Over the past 20 years, there has been no discernable benefit from holding equity income funds over the average fund in the UK all companies sector and, indeed, the average UK equity income fund is now underperforming the UK all companies sector over one, three and five years.
Income funds tend to be biased heavily towards value stocks, so style is a major driver of returns in the sector. Growth stocks tend to trade on high price/earnings ratios and offer low dividend yields. By contrast, value stocks generally trade on lower p/e multiples and offer higher yields. Value investors buy stocks at relatively low prices in the expectation that the underlying strength of the business will enable the share price to increase over time. Companies in this category are often from the more economically sensitive areas of the market such as utilities, retailers and banks.
It is no surprise that income funds and growth funds take their turn in the spotlight during different stages of the business cycle. During bouts of volatility, it has been increasingly difficult to profit from the value approach that equity income funds tend to adopt. Companies on low valuations have often turned into value traps and continued to underperform. From a yield perspective, the banking sector – a traditional hunting ground for value investors – has been very cheap. Dividend growth in the sector is likely to slow, however, making it more challenging for UK equity income funds to continue to grow dividends as quickly as in the past.
Given the sector requirements, the UK equity income manager has been stuck between a rock and a hard place. Managers either break away from traditional value stocks to generate superior returns or adopt a barbell approach, selecting some high-yield stocks with low earnings growth potential and others with high earnings growth potential but low yields. Those funds that have held on to their strong performance have used a blend of strategies.
Investors can generate higher returns if they can identify which strategy is likely to outperform in the near future. This can be difficult for the ordinary investor but fund of funds managers can monitor and adapt to conditions, selecting the best funds based on a thorough analysis of fundamentals.
Mark Harris is head of fund of funds at New Star