What are the best funds for income?
The UK equity income sector has consistently been one of the most popular for investors. It is the second-biggest of the Investment Management Association sectors, with around £53bn invested, but the lack of clarity over the rate at which funds pay income has raised concerns that some investors may be investing in the wrong funds for their needs.
With 102 funds in the sector, it is one of the best served in terms of choice for the investor but the way funds target and distribute dividend income varies widely. The usual ranking method for these funds is to look at total return, combining capital gains and income reinvested but many older investors want to withdraw income, so this is not always the best way to identify the best funds.
Caliber Financial Management managing director Roger Yates says: “People are buying income funds thinking their purpose is income but all it means is there is a slight lean towards income and there is no commitment whatsoever to maintain income or grow income whatsoever.”
To help address this problem, this month sees the launch of the Money Marketing UK equity income dividend return survey.
The dividend income table is the work of retired IFA Bruce Dalton, who has been doing the analysis himself over the last 10 years.
Dalton says total returns can be a good measure for many investors, particularly those in the accumulation phase of their lives, but for investors in retirement, the amount of dividend paid becomes much more important.
He was frustrated with the difficulty he found in getting dividend information directly from fund companies, so he sourced the dividend information and analysed the level of income paid out by each fund in the UK equity income sector.
The information presented here is the result of that work and divides funds into quartiles depending on their cumulative dividends paid over rolling three-year periods.
Independent fund management consultant and former Artemis product development director Nick Wells (pictured) says: “It is a very good idea to have that sort of information available as so many people rely on the income. If you look at Department for Work and Pensions’ statistics, you can see the number of baby boomers, who have been the great investing public in years gone by. They are now moving to the decumulation stage.
“The length of time that many of these people will spend in retirement means that rising income is a need.
“Bond investing is not going to get you increasing dividend flows and it is the increasing dividend that is so important.”
But fund firms do not release dividend income readily, preferring to use total returns as a measure of their performance.
Pantheon Investments director Helen Richardson says the lack of easily accessible dividend data is frustrating.
She says: “You have to build specific reports to try to generate dividend information. It is very difficult, whereas if you are looking at total return, you can get that information anywhere.”
The IMA sector definition covers “funds which invest at least 80 per cent in UK equities and which intend to achieve a historic yield on the distributable income in excess of 110 per cent of the FTSE all share yield at the fund’s year-end”. The IMA does now provide a breakdown of the yields of all the funds in the UK equity income sector.
However, yield is based on the value of underlying investments and fluctuates in line with market moves. The IMA figures also show the yield as declared at the end of the fund’s financial year. With the year-end figures spread over a 12-month period, no meaningful comparison is possible.
Yates says the difference between yield and dividend is the difference between a photo and a video. He says: “You cannot just look at a photograph of where a fund is at the moment, you need to look at where it has been in the past and what it says it is going to do for the future.”
Instead, he says a look at the level of dividend paid can add value to the investment decision. “This is something that is long overdue for people who see the income from equities as one of the legs on the retirement stool. You have your pension, you have your other savings but equities should be usable for income in their own right.”
Looking at dividends paid out by different UK equity funds shows some interesting results, particularly when they are compared with total- return figures. The dividend data listed is for rolling three-year periods to December 31 each year.
Of the 22 top-quartile income-producing funds, only six are top quartile for total returns while five are in the bottom quartile, which shows good total returns are not necessarily the best method of selection for income-seeking investors.
The same comparison also operates in reverse.
Of the top 22 funds in terms of terms of total returns over the last three years, six are in the top quartile in terms of dividend paid out while three are in the bottom quartile for dividends.
The bottom fund for total returns, Marlborough UK equity income, which has returned 17.4 per cent in the last three years, is eighth in terms of the amount of dividend paid out over the last three years, only four places behind Unicorn UK income fund, the top-performing fund in terms of total return.
The difference this makes to income-seeking investors can be huge. The top income-paying fund over the last three years is Chelverton UK equity income, which paid out £276.08 per £1,000 invested.
At the other end of the scale, the S&W Church House balanced value and income fund paid just £115.48 per £1,000 invested.
Even within the top 10 funds by total return, there is a big difference in dividend paid out. Top-performing fund Unicorn UK income returned 107.7 per cent in the three years to Jan 20 and paid out £232.03 per £1,000 invested.
The 10th-best fund by total return was BlackRock UK income, which returned 57.6 per cent over the same timescale but paid out income of £163.76.
If you scale this up for investors with bigger sums who are relying on the income paid out as part of a retirement strategy, this difference can be very wide.
The difference between the highest and lowest-income- generating funds over the last three years works out at £160.60 per £1,000 invested, so for an investor with £50,000 in the fund, this is worth £8,030 - £2,676.66 a year.
The difference between the best and 10th-best funds by total return, the Unicorn and BlackRock funds, is £68.27 per £1,000, worth £3,413 for an investor with £50,000 invested over the last three years - £1,137 a year.
The amount of income paid out is only part of the story for income-seeking investors as consistency is also critical.
The list of selected funds published here shows some of the most popular and high-profile funds among IFAs, along with their ability to pay dividend income consistently.
Only four of the selected funds, Allianz RCM UK equity income, JO Hambro UK equity income, Schroder income maximiser and Smith & Williamson UK equity income, have managed to stay in the top quartile for the periods ending 2008 to 2011, with Allianz and Smith & Williamson managing to remain top quartile in every period since 2006.
Yates says the concentration on total returns means fund managers’ aims now no longer match their investors’ aims.
He says: “It is a matter of priorities. For many investors, maintaining the income is number one, maintaining the capital is number two, getting the income to increase is number three. It is a matter of how a fund manager looks at that. At the moment, it is getting the capital to grow is one, if there is any income, well that is good.”
Looking at the level of the dividends paid is only half the story. Equity income fund managers have a responsibility to protect the value of capital and many are seeking a mix of capital growth and dividend.
Hargreaves Lansdown (pictured) head of research Mark Dampier says this approach can lead investors down blind alleys.
He points to a dramatic cut in dividend from the Newton higher-income fund this year as well as New Star’s equity income fund implosion as examples of the dangers of focusing too much on dividends. He says: “If you do not protect the capital, it is no use just looking at dividends. you get trounced later on.”
Dampier says some funds labelled as high income do not do what they say on the label but he points out that advisers should be thoroughly checking the details of any prospective investment anyway.
He says: “There is a tightrope that income managers have to walk and they do not all tend to do it. I completely agree that some funds call themselves high income and they are not really. On any fund, you really have to look under the bonnet. You have to look behind the fund manager’s record and look at what the fund objectives are and what they are trying to do.”
Richardson also believes relying on dividend information is dangerous, particularly for execution-only investors but says there is a need for the dividend record to be taken into account more regularly for the investor.
Richardson says: “There is a definite need for the dividend figures to be out there and to be more available but it comes with danger, particularly for people who are reliant on that income. There is so much more risk involved in that area and it needs to be made clear that the dividend yield is variable rather than set in stone.”