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Darius McDermott: Look beyond headline yields for UK Equity Income

When picking funds in this sector, it is important to take a step back and think about the total return, not just the income

Darius-McDermott-700x450.jpgIt has been an eventful year for the UK Equity Income sector so far. Back in March, the Investment Association decided to lower its yield requirement from 110 per cent to 100 per cent of the yield on the FTSE All Share over a three-year rolling period.

The move followed a five-month review by the trade body, where a number of options were considered, such as splitting the sector in two and removing yield requirements altogether.

On 9 March, some well-known UK equity income funds were dropped from the sector because their yields fell short of the hurdle. These included Rathbone Income, Evenlode Income and Royal London UK Equity Income.

IA lowers fund entry barrier for UK Equity Income

I welcome the final decision by the IA as it makes it easier for fund buyers to compare UK equity income vehicles. It also means fund managers are under less pressure to chase yield and deviate from their investment strategy in a bid to remain in the sector. Since March, Rathbone Income and Royal London UK Equity Income, among others, have returned to the sector.

Elite Rated Evenlode Income represents a notable exception, however. Managers Hugh Yarrow and Ben Peters have decided not to return because they do not want to be constrained in any way by the yield requirement. We like fund managers who have courage in their convictions and investment processes, so I respect their position.

When it comes to selecting a UK equity income fund, it is not just a question of focusing on headline yield. I like managers who target quality companies with sustainable dividend growth, supported by strong balance sheets. It is important to take a step back and think about the total return, not just the income.

Right now, dividend concentration across a handful of FTSE 100 companies represents a major challenge for income-seeking investors. The top five dividend-paying companies account for 38 per cent of total dividends paid.

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I like managers able to diversify their income exposure outside of the FTSE 100, meaning their income stream is less vulnerable to any high-profile dividend cuts. You can also gain access to exciting small and mid-caps, which have a strong track record of growing their dividends.

Avoiding dividend cuts is particularly important at a time when dividend cover for the UK’s largest 100 companies has fallen to its lowest level since 2009. Although listed businesses across the banking and oil and gas sectors have sought to get their balance sheets into shape over the past five to 10 years, they are still paying out five times more in dividends than they are making in profits. That is a worrying statistic.

Fund picks

I like Elite Rated Standard Life Investments UK Equity Income Unconstrained because fund manager Thomas Moore pays close attention to dividend cover, among other metrics. He is happy to steer clear of traditional income-payers, where he sees any potential question marks over dividends. This means the fund can differ dramatically from others in the equity income sector. I also like that he invests across the market spectrum.

Another fund that offers significant exposure away from the FTSE 100 is Elite Rated Marlborough Multi Cap Income. Manager Siddarth Chand Lall currently allocates 72 per cent of the portfolio to small- and mid-caps. He studies financial statements and uses models to test the sustainability of dividends.

Defensive managers

Looking ahead, as Brexit negotiations continue and central banks across the globe try to unwind extraordinary monetary policies, market volatility has the potential to rise.

Fortunately, a number of UK equity income fund managers have historically provided investors with some downside protection, alongside upside participation when times are good. These include Michael Clark, who uses covered call options to manage volatility within the Elite Rated Fidelity Enhanced Income fund.

Investment trusts also have the potential to deliver consistent dividend payments during challenging markets because they can draw on revenue reserves. Here, I would highlight Elite Rated City of London Investment Trust, which tends to provide solid returns and dividend growth. The trust has a fantastic track record of raising dividends over more than 50 years, which is no easy feat.

Another investment company to consider is Elite Rated Lowland Investment Company. Managers James Henderson and Laura Foll have built an impressive track record in the small- and mid-cap space. Lowland works well for investors seeking a reasonable level of income, alongside long-term growth.

The good news is there are many talented stock pickers to choose from in the UK equity income sector. Look for funds with a solid track record of dividend growth and a repeatable process through different market conditions. Who knows what may lie ahead.

Darius McDermott is managing director at FundCalibre

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