Avoiding herd mentality in UK equity income funds

Should investors be  about suggestions of a “herd mentality” among UK equity income fund managers?

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A cornerstone of the UK retail investment market, the UK equity income sector hosts some very popular funds but suggestions of a ‘herd mentality’ among fund managers has led some to question whether investors should look for more diversification.

According to FE Analytics, 72 of the 99 funds in the IMA UK Equity Income sector hold GlaxoSmithKline within their top 10 holdings, while 53 have Vodafone as one of their top positions.

Some have warned that such concentration of holdings could prove problematic. Darwin Investment Managers founder David Jane says: “Equity income has had a tailwind over the last few years, with extremely low official rates pushing investors towards those stocks with yield characteristics.

“This has disguised the high concentration risk element of this strategy, encouraging investors towards the increasingly scarce universe of stocks that meet these criteria. With the sustainability of quantitative easing now under question, bond proxies such as these are likely to be exposed as such.”

Hargreaves Lansdown head of research Mark Dampier is mindful that many investors have put money into popular fund managers but suggest they should diversify more. Dampier says: “There has always been a bit of crowding. Most people just choose the fund managers they like. However you need to diversify for manager risk.”

Dampier highlights funds such as the £360m Marlborough Multi Cap Income fund. It has a differentiated portfolio make-up, with its top 10 holdings consisting of names such as Polar Capital, Cineworld Group and Talk Talk Telecom Group.

The growing dividends that the commonly-held large stocks of the FTSE 100 pay out are attractive to fund managers looking to satisfy the growing yield demands of their investors. However, F&C co-head of multi-manager Gary Potter believes many investors are missing a trick by not looking past the typically larger UK equity income funds towards more nimble portfolios.

Instead, Potter has identified what he calls a “whole new breed” of UK equity income funds filling their portfolios with less popular stocks as having the best opportunity in this current climate.

Potter says: “There is a whole new breed of income funds available for those looking to go off the beaten track – which is what I think they should be trying. Our opinion is that some sectors that have become more defensive have become quite highly valued.

“I am saying those with small funds that embrace small caps are the absolute sweet spot right now in the economy. People are missing out on funds that are building their track record and not living off it.”

One fund that Potter praises for doing something different is the £87m Chelverton UK Equity Income fund. Managed by David Taylor and David Horner, the fund invests in UK small and mid cap companies, with 50 per cent of the portfolio allocated to each sector, and steers clear of the FTSE 100.

Taylor says: “We are a bit like the tortoise in the hare and the tortoise. We have a fantastic spread of 80 stocks which gives us a nice balance.

“We have tried to keep a real balance across everything because there has been no real sustained sector leadership. We are income purists and our investment process is that we only invest in companies that yield four per cent on a 12 month year.”

Architas senior investment manager Sheldon MacDonald points out there are advantages to picking smaller funds with less commonly-seen holdings. He says not holding Vodafone, for example, allows a manager to move down the cap scale towards holdings with more growth potential.

MacDonald says: “The fund manager also needs to think about what the dividend policy is. If Vodafone were to cut its dividends, would all dividend income funds holding it sell it? There is a lot of second guessing going on and all managers will keep that in mind when considering the value of the stock.”

Architas has been holding one such fund within his multi-manager range – the £1.8bn Jo Hambro Capital Management UK Equity Income fund. Held by Architas for seven years, the fund’s holdings have some differentiation from the typical portfolios of its UK equity income brethren and ITV, Centrica and TUI Travel PLC feature in its top 10.

MacDonald says: “We like it for its high conviction and discipline. This ensures the managers are continually reminding themselves of where the value is. They have also taken steps to keep their fund size limited. By limiting their fund size it means their smaller positions give them flexibility.”

With events such as the eventual withdrawal of quantitative easing and concerns that “expensive defensives” are due a valuation correction, could investors in the UK equity income sector stand to benefit from different and diversified investment portfolios?

In the context of the bigger picture, MacDonald says: “As yields have risen in the fixed income space, that relative attraction of dividends has gone away.”

Taylor agrees with this sentiment and indicates the benefits of less typical stocks for UK equity income managers. He says: “The whole area of non-FTSE income has become a more attractive area. It is a subtle change.”

Stock Percentage of IMA UK Equity Income funds owning in top 10
Glaxosmithkline 73%
Vodafone Group 54%
BP 54%
Royal Dutch Shell 49%
British American Tobacco 44%