Despite their position at the heart of many portfolios, UK equity income funds have struggled to maintain their popularity in recent years.
On top of general investor antipathy towards stocks since the start of the financial crisis, the strategies additionally suffered from an above-average exposure to banks following the collapse of Lehman Brothers. More misery was heaped on the sector in 2010, when another previously reliable source of yield – BP – fell sharply in value and was forced to suspend its dividend payments for three quarters following the Gulf of Mexico oil spill.
Nevertheless, wealth managers say UK equity income remains a key allocation for their clients. Ben Willis, head of research at Whitechurch Securities, has upped his exposure in recent months.
He says: “We have been big holders of UK equity income since we have been running discretionary portfolios. It fits in well with our client demographic – the need for income – and also you have got the quality that it offers over the long term, which is a rising income and the potential for capital growth as well. It is almost like having your cake and eating it.”
Vanilla approach
HFM Columbus investment director Rob Pemberton has been overweight equity income for the past two years and says the strategy suits his firm’s plain vanilla approach.
Yielding equity funds are particularly attractive at present, he adds, given the low interest rate/low capital growth environment in the UK.
“The sorts of company that are producing dividends, to an extent by default, have strong balance sheets and strong cash flows,” Pemberton continues. “That is the sort of company we want to own.”
In terms of product selection, investors tend not to look far down the list when choosing UK equity income funds. A select band of well-established names dominate the sector, still led by Neil Woodford, whose Invesco Perpetual Income and High Income portfolios account for £20bn – more than a third of total assets under management in the IMA UK Equity Income sector. The peer group has a long tail of smaller portfolios as a result, with the bottom 75 funds holding combined assets of £8bn.
Fund buyers find opportunities among these smaller offerings, however. For example, James Calder, research director at City Asset Management, notes: “The world and his dad have the usual suspects,” and says he prefers a more dynamic approach.
‘Weight’ the anchor
As such, Calder favours managers with strong views, such as Stephen Bailey and Jan Luthman on CF Liontrust Macro Equity Income, and Richard Staveley’s River & Mercantile UK Equity Income Fund.
These ‘anchoring’ funds invest in different parts of the market, he adds, and therefore act as complementary holdings.
Similarly, Willis uses one of the lesser-known, but rising, names in the sector – Francis Brooke, manager of Troy Asset Management’s £600m Trojan Income portfolio. He says the fund has been “phenomenal” on a risk-adjusted basis, in part because Brooke is not afraid to hold high cash positions. At the end of April the portfolio held almost 8% of its assets in cash and equivalents.
But perhaps the biggest challenge to the established order in recent years has come from a new breed of innovative products, led by Schroder Income Maximiser.
Unveiled in 2005, the fund uses a derivatives overlay to generate a target income of 7%. In essence, the portfolio seeks to boost yield by writing call options on its underlying holdings.
When markets are rising, the fund is therefore likely to lag traditional equity income vehicles, in terms of total return. When markets are falling, however, the option premiums it receives serve to cushion the portfolio.
Popular approach
The approach has proved popular, and by the end of April the fund had grown to almost £800m in assets.
Pemberton and Willis both hold the Schroders portfolio, using it as a diversifier for conventional UK equity income vehicles, rather than a core position.
“We have held [Income Maximiser] since 2007, and we use that merrily because it has always hit its target income of 7%,” Willis explains.
“But it is cyclical. It is deep value and has been volatile, particularly recently. So it is complementary to the defensive positions we hold elsewhere.”
Pemberton uses the fund across his client portfolios, alongside traditional offerings from Invesco Perpetual, Threadneedle and Artemis.
Unique attributes
He says: “Schroders is not clustered with the rest, it is quite different. So you need to know what you are owning with this one. It will give you a high yield, but it will also give you a much more volatile capital return.
“An enhanced yield strategy is, prima facie, a good thing. But you have got to be aware that it is the cherry on the cake – the cake is the underlying portfolio.”
The success of Schroder Income Maximiser in attracting attention in the sector has inspired other groups to launch similar products.
Among them are Insight Investment’s UK Equity Income Booster Fund, which was unveiled in March 2009 and targets a yield of 8%; Santander Enhanced Income Portfolio; Fidelity Enhanced Income; and Ignis UK Enhanced Income.
Willis has some exposure to the Insight fund, which he says is “between Woodford and Schroders” on the volatility scale, and which has delivered on its higher income target.
Funds employing yield-boosting call option strategies can also be found outside the IMA UK Equity Income sector.
These include IFSL Harewood UK Enhanced Income and RWC Enhanced Income. RWC kept its fund outside the IMA peer group to give it greater flexibility on asset allocation.
Overseas equities
In May, co-managers Nick Purves, Ian Lance and John Teahan, who previously ran Schroder Income Maximiser, held 15% of the portfolio in overseas equities and 10% in cash – more than the 20% combined limit allowed in IMA UK Equity Income.
Away from the open-ended arena, investment trusts also offer options for yield seekers.
Unlike unit trusts and Oeics, which have to distribute their income every year, investment trusts can hold back up to 15% of the income they generate, to distribute in leaner times.
Among the funds using this facility is the £750m City of London portfolio, which has increased its dividend for 45 consecutive years.
Since April, investment trusts have been able to distribute income from capital profits, enabling funds with lower revenue reserves to boost their yield.
In the UK equity income space, Willis uses the Edinburgh investment trust and Aberforth Geared Income, which he describes as “a volatile beast”.
