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Income benefits

Kira Nickerson Investment Matters

The worth of dividends never seems to be appreciated quite as much as when markets are falling but in periods of rapid growth, they are quickly discounted. After the recent strong run in growth stocks, a reminder of the attributes of equity income is sometimes useful for investors. By and large, the UK investor is swayed by the press and the more recent headline-grabbing 40-50 per cent-plus rises in the market has caught the attention of many.

Just like the big increases in markets such as China and Russia caught the attention of growth investors in recent years, it is hard for the average person not to get influenced by the appearance of such stunning returns.

As the equity rally has continued, retail investors appear more interested in growth than income. IMA stats show that £90m of net retail sales were in the all companies sector in August while £25m came out of the equity income sector.

In the same month, £68m-worth of net retail sales were in the new income & growth sector. If you look at institutional investors – they were doing the exact opposite with £118m coming out of the all companies sector and £28m in net sales were in equity income and a further £98m in income & growth funds.

Despite all these persuasive arguments about the attributes of income investing, it continues to be growth funds that remain the most popular. Although there has been a surge in equity income sales in the past few years, the sheer number of funds in this space has remained remarkably static for years, whereas the number of UK all companies funds has grown steadily, with more than 100 launched in the past five years alone. According to Trustnet data, there are 153 funds in the UK all companies sector with a 10- year track record and 233 have been around for five years. Today, there are 327 funds in the sector.

Of the 85 funds in the UK equity income sector (plus the 18 in the new income & growth sector), 58 have a 10-year track record and 74 have been around for five years.

While launches in the UK equity income space have been taking a back seat more recently to the trend towards foreign income funds, the sector has recently added a new constituent. Evenload income, run by former Rathbones manager Hugh Yarrow, aims to invest in a concentrated portfolio of undervalued, income-generating stocks. Yarrow says the initial yield forecast for the fund is 4.3 per cent and it will contain a maximum of just 30 stocks. Yarrow, who is supported on the fund by analyst Ben Peters, said the typical holding period for stocks will be three to four years, giving the fund a low annual turnover of around 30 per cent.

Recognising the continued importance of dividends to overall returns, Yarrow said the fund will not play a barbell strategy and will look to grow its dividend each year although not at the expense of capital growth. That is the same characteristics which attract Yarrow to his holdings. Just because a stock has a high dividend does not mean it is necessarily a good investment for an income fund. “Many companies are over-distributing,” Yarrow notes. He cites BP as an example. Avoiding the stock for now, Yarrow says BP has decided against dividend cuts as it feels its share price will suffer but in continuing to distribute at its current level, it is potentially under-investing in the overall busi-ness and therefore, restricting growth.

Considering the popularity at the moment of emerging markets or domestically, in growth funds, the timing of an income fund launch bucks the typical marketing trend to launch what is popular. Equity income is often depicted as a more staid option yet there are plenty of attributes around equity income which should capture attention. And the idea that equity income funds are only good in difficult times is a concept that many investors would do well to disregard.

According to US research from investment group Tweedy, Browne over the past 100 plus years, an investment in a market-oriented portfolio that included reinvested dividends would have produced 85 times the wealth generated by the same portfolio relying solely on capital gains. This was the case for both US and UK equities.

The off-cited 2008 Barclays Gilt & Equity study highlights the same point. A £100 investment in UK equities at the end of 1899 would be worth just £209 in today’s money (£13,580 nominally) whereas if the income was reinvested, it would be worth £25,277 (£1.6m nominally).

In support of its assertions, Tweedy, Browne also quoted a 2003 editorial from the Financial Analysts Journal which argues that dividends dwarf the combined importance of inflation, growth and changing valuations. Entitled Dividends and the Three Dwarfs, Robert D Arnott examined the various components of equity returns for the 200 years ending in 2002 with the conclusion that dividends were far and away the main source of the real return. The total annualised return on a US$100 investment in US equities from 1802 to 2002 was calculated as 7.9 per cent. That amount consisted of a 5 per cent return from dividends, a 1.4 per cent return from inflation, a 0.6 per cent return from rising valuation levels, and a 0.8 per cent return from real growth in dividends.

The more recent performance by UK equity income funds are not with-out attention-grabbing figures either. On a total returns basis over the 15 years to October 8, the average fund in the IMA’s UK equity income sector has gained 171.38 per cent cumulatively, according to data from Finan-cial Express. This stacks up well compared with the 15-year gains in the growth sector, UK all companies, which gained 157.14 per cent over the same timeframe. A 10-year look shows similar results, with UK equity income funds on average doing better than those in the all companies sector.

Income may not be in fashion at the moment, considering the attention being paid to the rapid stock price rises in the FTSE. Advisers may be more than aware of this but it is at times such as this, when investors are being drawn in by the sensational headlines, to remind them of the practicalities of income and that it is not just for the bear market years.


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