Betrayed

Equity income funds’ performance tumbled in the past year as the credit crunch bit into high yielding stocks – especially financials – destroying a reputation for reliability. Paul Farrow examines the outlook of a once-faithful sector gone awry.

Investors have always been able to rely on equity income funds for steady performance. It would be unwise to compare their performance to that of a Volvo – remember Exeter’s zeros funds – but they have always had an air of reliability about them. Or they did. Over the past year they have had a tortuous ride – it has been an annus horribilis not experienced for almost a decade.

Equity income funds rarely let investors down, delivering positive returns in 15 of the 20 years until 2006 – the sector is also blessed with experienced fund managers that have seen stockmarket woe before. But the average fund is down 20% over the past year and many IFA favourites, with experienced managers at the helm, have been struggling the most.

For example, Axa Framlington Equity Income (George Luckraft) is down 25%, New Star Higher Income (Toby Thompson) down about 30% and Henderson UK Equity Income (James Henderson) down 23%. The latest Principal Income Study placed Anthony Nutt (Jupiter Income) and Carl Stick (Rathbone Income) white list regulars, in the grey list, because they have both suffered from high yielding value stocks.

The poor performance has resulted in money flowing out of the equity income sector – a trend that would have been unthinkable in recent years. In the past five months the sector has seen net outflows according to the Investment Management Association (IMA) – in July net retail outflows were £112m, June £77m, May £85m, April £71m and March £90m.

The Principal study reiterates what investors already know – that banks have been the main reason for their struggles. When the credit crunch began to bite 12 months ago, financials lost their appeal and mining stocks continued to offer little to no yield. What is more, some of the traditionally highest-yielding stocks just have not been offering appealing yields.

“Financials are a key for equity income managers because they provide most of the UK stockmarket’s income, so to beat the market you need to hold them,” says Charles Deptford, UK equity income manager at New Star. “The difficulties equity income managers are facing aren’t linked to the general market falls as such, but to the fact that it is difficult for an equity income manager to find the right stocks to invest in to be able to beat the FTSE yield.”

Parallels to the crisis have been made with the technology boom in the late 1990s. Bill Mott, the former Credit Suisse star manager now ensconced at PSigma Investment Management, says it is. “The correlation between today and the TMT [technology, media and telecoms] boom of the late 1990s is staggering. Technology stocks were seen as the future for the world economy and, at the time, who could have argued with such logic? Today we are seeing the same psychology in commodities and natural resources,” adds Mott.

But others in the sector reckon that today’s situation is far worse. They say it is necessary to go back to the early 1970s to find a stockmarket and economic environment that was as difficult as this one. “Unemployment in the UK could rise, we have yet to see significant problems on the leveraged buyout front, there has been no sign of a macroeconomic recovery over the summer and there is zero evidence of the start of an economic recovery at company level. No one is lending, whether it is banks or private equity. The system has seized up. The government is unable to help because of the financial constraints it is under,” says Jeremy Lang at Liontrust.

The financial crisis has naturally put pressure on company balance sheets – and the equity income manager’s chief weapon, dividends. Over the past few years, investors hoping for decent dividends have had little to worry about. Full-year 2007 dividend distributions in Britain rose 7.7% on average compared with 2006, with not a single FTSE 100 company decreasing its dividend.

However, the impact of the credit crisis and the consumer slowdown is beginning to have an effect on dividend payouts this year. The banks have cut dividends, while retailers such as Woolworth’s and Kingfisher have also cut payouts. Punch Taverns is one of the latest to scrap its dividend. Deptford admits that it is becoming difficult to find stocks that meet his criteria because of the pace at which companies are scrapping or cutting dividends. He is happy to forgo a little income for certainty that income will get paid in cash.

But others remain sanguine about the prospects of finding companies that can increase their dividends. According to M&G, 39 of the 46 (85%) FTSE 100 companies that reported in July and August increased their distributions, with 24 of those increasing their dividend by 10% or more. Some increases are higher, for example Rolls Royce (41% increase) and BP (31%).

“To me, this presents a positive picture of the resilience of many UK companies so far,” says Richard Hughes at M&G. “I believe there are still plenty of opportunities to find shares offering yields above the market average, despite the ongoing effects of the credit crisis and continued volatility in share prices. It is also important to remember that dividends can provide real income growth no matter what share prices are doing, and in this way they form an important part of the returns from equities.”

Likewise, Lang reckons it was more difficult to find growing dividend yields between 1998 and 2003 than today. He says that there are more than 150 stocks with a market capitalisation of more than £100 million in the British stockmarket that are yielding over 7%,which is about the same as in March 2003. “But investors do not have this level of pessimism about stocks across the whole market. The average yield on the UK stockmarket is about 3.5% while the current historic yield on the Liontrust First Income fund is 6.13%,” he adds.

