Daniel Godfrey: The UK equity income sector is ‘clearly broken’

WEB_210416_Profile_Image1The recent exodus of funds from the UK income sector and the decision to redefine income funds are signals the sector is “clearly broken”, argues former Investment Association chief executive Daniel Godfrey.

The UK investment trade body has launched a four-week consultation for its members examining the qualifying yield funds must achieve to be included in the UK equity income sector after a number of popular funds were expelled from the sector.

A fund currently qualifies for the IA sector by maintaining an average yield of more than 10 per cent than the FTSE All Share over a three-year period.

Currently yield is calculated by taking income produced during the year as a percentage of the price of the fund at the end of the year. Therefore if a fund has increased its capital this has the effect of reducing the yield.

Godfrey says: “Over the last few years, a number of income funds that have done a great job for investors have been forced out of the income fund sector.

“The managers concerned have preferred to leave the sector than to change their successful approach. However, for a sector to lose so many funds on those grounds is a clear signal that the sector definition has been broken by a long period of low interest rates.”

Around £19bn of income funds currently sit in the UK All Companies sector, after being thrown out of the UK Equity Income sector for not following the requirement rules.

Carl Stick’s £1.2bn Rathbone Income fund is the latest fund to be kicked out of the IA UK Equity Income sector.

Mark Barnett of Invesco Perpetual and Kevin Murphy and Nick Kirrage of Schroders have also been banished to the UK All Companies sector.

Neil Woodford’s popular Equity Income fund has come close to failing to meet the sector criteria.

Three options are being put before asset managers in the IA consultation including lowering the bar so funds only have to perform better than the index or to produce more statistics about their performance.

A final option is to make no change to the sector definition.

Godfrey says: “Investors looking for income may want one or all of a number of features. These include a starting yield that is higher than they could get from deposits, a starting yield that is higher than the index, a fund that is seeking to preserve their income level or a fund that is seeking to grow income by inflation or higher each year.”

Godfrey says the sector should be defined by funds that have “a clearly stated income objective” across these criteria so that investors can make an informed choice.

He adds: “For example, I may not mind that my starting yield is no higher than the index if I believe that the manager is capable of increasing my income by inflation every year. Or you may care far more about a high starting yield.”

“Maybe it’s time to move away from strict numeric criteria and towards a clear reflection of a fund’s objectives.”

Chelsea Financial managing director Darius McDermott says it is important that the managers are not forced to buy stocks or sectors they don’t like just to achieve a yield target.

He says of the options the IA are looking at his preferred one is for funds to have an index yield.

Stephen Bailey, co-manager on the macro thematic team at Liontrust, says changing the rules for inclusion in the IA’s UK equity income sector seems “a little unedifying” as it narrows eligibility.

The £521m Liontrust Macro Equity Income currently sits in the UK equity income sector. The firm’s spokeswoman says the fund has met its income requirements, so isn’t at risk from being booted out of the sector.

Bailey says: “All managers operate in the same market and likely enjoy equal measures of operational freedom, so we don’t necessarily subscribe to the argument that the market is at fault for missed yield objectives.”

Bailey says the sector rule requires “a live anchor” and it needs to be the FTSE All Share dividend yield for UK-focussed funds.

He adds the IA needs to explain how the new threshold will be arrived at.

“Many investors in the sector will expect a high level of dividend return which hopefully grows at a rate over and above inflation,” says Bailey.

“If these investors wanted a growth bias they would presumably have selected a fund from the IA’s UK All Companies sector.”