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Yield of dreams

Our panel discuss whether the size of some equity income funds is hindering performance and the problems of delivering yield.

There are a number of very big funds in the UK equity income sector. Do you feel that size is an issue? Can it potentially hinder fund performance?

Harrison: The important thing in the way we run income funds is that we are not dependent on liquidity to allow us to trade actively. We run the funds strategically and rely on positioning the funds for what we believe will happen next rather than trying to reposition funds in response to current events. Liquidity is only an issue if you are trying to do the same thing as everyone else.

Beagles: I have already voted with my feet on this one. Having left Newton’s multi-billion-pound product and launched JOHCM’s capped UK equity income fund, I obviously believe that the very big funds in the sector will increasingly struggle to provide investors with superior returns in the future. The big funds will have to increase their number of holdings or concentrate on taking big structural bets. Neither of these looks very appealing. I believe our smaller fund size at JOHCM gives us a massive competitive advantage.

Britton: Absolutely. The UK equity income sector has proved a popular option for many investors in recent years. It has a number of outstanding managers who have attracted a lot of assets over this time, including Neil Woodford, Jeremy Lang and Tony Nutt, but they all now have over 1bn to manage. Naturally, it leads the portfolio towards the FTSE 100, which is more efficient than the mid-cap and small-cap sectors and, thus, it is harder to exploit pricing anomalies.

Are you comfortable with your current FTSE 100 position given the possible further deterioration of the dollar and its potential impact on returns?

Harrison: We think the FTSE can continue to make progress as long as the major imbalances in the economy do not start to unwind in a disorderly fashion. This applies to the nascent bubbles in the housing and bond markets, a dollar sell-off or collapse in consumer confidence. We do not actively target a FTSE 100 weighting in our funds as we seek out themes and these are the key drivers of the stocks we put into the portfolio.

Beagles: I am concerned about my FTSE 100 weighting because I think I should have more in the bigger stocks. We are relaxed about the outlook for the dollar and do not think it will depreciate further from here. Consequently, the lower valuations and higher yields available in the FTSE 100 relative to mid and small caps have some appeal.

Britton: Yes, because we have deliberately skewed our portfolio away from the FTSE 100, partly because we favour other parts of the market but also with the dollar in mind. If the dollar declines further – as we suspect it might – then dollar earnings will generate less cash in sterling terms for FTSE 100-based income funds to distribute to their investors. We are very focused on being able to continue generating cash for investors.

How actively do you manage your yield? What tactics do you use either to increase or smooth your yield year on year?

Harrison: We actively manage the yield on the fund, aiming to achieve a steady growth in the distribution and maintain the premium yield on the fund. We do this by managing the overall level of dividend received by the fund and ensuring that sufficient income is received, freeing up the maximum amount of capital to seek out growth.

Beagles: The discipline of only owning stocks that yield more than the market means the overall yield on the fund tends to look after itself. Often we are forced to sell our lowest-yielding stock and replace it with a higher-yielding name. This means there is little need for income management.

Britton: Distribution management is a key part of managing an equity income fund. The T Bailey equity income fund pays out four times a year and we try to ensure that we deliver a consistent income across all four distribution dates as best as we can. A purpose-built detailed income forecasting model is used to assist this. Our main focus is on achieving a 4 per cent gross yield without sacrificing or putting at undue risk on investors’ capital.

What are the biggest challenges you are facing at the moment with regard to delivering to investors?

Harrison: There is significant uncertainty about the economic outlook and whether inflation or deflation is the bigger threat. Trying to generate strong themes in such an environment is a challenge although we believe firmly there are times in markets when it is better to be thinking rather than acting.

Beagles: With the equity market having rallied over 50 per cent in two years, valuations are not as cheap as they were. Consequently, most investors would be happy if we can deliver a total return of close to 10 per cent a year but this is still a challenging target, particularly in the context of a prospective real return.

Britton: Living up to the high standards that the T Bailey equity income fund has set since its launch last year will be challenging but so far we seem to be achieving this. The fund has the ability to take advantage of a much greater range of investments under Ucits III rule. Explaining this new-found flexibility takes a little time but, once understood by financial advisers, it seems to be well liked.

What sectors do you favour at present?

Harrison: We are keen on life insurance, electricity, oils and pharmaceuticals. These are areas where dividend yields are attractive and well supported and where the growth potential is underpriced. Thematically, these fit into a number of slots – stable growth, strong cashflow returning to shareholders, pricing power in a deflationary world.

Beagles: The valuation on UK banks remains very modest. Bears argue that bad debts are unsustainably low but the corporate sector is in its best financial health for decades and mortgage arrears are likely to increase only modestly. Elsewhere, a number of engineering stocks look attractive, particularly those which serve the oil and mining industries, where capital expenditure is exploding.

In the life insurance sector, demand is improving and supply is shrinking, yet most analysts continue to focus on historic issues such as misselling and mortality rates.

Britton: We remain advocates of the mid and small-cap sectors, not to the exclusion of the FTSE 100, but certainly with conviction.

Small, nimble, well managed funds can continue to add value from these sectors, even when focused on delivering income. It is reassuring to see a fund such as Framlington equity income cap with its size at around 700m, recognising that it is harder to add value from these sectors when too much cash needs to be found a home in the market. More groups should follow this example.

Do you believe investor appetite for equity income funds will continue? Do you feel they are still the safe option?

Harrison: UK equity income funds should continue to do well, as long as the growth outlook remains modest and returns relatively low. This is because in this environment growth will be relatively scarce and a significant proportion of the total return from markets will come from income. Companies that can grow this component or where it is underpinned by strong cashflow remain undervalued. This suggests that value as a broad theme still has further to run.

Beagles: Equity income funds that can still offer investors a running yield comparable with what they can achieve in the bank will continue to find support. However, it is unlikely that the sector will outperform the market as significantly as it has done in the last five years. Indeed, the market may be much more style-neutral in the next couple of years.

Britton: Yes, they will continue to be a popular choice for investors who see them, rightly or wrongly, as a safer option. It should still, however, be understood that this is equity risk. With future equity returns expected to be more subdued than what has historically been the case, the yield will form an increasing proportion of overall returns. As such, equity income funds are a sensible choice for many.

Do you expect more companies which used to be viewed as growth companies but increasingly trade like utilities, such as Vodafone, to start paying attractive dividends?

Harrison: In the cycle of any business, there are emerging, growth, maturing and declining phases, so it is likely that today’s growth companies will eventually become tomorrow’s income stocks.

The timescales over which this occurs may be difficult to predict but it is an undeniable fact of life.

Beagles: There has been a material shift in attitudes from the UK corporate sector and an acknowledgement that income represents an important part of total shareholder return. However, if we are not careful, the increasingly noisy calls by some institutional shareholders, demanding that companies return all generated cash in the form of buybacks and dividends, may lead to a reduction in organically generated revenue growth for the whole market. More balance is required on this issue.

Britton: Indeed. A lot of companies that historically have been tagged as growth have matured to a stage where they are making profits, have paid down a lot of debt and are now throwing off surplus cash. It is important not to pigeonhole certain stocks but to look forward to see how each business is changing, not just in terms of its strategy but also its financial position.

Leigh Harrison, manager, Credit Suisse income, monthly income and alpha income fundsClive Beagles, manager, JO Hambro Capital Management UK equity income fundJason Britton,fund manager, T Bailey


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