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Yield trip

UK equity income funds remain as popular as ever. That is not surprising considering that they meet the objectives of so many of our clients – capital growth and income growth.

Quite frankly – apart from buy to let – what other asset class offers rising income? I can hear the cries of protest from commercial property advocates but I have yet to see any evidence that those invested in property funds have experienced rising income over the years.

Until now, the problem for equity income investors has been that in order to achieve diversification, they had to accept lowering their overall yield. That is because overseas equity markets as a whole have never really offered much yield. That picture is now beginning to change so it is not surprising that we are seeing the launch of some global equity income funds.

I believe that for many clients, a global equity income fund is an ideal choice, since few investors or IFAs feel comfortable making their own asset allocation decisions. I therefore welcome the launch of the Schroder global equity income fund, which will be managed by Sonja Schemmann. She is not yet well known in the UK but has experience of running global money successfully at DWS.

She explains that before the 1990s, there was no real demand for equity income on the Continent, mainly because European investors have always been more bond orientated. Unfortunately, they decided to go overweight in equities just in time for the bursting of the tech bubble. However, the income story has begun to reassert itself simply because of demographics – people getting older and needing additional income.

Tied up with this is the pension debate, as European investors in particular are hugely under-pensioned.

At the same time, private investors have witnessed significant wealth destruction through capital expenditure. For example, Chrysler destroyed some euro 70bn in one deal. So companies reinvesting earnings is not always a good deal for shareholders – something that perhaps Chancellor Gordon Brown should have grasped before his changes in advance corporation tax – and there is a growing appreciation of the value of dividends.

The idea that companies that pay a dividend are actually weak is, of course, rubbish. Paying a dividend puts real financial discipline into a company, encouraging it to strike a balance between earnings’ growth and dividends that normally leads to a stronger share price.

In fact, there is some evidence to suggest that higher dividends are beneficial to earnings’ growth.

There is undoubtedly a momentum for yield. Over 90 per cent of companies yielding more than 3 per cent are listed outside the UK. In Europe, there are around 10 to 15 funds concentrating on this area of the market. However, Miss Schemmann says there are over 400 stocks with a yield premium of the quality and size she is looking for.

The new fund will target a yield of 2 per cent above the MSCI All Countries World index. The fund will have around 80 stocks and I was glad to hear that the portfolio construction will be unrestricted by any benchmark.

Up to 10 per cent can be invested in convertibles which will have a good yield but with bond characteristics to offer some downside protection.

The market cap size is likely to be around $2.5bn with a yield premium 1 per cent above the regional market average. As you might expect, there will be a significant emphasis on dividend quality, looking at stability over 12 months and looking to exclude stocks which are at the top end of the payout ratios. This will mean that cyclical companies are likely to be avoided. Given that these types of companies have had a tremendous run over recent years, I think the fund will start in a good position.

In terms of asset allocation, the fund will be invested around 32 per cent in the US, with about the same in Europe and 17 per cent in the UK. Another 15 per cent will be invested in Asia (excluding Japan) and 5 per cent in emerging markets. The investment process is a combination of top down and bottom up although greater emphasis will be placed on the latter.

I have already mentioned some of the bottom-up angles but clearly cash generation will be an important one. However, it is important to keep an eye on the global growth trends. These will include the interest rate cycle and currency movements. You should be aware that the fund will not be hedged so there will be some currency risk. Given the strength of sterling, I could argue that this could be an advantage in the short term. My own view is that sterling will weaken in due course, given that we have a trade deficit of our own and the Chancellor has maxed out all the Government’s credit cards.

With an estimated yield of 4 per cent and a talented fund manager keen to prove herself on the UK scene, I think Schroders has a winning formula. I believe the fund will make an ideal diversifier for private clients who already have significant holdings in the well known UK equity income funds.

Mark Dampier is head of research at Hargreaves Lansdown.


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