Ask James Henderson, Henderson’s UK Equity Income manager, whether it is more difficult to find companies generating decent payouts and his answer is an emphatic “no”. He says that many “corporates are in relatively good health” and that finding dividends is getting easier, not more difficult. “The fall in the market means we are being presented with many good quality, high-yielding companies that are set to grow their dividend,” adds Henderson. “Stocks that are able to grow their dividends in these difficult times will obtain a good rating. For example Lloyds TSB is yielding 12%. Its capital value could double and it would still be yielding 6%. This is more than you would get if you deposited your money in one of their accounts.”

Yet the battle for yield is going to intensify in the months ahead – equity income fund managers have until the year-end to ensure they meet IMA guidelines. There has been growing criticism Invesco Perpetual High Income 22.74%Invesco Perpetual Income 22.29%St James UK High Income 21.32%Threadneedle UK Equity Income 13.35%Trojan Income 11.27%Invesco Perpetual UK Strategic Income 10.83%Threadneedle UK Monthly Income 10.76%Standard Life UK Equity High Income 10.72%Neptune Income 9.87%JM Finn Investment UK Portfolio 9.70%from a few groups – some of which have been lambasted for poor performance – that they are not being judged on a level playing field. Many equity income managers do not play for just yield – capital growth is often high on the agenda – and as a result some do not yield what the IMA guides say they should. The IMA has changed the definition to funds that invest at least 80% in British equities and that aim to achieve a yield on the distributable income in excess of 110% of the FTSE All-Share yield.

Take JPM Premier Equity Income, for instance – a sizeable fund sold by many IFAs that was named and shamed by Bestinvest in its Spot The Dog guide for three years of rather lacklustre performance, because its performance is based on yield. It is the likes of Toby Thompson at New Star and JPM that feel the heat. Thompson, for instance, intends to buy stocks yielding at least 120% of the average FTSE All-Share stock, and to sell when the yield falls back to the average. It is a reason, say advisers, why the fund has trailed its peers over the past 12 months. New Star UK Strategic Income 19.40%M&G Charifund 15.30%Newton Higher Income 14.60%Neptune Income 14.60%Lincoln UK Equity Income 14.40%Allianz RCM UK Equity Income 14.40%New Star Equity Income 14.30%JOHCM UK Equity Income 14.30%Unicorn UK Income 14.20%Resolution Asset Higher Yield 14.20%Axa UK Equity Income 14.20%Many of those groups – led by Liontrust – that play the yield card, have got together to build a comparison table that allows investors to choose an income fund according to their requirements. If an investor is looking for an investment fund that produces the highest yield the table will show which are top of the pops. Alternatively, they may prefer to reinvest their dividends and choose best total return over three years.

Liontrust’s table (see fundfact.com) aims to clarify the growing confusion surrounding the definition of income funds, or in its words make the equity income sector “fair game”. Rank the funds on the basis of total return over three years and Invesco Perpetual High Income fund would emerge at the top of the tables. Yet on income alone, it is a different scenario. The New Star Higher Income fund and JPM Premier Equity Income would be among the best performers. The new yield tool also allows funds to be ranked by the tenure of the fund manager, or by the number of years that the fund dividend has grown.

Liontrust says it would like to see any flouters of the IMA guidelines kicked out of the Equity Income sector. According to figures from www.fundfact.com and Trustnet, under half of the 87 funds in the sector frequently fail to hit the yield target. As it stands, Invesco Perpetual High Income (3.61%), Invesco Perpetual Income (3.86%), Cazenove UK Equity Income (3.36%), Threadneedle UK Equity Income (3.47%), Insight Investment Equity High Income (3.5%), BlackRock UK Income (3.68%) Swip UK Income (3.9%) Walker Crips Equity Income (3.9%) are falling foul, say Liontrust.

Nigel Legge, Liontrust’s chief executive, has called on the IMA to be stricter in its UK Equity Income sector definitions, or to split the sector. He argues that greater action needs to be taken by the trade body to ensure adherence to the sector’s rules. He says: “If rules are set for sectors, then surely they need to be enforced. How effective can a rule be if it uses the word aim? We could all say we are terribly sorry but we were aiming to keep within the 70mph speed limit on the M1, m’lord.”

Legge says a sector split of those who do not provide the yield is a potential solution. “This would enable advisers and their clients to makelike-for-like comparisons and for funds to meet the exact needs of the different investors in the sector.” The IMA insists it has no plans to add to its recent revamp of the UK Equity Income sector. Those that fail to meet its parameters by January 2009 will have to leave the sector. Ask Invesco whether it is concerned that it may get kicked out of the Equity Income sector and the reply is “we don’t want to comment on this at the moment”.

Meanwhile, BlackRock reckons it will be okay by January. A spokesman adds: “We agree with the principle of a clearer test for equity income funds. In March this year there was a change to the way yield on these funds is calculated. Like all equity income funds we have until the end of 2008 to meet the new requirements – which we expect to do. In the meantime, the fund – which has grown income every year since it was launched in 1984 – continues to perform well having outperformed the FTSE All-Share by 3% in the six months up to the end of August.”

