It has been a tough year for UK equity income funds. In March, the Investment Association made major changes to yield requirements for the sector, reducing the yield threshold over a three-year rolling period from 110 per cent to 100 per cent of the FTSE All Share. Funds failing to meet this target face the risk of removal from the peer group.
The change elicited a mixed response from the industry. Some managers welcomed the move as pragmatic in light of the low interest rate environment; however, many others remained critical, stating investors may not receive what they signed up for and that lowering of the yield might encourage managers to work less hard. In addition, growing anxiety about the UK equity market in general, amid the ongoing Brexit negotiations and recent geopolitical issues, has pushed investors off risky assets and towards safe havens. The outlook for sectors such as pharmaceuticals and tobacco, which have been the mainstays of income funds, has also been deteriorating, adding to the overall challenges for the sector.
However, analysts feel that dividend growth is unlikely to be affected despite share prices taking a hit because of negative investor sentiment. With the lack of investment opportunities globally, companies may choose to pay out investors instead of ploughing the money back in for expansion.
Given the current economic uncertainties, investors should look beyond the headline yield and focus on funds that invest in good quality companies with strong fundamentals and dividend growth. One of the biggest risks to income funds are companies that cut dividends. Stock selection is key in order to avoid investing in businesses that may not be able to sustain their future dividends.
One fund that has consistently outperformed its peers and achieved its objective of income generation is Royal London UK Equity Income. It has been managed by Martin Cholwill since 2005, who has recently been joined by Richard Marwood as deputy manager.
Sector: UK Equity Income
Benchmark: FTSE All Share Index
AUM: £1,897m as at 31/08/2017
Management: Martin Cholwill
FE Alpha Manager rated: No
FE Crown Fund Rating: Four
The fund aims to invest in high-yielding UK companies that should be able to increase their dividends over time. In order to achieve that, Cholwill targets companies with high levels of cash on their balance sheet rather than profits.
The fund invests across different industries in a bid to spread risk. What is more, the managers pay high attention to the contribution of every stock to the risk of the entire portfolio. It holds more medium-sized businesses than most income funds, which tend to focus on the UK’s largest companies. However, according to the investment team, they do not specifically target mid-caps, although this could change in future.
The managers often adopt a contrarian view, investing in companies which are out of favour and pulling out of stocks which have become overvalued and may result in a lower dividend yield.
The fund has recorded a first quartile performance over five and 10-year periods as at the end of August. It tends to be one of the best performers in its sector when markets are rising but does a little worse comparedwith its peers when markets fall – a characteristic that can partly be explained by its high exposure to medium-sized companies.
The fund may well benefit from being heavily invested in medium-sized companies, as the larger dividend-payers have been very popular in recent years and their share prices have increased to the point where some commentators say they look overvalued. Medium-sized dividend-payers have been relatively overlooked as they are regarded as less defensive. While the value of the fund is likely to move more dramatically than most of its peers, the extra returns generated make up for the extra risks.
Overall, the fund is underpinned by cautious economic growth assumptions, and its focus on strong market positions, cash flow-backed dividends and robust balance sheets should provide resilience in a range of possible economic outcomes.
This fund is best suited to those willing to invest for at least five years. It has an OCF of 0.68 per cent and has an FE Risk Score of 91 currently (zero being cash and the FTSE 100 being 100).
Namrata Nanda is institutional marketing manager at FE