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UK equity income managers face a quandary. The past 12 months have arguably hit the sector harder than any other, especially where funds have exposure to banks, with the average fund losing 23.2 per cent.

On top of this, the Investment Management Association unveiled plans in January to tackle yield concerns by stating that funds must invest at least 80 per cent in UK equities and aim to achieve a yield on distributable income in excess of 110 per cent of the FTSE All Share yield.

This could change the scene for UK equity income, with some funds likely to fall out of the sector while those that have traditionally chased performance may find their returns curtailed by the need to produce such a yield.

According to recent Lipper figures, 37 of the 92 funds in the sector are not yet producing the yield target although some fund management firms disagree with the figures.

The IMA has made it clear that those which fail to meet its parameters by January 2009 will be removed from the sector.

Some managers, such as Newton higher-income manager Tineke Frikkee, believe the IMA’s move will provide investors with a more accurate review of the sector.

She says: “I would be surprised if everyone stayed in the sector once the 12 months are up. It will change the landscape as performance- chasing is counteracted.”

Hargreaves Lansdown investment manager Ben Yearsley says it is important to strike a balance between yield and performance returns. He says: “I would rather they did not chase yield in markets like this, given the big sums that are currently being drawn out of the sector.

“It is getting the balance right between performance and the yield returns. Some, like Toby Thompson, for example, go to the extreme as I think he does not pick any stocks that are not yielding 120 per cent of the FTSE All Share. That can hinder performance.”

JP Morgan head of UK retail sales Michael Parsons says in normal market conditions, fund firms should be forced to stick to the rules but more difficult markets should offer scope for some freedom.

Parsons says: “There is no point in having the sector if you do not look to achieve that 110 per cent target but in markets like these, you have to give a degree of flexibility. However, that is a decision for the IMA.”

The yield requirement means that choosing funds has become even more difficult for IFAs. Where should they go to find the best funds in the sector that offer a balance between performance and a yield?

Principal Investment Management, which revealed its latest White List last week, is one such source. George Luckraft and Carl Stick were both omitted from the list of the top 12 recommended funds, replaced by Threadneedle’s UK equity income and monthly income funds run by Leigh Harrison and Jonathan Barber.

Principal says the difficult market for dividend-paying stocks has led to areas typically favoured by income seekers being downgraded. This has driven dividend yields higher, with the FTSE All Share yield at 4.2 per cent, having stood at 2.8 per cent 12 months ago.

The firm says this will present opportunities but they will not be easy to exploit, given that the slowing economy means companies will be cutting their dividends.

Principal says: “The skill will be constructing a portfolio of those companies harshly treated by an emotional market that are able to maintain and grow their dividend despite difficult conditions. It is likely to be the proven performers of the White List who are best placed to achieve this.”

Those stalwarts are likely to include Artemis income run by Adrian Frost and Invesco Perpetual income and higher income run by Neil Woodford.

Chelsea Financial Services managing director Darius McDermott says in markets like these, it is total returns that matter more than ever.

He says: “You have to ask if an investor really wants to take a 25 per cent loss to receive a 4 per cent yield or lose 10 per cent and get a smaller yield.

“The difference between the best performer and the worst performer is as wide as it has ever been in the UK equity income sector – almost 30 per cent in the past 12 months. Figures also show that 60 to 70 per cent of investors reinvest their dividends so the argument for growth strategies is there.

“I would tend to offer a mixture of growth and yield. Funds such as Newton higher income and New Star higher income have the focus there for those who wants those yields while others offer the growth to balance it out.

“The Schroder income maximiser is a valid yield alternative that is performing well in the IMA specialist sector.”

Plan Invest investment adviser Will Beighton says: “UK equity income still has a place in a growth portfolio as it offers a different approach for diversification. The difference now lies in our research where we look at how a fund is invested for yield purposes rather than just performance returns.”

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