Inequality of equities

Of all the many oxymorons in the investment business (and there are a lot), none is looking quite so oxymoronic these days as the concept of the equity income fund. In a market which has seen the dividend yield cut to its lowest level in living memory, the idea that any investor would actively seek out an income from equities looks more improbable by the day.

Of all the many oxymorons in the investment business (and there are a lot), none is looking quite so oxymoronic these days as the concept of the equity income fund. In a market which has seen the dividend yield cut to its lowest level in living memory, the idea that any investor would actively seek out an income from equities looks more improbable by the day.

Yet the UK Equity Income sector of the unit trust business remains alive and well. It is one of the most popular sectors in the business. Despite the reclassification of funds by the trade body Autif last summer, which saw a number of so-called income funds defect to the larger All Companies sector, there are still more than 80 funds around in the equity income sector.

Not surprisingly, the last year has found fund managers in the sector struggling to keep pace with a market that at times has seemed to regard even the mention of dividends as a dirty word. To qualify for equity income fund status, a unit trust must invest at least 80 per cent of its assets in UK equities and aim for a yield that is 10 per cent higher than that of the FTSE all-share index.

With the gross dividend yield on the market falling as low as 2.5 per cent last year, the threshold for qualification over the year as a whole was a not very handsome 3 per cent.

Yet, according to Standard & Poor's Fund Research, in their latest review of the sector, a surprisingly large number of funds in the sector failed to meet even this seemingly undemanding target. This is despite the fact that three-quarters of funds now take management fees out of capital rather than out of their income account, so as to preserve the yield on their funds.

Added to the equity income fund managers' problem in 1999 was that high-yielding shares, one of the staple hunting grounds of income fund managers, failed to perform well in a year in which hype and hope were where the action was. Of the 15 shares in the FTSE 100 index with the highest yields, only two (ICI and BATs) ranked better than halfway in performance terms. And of the top 15 performers in the FTSE 100, none had a yield of more than 2.8 per cent, and half had yields of less than 2 per cent. One or two had no yield.

As the graph shows, most income funds lagged well behind the market in total return terms in the past two years. Even a superstar such as Jupiter Income, comfortably the best, has now underperformed the market for two years running, having outperformed for three years before that. The paradox is that most income funds are still sold heavily on the strength of their past performance, although this past performance is inevitably largely the result of capital growth, not income-generating ability.

Investors who actually buy these funds on income grounds, and consume the income rather than reinvest it, will not have enjoyed the reinvested capital gains the performance figures incorporate.

As the Fund Research report makes clear, equity income fund managers tend to adopt one of two strategies to meet their yield requirements. One, which might be called the orthodox way, is to limit their universe of equities to those shares which already have above-market dividend yields. The second way, slightly more aggressive, is to relax the yield criteria when picking individual shares and try to meet the fund's overall yield requirements by investing in bonds and/or convertibles, relying on low-income shares to provide capital growth.

With most funds working on traditional value criteria in selecting shares, the recent emphasis on growth has hurt them, though the trend showed signs of reversing last year.

Despite the tough market conditions, some funds in the sector still command strong track records and a big following among financial advisers. The three funds which merit the highest (AAA) rating from Fund Research are shown in the table.

All three are run by managers who have demonstrated genuine stockpicking ability. Perpetual Income, managed by Neil Woodford, is a popular fund which has always been more volatile than other equity income funds. Like several Perpetual funds, it suffered a poor year, and specifically from its decision to go to overweight financial stocks.

Newton Higher Income and Jupiter Income are the two most successful funds in the sector, each with an outstanding track record, though of the two, that of William Littlewood, Jupiter Income's fund manager, is the more impressive. His success in outperforming the market over a long period is all the more remarkable because it was achieved with below average volatility and an above average-sized portfolio. In general, higher returns and lower risk is not something that go together, but not here. Another distinctive feature of Mr Littlewood's investment approach is that he combines stockpicking skill with a knack for calling important turns in the market.

Can he keep it up? Well, for all fund managers, nemesis is by definition only one poor year away. But, an analysis of the way Mr Littlewood invests supports the view that here is one active fund manager who has earned his (above average) fees.

The challenge for Mr Littlewood is to sustain this performance now that his fund has grown so rapidly. At £1,500m, the fund is one of the 20 largest unit trusts in the UK, having doubled in little more than a year. His competitors in the rest of the equity income sector must be hoping that the next rotation shift in the market will bring back into favour those shares which actually do have the income qualities that their name so visibly advertises.

davisbiz@aol.com