compromise their investment approach to chase yields.
He explained: “The IA basically altered the sector to facilitate them because there were people like Neil Woodford, Mark Barnett running billions of pounds who were flitting between the Equity Income and All Companies sectors when their mandate is to provide an income.”
However, data released by Neptune earlier this week showed that over the last year, yields from the IA UK Equity Income sector have fallen significantly since the change.
“It appears that many income managers have reacted to the yield change by deliberately reducing their yield, presumably in an effort to boost their growth potential,” Geffen (pictured) said.
Percentage of funds and assets yielding more than 110% of the FTSE All Share
Source: Neptune Investment Management
As the above charts show, the percentage of funds in the IA UK Equity Income sector yielding 110 per cent of the FTSE All Share has fallen from 87 per cent in September 2016 to 48 per cent in September 2017. Meanwhile, the percentage of assets yielding 110 per cent of the index has fallen from 73 per cent to just 33 per cent.
Furthermore, the percentage of funds in the sector yielding 100 per cent of the All Share at the end of September 2017 has fallen from 96 per cent to 81 per cent one year on.
It should be noted that under the new parameters for the sector it is only when a fund’s yield falls to 90 per cent or less of the FTSE All Share in one calendar year that it is removed from the sector.
The manager of the £207m Neptune Income fund said this shows that “the interests of many UK equity income funds and their income-seeking investors no longer appear aligned”.
He added: “Some funds now don’t even yield as much as the market. For income investors who have come to rely on equity income funds for a high and growing income stream, this is a massive risk.
“Deliberately sacrificing yield is more often than not going to result in falling dividends, and many could end up with less money than they expected.”
Geffen said he feared many investors in these funds were not aware of the changes as much of the money in the sector was invested before the yield target changed, when funds were yielding more.
Not everyone agrees that this is necessarily a negative for investors, however, with Whitechurch’s Willis noting that, while some funds may be offering lower dividend yields than they were a year ago, they are still offering a yield-focused mandate.
“If you can get a dividend grower that are growing their capital base as well then that is key,” he explained. “I think investors in equity income understand that and are prepared to accept lower yields because that is where the market has been going.”
Flows into equity income funds in recent years has also made it harder to offer yields significantly higher than the market.
Indeed, with the rise of bond proxies such as tobacco stocks and the difficult run for cyclical sectors including miners and banks, the dividend roster has shrunk.
“The top 10 [dividend payers] make up about 50 per cent of all the income produced in the market and when you look at equity income funds there was homogeneity between a lot of funds,” Willis noted.
“There still is because they might not hold as much HSBC as the market, but a lot of them will still hold it because you can’t ignore its dividend.
“Some won’t hold the oil majors but plenty will because they pay such big dividends. But the problem is they are generally uncovered and we have seen if the oil price goes down they come under extreme pressure.”
Overall, he said holdings will depend on the primary focus of the fund: whether it is trying to offer a high headline yield or growing sustainable dividends.
He said managers in the sector should at the very least be aiming to offer a yield that is higher than the FTSE All Share.
“Part of me thinks you should generate a yield higher than the market whether it is 110 per cent or not, I don’t know,” Willis said. “But it should be more than the market because otherwise why not go out and buy a passive index tracker.
“You want active management because if you are looking for income you want to get hopefully an income that is higher than the market but also you want some stockpicking skills so they can outperform over the mid-to-long term.”
Geffen runs the four FE Crown-rated Neptune Income fund, which has boasted a top quartile performance over three years. However, it has slipped into the third quartile over 10 years, returning just 67.67 per cent compared with a 73.59 per cent gain for the average sector fund and a 70.99 per cent rise in the FTSE All-Share benchmark.
Performance of fund vs sector and benchmark over 10yrs
Source: FE Analytics
Currently, the fund has a yield of 4.79 per cent, among the top 10 highest in the IA UK Equity Income sector and ahead of the FTSE All Share’s yield of 3.61 per cent as at the end of June.
While low yields are an issue, he said the backdrop for UK equities and particularly UK income stocks on a one-to-three year view is also extremely challenging.
“Initially resilient post-Brexit, the UK economy has faltered since the start of the year,” he said. “Wage growth has been in negative territory since the second quarter, having been positive since 2014, consumer confidence and retail sales are falling, business investment is stalling and house prices are beginning to stagnate.
“The slide in UK car and high street sales in September is yet more evidence of an economy under pressure.”