Equity income funds were once the mainstay for investors who wanted a regular income without putting their capital unduly at risk.
The manager identifies stable blue-chip stocks that pay healthy dividends and then, if he has made the right choices, the investor sits back and watches the income roll in.
Even growth investors have found equity income funds attractive, as they have been able to benefit from the relative security of their capital and simply reinvest the income to increase their holdings.
It worked for 15 of the 20 years up to 2006. Then suddenly, in 2007, as the financial tsunami hit, it all started to go wrong.
By the end of the third quarter of 2008, the average fund was down by 20 per cent compared with a year earlier, and in the current year to date the UK equity income sector has returned less than 4 per cent. This compares with average returns of around 5.5 per cent for the all companies sector,and further cuts are in prospect as companies continue to retrench.
Fund managers seeking income have therefore had their work cut out. A recent survey by Capita Registrars shows that, in the first half of 2009, the top 700 companies listed on the London Stock Exchange’s main market cut dividends by 9 per cent compared with 2008 while 70 companies that paid a dividend a year earlier paid no dividend at all.
For the first time in living memory, capital inflows exceeded dividends by an astonishing £23bn and Capita estimates that total dividend payments for the full year will fall by 13 per cent compared with 2008.
Paul Taylor, head of corporate advisory at Capita, says that some of the figures could be accounted for because companies had been taken over or gone out of business.
He says: “Two years ago, banks paid out a third of all dividends while oil companies contributed 15 per cent. That has turned around now, with oils paying out a third.”
He adds that retailers, support services companies, real estate firms and banks were the most likely to have cut dividends to zero.
M&G dividend fund manager Richard Hughes says companies cut their dividends early in the economic cycle. “In previous downturns, companies would try to maintain them for the first year of the recession and possibly even two in the hope that their profits would recover. This time round, they have cut dividends almost immediately.”
Investors have voted with their feet. According to the Investment Management Association, the UK equity income sector was the worst-selling sector during August, with net retail outflows of £25.8m.
Informed Choice managing director Martin Bamford says: “It is important to consider more than just a single month of fund sales data but this is quite a stark indication of where investor cash is going.”
But he points out that the sector itself masks a huge variation in performance over the last year. He says: “The top- performing fund over 12 months is Unicorn UK income, an equity income fund from a rather boutique asset manager. It has returned nearly 33 per cent over the last year, giving its cumulative performance statistics a real boost into first-quartile territory over the last one, three and five years. In the longer term, the discrete performance of this fund is more variable.”
At the other end of the spectrum, the worst performer in the sector during the past year has been New Star UK strategic Income.
Bamford says: “With average funds returning close to 4 per cent, this fund has lost investors nearly 5.5 per cent over the last year. It used to be an above-average performer but assets in this fund now hover around the relatively small £20m level. The manager, Paul Craig, might be overstretched as he is responsible for several New Star funds. This might get tided up somewhat as part of the Henderson rebranding due to take place soon.”
As companies cut dividends, this restricts choice for manager and leaves them overexposed in particular sectors or even stocks.
Bamford says: “One factor to consider when looking at this sector is how focused the payment of healthy dividends is becoming in the UK stockmarket.
“This is pushing fund managers in this sector towards a smaller number of companies than they have been used to dealing with before. If companies are looking to rebuild balance sheets over the next year, then it would be expected for them to cut dividends to shareholders, particularly if they are raising fresh capital at the same time.”
Dennehy Weller managing director Brian Dennehy is nevertheless optimistic about the sector and thinks equity income funds are due for a revival.
He recommends looking at funds that have been underperforming in the last six months.
“Look for international companies with a great cashflow,” he says, adding that he particularly likes Newton higher income and Invesco Perpetual income (in the UK equity income & growth sector).
Dennehy says: “Equally, we should closely monitor those that have shown the agility to outperform through the various phases of the last couple of years, before and after the March 2009 watershed, such as JOHCM UK equity income.”
Investors and fund managers are certainly going to need an innovative approach to seeking income and to look outside the traditional high-yield stocks that have provided income in the past as companies hold dividends or their shares become overvalued.
Bamford says: “The sector might not have great prospects over the next year but some opportunities continue to exist for the right managers and as part of a well diversified portfolio. If anything, simply looking at what the majority of retail investors did in August and doing the complete opposite might be a sensible investment strategy to employ.”