UK equity income fund managers have firmly established themselves in recent years as the brightest stars in the City’s firmament, at least as far as retail investors are concerned.
In the six years since the dot com bubble burst, they have proved their metal in both a severe bear market and the subsequent bull run. Names like Neil Woodford, George Luckraft and Tony Nutt now sit in the pantheon where once only Anthony Bolton stood.
This relatively new fame is backed up by their performance. Figures from Trustnet show that the average fund in the UK Equity Income sector clocked up a total return of 60.1% over five years to September 19th and 58.2% over three years, comfortably outperforming the FTSE All Share over both periods. It is not surprising that equity income funds today comprise a significant portion of investors’ portfolios.
It was not always thus. During the technology boom of the late nineties it was growth funds that were in vogue. Equity income funds, which often have an emphasis on blue chip value stocks, generally lagged the market and investors shunned the sector in favour of racier alternatives.
Charles Brand, head of managed funds at Principal Investment Management, which compiles the influential equity income fund White List, says: “Five years ago fund management houses couldn’t give them away.”
The ensuing bear market quickly changed all that. As markets slid from their peak in December 1999, their fall precipitated by September 11th, investors fled into defensive stocks, such as utilities and tobacco companies. In a world of falling share prices, yield was suddenly important again and the traditional stock hunting ground of equity income funds became the focus of the wider market.
Valuations have risen sharply since then, particularly among small and mid cap stocks, which has helped fuel strong performance from equity income funds. The trade-off of this is that yields have fallen and managers are being forced to look elsewhere to ensure they meet Investment Management Association (IMA) sector requirements.
These state equity income funds must yield at least 10% more than the FTSE All Share. As a result, most managers have increased exposure to large caps recently, while others like Adrian Frost of Artemis, Rathbones’ Carl Stick and Clive Beagles of JO Hambro Capital Management are dipping into the Eastern European property market in search of higher yields.
Principal’s Brand is worried that some funds are finding it difficult to generate sufficient yield at the moment. “One of the issues we are concerned about is that a lot of these funds are struggling to achieve their yield targets,” he says.
The increasingly difficult environment for yield focused funds is illustrated by the fact that a key index, the FTSE 350 Higher Yield, has underperformed the FTSE All Share over the last year, marking the reversal in a long-standing pattern of outperformance against the wider market. Over 12 months the index has returned 12.3% compared a 14.5% rise in the FTSE All Share.
So does this signal an end to the millennial reign of equity income funds?
Dan Kemp, head of multi-manager at Christows, believes equity income funds face obstacles going forwards and says they could start to underperform their peers in the UK All Companies sector. He is subsequently urging advisers to reassess clients equity income fund exposure, which is some cases could be high on the back of the sector’s success.
Markets, he says, have been very supportive of equity income funds over the last five years, but he believes an imminent global slowdown means sentiment will favour genuine growth companies rather than the defensive and cyclical stocks that have underpinned equity income funds’ strong performance.
“There are a number of different challenges facing equity income fund managers at the moment, which suggests that although they should always have a place in client portfolios, the capital allocated to that part of the market should perhaps be less,” Kemp says. “Equity income fund managers are going to find life more difficult going forward than it has been over the last few years.”
Kemp, who has reduced his portfolios’ exposure to UK equity income funds in recent months, points out that high yield stocks behave in a similar fashion to bonds and act as bond proxies. There has been significant gilt and corporate bond yield compression recently and spreads have narrowed. With the tightening cycle set to reverse in light of rising global interest rates, Kemp believes this could spell bad news for high yield stocks.
He says: “We are now at a stage where we’re quite bearish about credit markets and it is likely these bond proxies will underperform.”
Karen Robertson, manager of the £340 million Standard Life UK High Income fund, agrees that is getting harder to find stocks offering an attractive yield, particularly among mid caps, and says the pool of cheap, high yield stocks that was available during the bear market has now mostly dried up.
“The environment is much more difficult than it was two years ago,” she says.
Robertson’s large cap exposure has steadily increased and she now holds 75% of her fund in large companies and 25% in mid caps, compared to a 50/50 split two years ago. Large cap stocks like Vodafone, HSBC and Royal Bank of Scotland, all of which Robertson holds, offer attractive yields of 5%, 4.5% and 4.5% respectively, she says. Overall, her fund yields 3.4% at present.
Robertson says: “There are times when income stocks underperform and we are in that environment. This is making it more difficult for funds that only buy high yielding stocks.”
Robertson, whose fund has outstripped the sector average over three years by 12.3%, adopts a more flexible approach than some of her peers, which can be useful in the current environment. Her fund can invest up to 25% in stocks with a below average yield on the basis that they provide capital or dividend growth prospects.
In contrast, funds like Toby Thompson’s New Star Higher Income and Tineke Frikkee’s Newton Higher Income have strict yield criteria. Thompson and Frikkee, his successor at Newton, can only invest in stocks that yield 120% and 115% of the FTSE All Share respectively.
Although a more flexible mandate may be useful at times like this, it does not necessarily mean performance will be better over the longer term, however. A stricter mandate can prevent a manager from getting carried away in a bull market and chasing bubbles. It can also ensure a decent yield is maintained.
Christows’ Kemp adds: “More flexible mandates give great opportunities to outperform in less supportive markets, but investors are likely to be disappointed with the yield the fund produces.”