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Yield to the rules

When is a rule not a rule? It appears to be when it is applied to the UK equity income sector as more than half of the funds in the sector do not meet the required level of yield set by the Investment Management Association.

This is worth thinking about for a moment. There are only two rules that have to be complied with for a fund to be included in this sector – at least 80 per cent of a portfolio must be invested in UK equities and the fund must aim to distribute income in excess of 110 per cent of the FTSE All-Share yield. For example, the target yield for funds was 4.64 per cent on August 7.

Yet, incredibly, the website and Trustnet show that fewer than half the funds in the sector were achieving the target yield on August 7.

If there are rules set for sectors, then surely they should be enforced.

Funds have not been ejected from the UK equity income sector yet because the IMA ruling only says they must “aim” to deliver the required yield. How effective can a rule be if it includes the word “aim”? We could all say that we are terribly sorry but we were aiming to keep within the 70mph speed limit on the M1, m’lord.

The use of the word “aim” has led to a wide divergence between the yields delivered by the 87 funds in the sector, from little more than 3 per cent up to 7 per cent. This also reflects the three broad approaches to the manage-ment of equity income funds.

In the first group are managers who set a minimum yield that has to be met before they buy a stock. This yield is typically above the average of the FTSE All-Share.

The second group takes a barbell approach, which is a mix of low yield and high yield with little in the middle.

A significant proportion of their portfolios comprise companies that the managers believe will enjoy strong growth. This can lead to these managers failing to hit the 110 per cent yield target.

In the third group are managers who construct portfolios to achieve a consistent yield to at least match the 110 per cent target and who seek to grow their funds’ dividends every year.

We are not criticising any equity income funds as there is no single right approach. But it is important that advisers and investors are able to compare like-for-like funds and that the funds meet their needs.

The UK equity income sector, which is the second- biggest with £46.36bn in funds under management (as of June 30), is commonly bought to provide a growing income in retirement.

Yet shows that only four funds in the sector have grown their dividend income for each of the last 10 years at least. More than half the funds in the sector have delivered consistent dividend income growth for just three years or less but what about investors who want their earnings to grow every year?

The IMA has taken some good initial steps to try to level the playing field. These include the introduction of a single method by which funds calculate their historic yield and a statement that if equity income funds do not aim to provide a yield of 110 per cent of the FTSE All-Share index by the end of this year they will be removed from the sector.

We welcome these measures but look forward to more action being taken. For example, the word “aim” could be dropped to erad- icate any ambiguity about whether the 110 per cent target yield rule will be enforced.

But we hope the industry will go further, with maybe the UK equity income sector being divided into two. A split could be based on whether or not funds deliver a yield of at least 110 per cent of the FTSE All-Share index.

This would enable advisers and their clients to make like-for-like comparisons and for funds to meet the exact needs of the different types of investors in this sector.

A large proportion of investors want an income yield that is higher than index-linked gilts and is growing but some will accept a lower yield and potentially lower volatility.

It is encouraging that there is a precedent. The IMA has revised the UK corporate bond and UK other bond sectors into three components. What could be wrong, therefore, in splitting the UK equity income sector into two?

Nigel Legge is chief executive of Liontrust Asset Management


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