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Are UK equity income funds herding into the same stocks?

15 June 2018

FE Trustnet breaks down the IA UK Equity Income sector and asks whether funds are too correlated with one another.

By Jonathan Jones,

Senior reporter, FE Trustnet

UK equity income managers could be accused of herding into the same stocks, according to research by FE Trustnet that shows many funds are closely correlated with each other.

Investors have increasingly raised concerns in recent years over fund managers’ ability to meet the IA UK Equity Income sector’s yield requirement as they are forced into the highest yield stocks in the UK equity market.

Yet, while yield criteria have been relaxed more recently, there appears to still be some evidence that managers are all buying the same stocks.

“Within the income sector there is a question about whether there is herding,” said Steve Magill, manager of the UBS UK Equity Income fund, who claims that it can often pay to be more diversified. “The evidence that we give to clients is that in 2016 we were number one in the industry by a country mile.”

Over the past five years the IA UK Equity Income sector has had a choppy ride, beating the FTSE All Share benchmark in 2013, 2014 and 2015 as well as so far this year.

However, when the market rotated in 2016, with value briefly making a comeback, the funds in the sector were caught out and underperformed the index in both 2016 and 2017.

Performance of sector vs index over 5yrs


Source: FE Analytics

Magill’s fund is the best performer over the past three years and was the top performer in 2016, when only 5 per cent of the sector beat the index.

This is in part thanks to the fund’s overweight positions in commodities stocks, such as mining and oil, said Magill, areas that have been avoided more recently after several miners cut their dividends in 2015.

To discover if whether there was evidence of herding, FE Trustnet looked at a range of metrics.

Firstly, we used the r-squared ratio, which measures the correlation of a fund’s returns relative to a benchmark (in this case the sector average).

Funds in the sector had an r-squared figure of 0.85 – typically anything above 0.7 is considered highly correlated – suggesting that funds in the sector have performed similarly to one another.

We then looked at the tracking error, which measures how closely each has tracked the returns of the sector average. A figure of less than 3.0 would label a fund a “tracker”. The IA UK Equity Income sector average was close to this at 3.6.

Finally, using the correlation table, another measure of how closely-linked a product is with another, the average of all funds in the sector has a score of 0.92 relative to the sector average over five years, with a figure of 1.0 suggesting that funds have moved completely in line with each other.

Veteran equity income investor Robin Geffen (pictured), manager of the Neptune Income fund, suggested that this was partly due to concentration of risk for funds in the sector, noting that the average IA UK Equity Income fund relies on its top 10 holdings to generate 43 per cent of its yield.

“Taking such an approach not only puts investors’ income on a weak footing, it also puts their capital at risk,” he explained. 

Robert Wilson, fund analyst at FE Invest, said this concentration has come about over the past decade because large-cap, quality growth stocks have outperformed, making it difficult for managers not to invest in such companies.

“To some extent, there is some herding if you are strict on definitions but you should also put it into context that there are only 100 big stocks in the FTSE 100 to pick from,” he said.

“Dividends come from more mature businesses with consistently strong cashflows so it makes sense that traditionally a lot of managers have backed [these].

The analyst added: “Growth as a style has been doing well for the last 15 years and essentially with globally accommodative monetary policies leading to rising markets it was easier for managers to pick these stocks.”

This particularly benefited the large-cap managers, with companies with dependable, growing dividend payouts benefitting from their ‘bond proxy’ status.

As such, large-cap managers saw yields compress, meaning that there were fewer stocks to choose from.

This in turn has made them look similar, said Wilson, who added that as a result some large names have been removed from the FE portfolio shortlist in recent months.

But as the chart above shows, there has been a sea-change over the last five years with a number of high-yielding companies put under pressure, particularly in the mining and oil sectors.

“The crowding element became an issue as when stocks disappointed. It was apparent a lot of managers were in the same names as portfolios behaved in the same way,” he said.

FE Invest research manager Charles Younes, added that while the performance of such stocks has played a part, it is also structurally difficult for managers to look different from one another.

“It is harder to behave differently when you mandate is so narrow,” explained Younes. “Only two sectors have a yield requirement, but contrary to IA Global Equity Income, here you are limited to the domestic market.

“These are two big constraints which might explain some of the structural herding element.”

One disappointment for Wilson with managers within the sector is that they have not been watching the cash flows of the companies they invest in closely enough.

“Arguably some managers have not been closely monitoring cash flows,” said FE Invest’s Wilson. “The deterioration of fundamentals (such as free cash flow cover) in some stocks should have alerted them to exit some of last few years stock blow ups but as we now know, they were unfortunately caught in the crossfires when the company cut its dividend.”

There are, however, ways for managers to differentiate themselves. One such way is to become highly concentrated, although Wilson noted that this does come with concentration risk.

He added that with volatility returning to the market, investors may be better served by finding a good manager that can make right calls at the right time within the large cap space with a portfolio of 25-30 stocks, although this approach can potentially lead to higher volatility with each stock having a large impact on portfolio performance.

Another option however, is to take a multi-cap approach, meaning that managers do not have to rely on a small number of large-cap stocks.

“Those that managed to beat the benchmark and peers were more diversified and, in most cases, had a bias to lower caps, in other words more diversified across market cap too,” Wilson said.

Performance of funds vs sector over 5yrs


Source: FE Analytics

Some have achieved it and Wilson said there are a number of good options.

One highlighted by FE Invest is five FE Crown-rated Miton UK Multi Cap run by Gervais Williams and FE Alpha Manager Martin Turner, which takes an all-cap approach, although he admitted that capacity may be an issue moving forward.

Mid- and small-cap funds such as Montanaro UK Income and Unicorn UK Income are also good options for investors, which are on the FE Invest shortlist.

“With volatility returning to the market what you want to do is find a good manager that is consistent in their application and one that pays a lot of attention to concentration risk within the large cap space and maybe blend that with another manager that goes across the market cap space,” Wilson added.

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.