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A notion divided

The changing nature of equity income has made it near impossible to distinguish between those managers who seek to provide a rising dividend and those willing to sacrifice some income in favour of potentially higher capital gains.

For those investors seeking an additional stream of income, such as those in retirement, a steady, growing dividend is important.

It is this attribute that has traditionally been seen as the cornerstone of equity income investing, yet today many funds are being managed with an eye to growing the capital and using dividends as a cushion from market falls.

Following the bear market of 2000-03, expressions such as total return, absolute returns and value replaced the talk of the late 1990s, which centred on the new economy and new paradigms.

Equity income funds came into their own from this time as they were less exposed to the non-dividend-paying firms in the field of technology and instead held more of the defensive stocks the market favoured.

Adding to its appeal, this increasingly competitive sector also features some of the best fund managers in the industry – the likes of Neil Woodford, Tony Nutt, Bill Mott, Jeremy Lang, Toby Thompson, Carl Stick and Karen Robertson to name just a few.

The increased interest in total returns following the collapse of the tech boom marries well with the attributes of the equity income sector but it has left the sector with a divided investor base – those seeking absolute returns and those looking for a steady income payout. This makes the decision to buy into, sell out of or even switch within this sector increasingly difficult, as identifying which fund is catering to which investor base is not easy.

The accessible information only serves to cloud the component elements of equity income funds, as performance figures can hide what portion of the return comes from capital growth and what portion from the income stream.

There are two main types of units or shares an investor can purchase within equity income funds – accumulation units where dividends are reinvested or income/distribution units where the investor takes the income stream.

Most published returns on equity income funds are based on the accumulation units, so the gains seen are not just capital growth but include income payouts. Therefore, comparing yields or overall returns is not enough and looking at a fund’s dividend payout history can be more vital.

Artemis communications director Nick Wells says investors need to look at distributions from an income-producing fund separately from what is happening to the capital value of the investment. To a traditional income investor seeking a steady rising dividend, he notes that capital fluctuations may be inconsequential compared with the security of distribution flows .

However, managers with an eye to total returns could be seeking to grow capital value at the expense of the income, believing the boost to the capital will improve the income.

So how can it be determined which fund manager in the equity income sector has the best dividend payout? Which manager has the best track record on providing the best rising level of income and which offers the best balance between the two?

The question of where returns are derived from is more vital than ever before in choosing funds within the sector, yet information needs have not kept pace with this trend.

Illustrating this point is some research from Hargreaves Lansdown investment manger Ben Yearsley, who examined the dividend payouts as well as the capital growth on some of the biggest names in the equity income sector over the 16 years ending December 31, 2006.

The figures, derived from Lipper and looking at the capital prices of the units in 1990 and the income paid per unit each year, shows that a 1,000 investment from 1990 to the end of 2006 would have produced anywhere from 543 to more than 1,700 in total dividend payouts. Meanwhile, the capital portion of that same 1,000 investment rose to 1,500 in some funds and to more than 5,000 in others.

Yes, the correlation of a high capital return does mean the fund that produced more than 5,000 was the portfolio that produced the 1,700 in income.

Yearsley’s research shows that most of the funds examined produced capital gains of just over 2,000, yet the income variance on all of these is still wide. For example, Framlington income produced 2,528 in capital returns over the 16-year period and issued 841 in income while the perhaps lesser known Axa UK equity income fund turned 1,000 into 2,404 in capital terms – 124 less – while adding 1,016 in income – 175 more.

Framlington income manager George Luckraft has historically managed his portfolios using a barbell approach, particularly in the time of the tech boom when company dividends were shrinking. He holds pure growths stocks to help capital gains and balances this with more traditional high-yielding stocks.

For a total return investor, the Framlington fund may hold more appeal. However, for a retiree seeking income, the greater payout may mean more.

Income fund managers who have suffered in recent years from what has been seen as a relative underperformance of their peer group include well-known names such as Jeremy Lang of Liontrust First Income and Toby Thompson of New Star. However, while both managers on a total return basis may not have been top of their peer group in recent years, as investors in their funds will state, these two managers are among the best for traditional income seekers, providing a rising level of income.


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