A bit of clarity will help financial advisers. Brian Dennehy at Dennehy Weller says the situation needs to be clarified for advisers’ sake – and quickly. He argues that funds have switched sectors before when they have not met (or wanted to meet) guidelines.

“If you can’t, or don’t want to, run a fund that meets the dividend requirement then switch to the UK All Companies sector, which is for total return funds, just as Newton did with the Newton Income fund quite a few years ago,” says Dennehy. “No flexibility, no exceptions, everyone knows where they stand. To do anything else must be a breach of the spirit of the Treating Customers Fairly rules, as it would totally lack the openness, honesty, and clarity to which fund managers and the IMA must be striving.”

The yield argument may be pedantic at a time when fund managers – and not just equity income – face their biggest challenge for years just to ride this storm out. Few managers are brave enough to suggest that we are past the worst. “I don’t feel there has been enough despair yet” and “the end to the credit crunch is not imminent”, are just some of the sound bites from the equity income brigade.

But that does not discount that equity income fund managers say they will make a comeback when a recovery has begun. Falling interest rates (increasingly likely) and a falling oil price (already happening) will be triggers, they say. “Cashflow and strong balance sheets is the key,” says Martin Cholwill at Royal London. “The TMT bubble was a good example of why not to lose faith in equity income – and opportunities exist for those looking on a long-term horizon.” The contrarians are already eyeing the sector because they say that is where value is to be found. Equity income and value are synonymous for many and many say investors might want to start drip-feeding their money to take full advantage of any recovery. The equity risk premium over gilts is widening and Lang reckons that once it hits the 5.5% mark, a buying opportunity beckons.

Mott – who is rated as a “buy” by several advisers at this juncture – reckons it is a once-in-a-decade opportunity to buy shares. He has just started to buy some small amounts of mining stocks and has built up a 2% position. He also owns shares in British banks such as Lloyds TSB and Barclays and insurers such as Pru, Legal & General and Aviva, because they are cheap.

“Significant UK interest rate cuts are now possible and will provide a stimulus to consumer activity. These are challenging times, and there is considerable fear around. But I have found throughout my investing life that the most important principle to stick to is ‘sell euphoria and buy despair’.” It is a strategy that has paid Mott dividends, in every sense of the word, over the long-term. lUK Equity Income – total returnUK Equity Income – income return


The IFAs’ view

Rob Harley, research analyst, Bestinvest
“Having had a torrid 18 months, we are approaching the point where the pendulum may start to swing more in favour of equity income funds. The risk is more balanced between financial stocks and the material/energy sectors given what has already been priced into the former. In addition, we may start to see industrial stocks, which have been popular growth stocks, come under earnings pressure as world growth slows. What funds should investors focus on? Artemis Income: apart from the experience of the underlying manager, we like the structural characteristics of the fund, which ensure a greater degree of economic diversity by sector (the fund has a maximum exposure to each economic sector of 15%), and investment style of the manager, which focuses on company cash flow characteristics as opposed to dividend yield premiums.”

Andrew Merricks, Skerritts Consultants
“My appetite for equity income funds has waned over the past year-and-a-half, simply because of what they tend to invest in rather than anything to do with the funds themselves. Because of their yield demands, they have necessarily been exposed to the demise of the banking sector – or at least those who adhere to the Investment Management Association (IMA) rules have done. Several better performers statistically have effectively cheated their way to the top of the tables by failing to achieve the yield requirement as set out by the sector guidelines, thus being able to avoid completely the financials.

Of the funds that I prefer, Martin Currie, F&C and Henderson remain in my favoured list, with Marlborough close behind. Their 12-month performance is hardly inspiring, but the managers have a strong record of consistency. I shy away instinctively from mega funds such as Invesco and Jupiter as, in this market, I think it is dangerous to be restricted in any way from moving quickly if necessary. Every manager of a large fund says that size does not matter. Invesco European Growth and Fidelity Special Situations are just two previous examples that this is not strictly true.”

Brian Dennehy, Dennehy Weller
“Four of the UK stockmarket’s biggest constituents yield more than gilts for the first time in 20 years – BP, Glaxo, HSBC, Vodafone. Looking at the FTSE 100 index as a whole, the area of 4500-4888 could yet prove to be irresistible, as the economic slowdown comes more into focus in coming months. At those levels the UK market should be a compelling “buy” for many institutions, sitting on huge volumes of cash, as dividends yields would be heading quickly to 5%, compared with gilt yields no higher than 4.5%.

In March 2003, a similar signal would have got you back into the stockmarket almost exactly at the bottom. Overall, there is a strong argument for buying UK equity income funds, particularly those with a strict discipline such as Newton Higher Income. When equity income is down and out, it should be bought, whether for income seekers or total return. If you want to observe an equity income portfolio in practice, over the long term, there is none better than M&G Dividend, in particular comparing the dividend output with building society interest. For example, over 43 years the M&G fund’s dividend payout has gone up in every year but two. And the opportunities for equity income overseas are also more compelling than ever.