Many income investors wrongly assess the quality of a fund based on their yields, according to Downing’s Neil Shillito (pictured), who warned that the amount of income a vehicle pays is not necessarily correlated to how successful it is. 
The manager, who heads up the Downing Diversified Global Managers fund, said higher yields can mean the funds are investing in lower-quality companies which, while potentially leading to a higher stream of income, could weigh heavily on capital appreciation and lead to losses.
Not only this, he pointed out that investors could be wrongly basing their decisions on inaccurate fund yield information given that both the dividend and fund’s share price will fluctuate on a daily basis.
“One of the main points for me is the general misunderstanding and lack of knowledge about yields, particularly the dividend yield and the fund yield,” Shillito said.
“The dividend yield on a fund might be 5 per cent but the fund yield is only 2.5 per cent because, in the intervening time, the share price has risen and the fund yield is a ratio between the dividend yield and the fund price.
“So, if your price has increased from £1 to £2 on a 5 per cent dividend yield, the fund yield becomes 2.5 per cent.
“I think it can work the other way of course. People can be led into the idea that they’re getting a 5 per cent yield and they’re not. It might be considerably less than that. And of course, the fund yield changes over time.”
As such, the manager said both advisers and investors require a better education in terms of what they’re receiving and how they are making their cash work.
This comes amid an ongoing market-wide ‘hunt for income’, which has been sparked by ultra-low interest rates and quantitative easing pushing bond yields to historic lows.
Shillito likened a fund’s yield to the yield on a bond. If, for instance, the government launches a 10-year gilt and its yield rises, investors are not receiving more income for the money because their capital has dropped.
Performance of indices over 5yrs
Source: FE Analytics
“It’s the same principle with equities but, of course, we’re not used to thinking of them in that way, because you tend to have either a growth mindset or a total return mindset,” the manager continued.
“You can think you’re doing very nicely with your 5 per cent dividend yield but, if the price has dropped, you’re losing cover so your total return is not very exciting. That, in a nutshell, is my gripe – I don’t think people really understand that.”
Elsewhere, Shillito warned income investors against choosing the fund with the highest yield without questioning why its pay-out ratio is so high.
Shillito reasoned that, in many ways, the fall in the yield requirement should actually push managers to further stand out in a broader universe of peers with similar mandates.
“One of the principle reasons that yield expectations are down is because, although we have recently seen a rate rise in the UK, it was highly predicted and it’s not very significant. Most commentators think that’s going to be the last one for a very long time,” the manager explained.
“We’re not going to be seeing half a per cent rise every year. That’s just not going to happen because economic growth is still weak and yields are still extremely low on government bonds. Therefore, under the current climate, there isn’t a huge motivation for corporates to pay high and growing dividends. Why should they?
“Cash is offering next-to-nothing, Treasuries are offering a very low percentage [yield]. Why would you be paying out huge dividends of 5 per cent when your investors can only get 2 per cent elsewhere? I would put my money on the reducing yield being the economic matter rather than complacency among managers.”
Performance of index over 5yrs
Source: FE Analytics
Instead, Shillito said investors need to focus on managers’ abilities to grow their dividends, rather than offer the highest yield possible.
“It’s why it’s so important that, if you’re going to invest in equity for income, you must have a reasonable degree of certainty that the fund manager is skilled enough to ensure a growing dividend yield,” he continued.
“A 5p yield to the pound is fine but what about 10 years from now? If you measure that against inflation, you have to have a rising dividend yield to compensate for the variable fund yield and also for inflation.”
Patrick Connolly, head of communications at Chase de Vere, agreed with Shillito’s belief that many investors are unsure of the difference between dividend yield and fund yield.
However, he argued that investors’ main concerns surround the amount of money they receive in cash terms and whether their capital rises or falls.
“I understand that investors wouldn’t understand the difference between fund yield and dividend yield, but most investors wouldn’t think they need to understand that,” Connolly said.
“Income investors care how much income they physically get and they care about capital appreciation or losses in pounds and pence.
“Whether the quoted yield for a fund has gone up or down – which may be to do with price movements – usually isn’t a consideration at all for them.”
“I think an important factor that people need to be aware of is paying charges and whether that’s coming from income or capital. But, really, the bottom line for investors is how much money they have made or lost, how much income are they getting and then, how their fund’s performance compares with the performance of other funds.”
That said, Connolly agreed with Shillito’s view that an income fund’s worth should not be dictated by the yield it offers. Instead, he said investors need to look at what each individual fund is trying to achieve and whether that is suited to their investment needs.
“Some funds are very much income orientated and for those the yield is the main criteria, but many of them – certainly many of the better-known funds – are total return-orientated,” he reasoned.
“If the best approach to get the total return is to have a slightly lower level of income, then I don’t think the managers are neglecting their duties at all. What they’re doing is managing the fund to what the manager thinks is the best effect."