Low interest rates: the enemy of income

Many investors looking for capital growth from their stockmarket-based holdings have done very nicely in their first year of ISA investment. Not only have they had a global range of funds from which to choose - and some specialist regional funds have rocketed in the last 12 months - but they have also had the opportunity to cash in on the volatile but spectacular rise of the technology-driven New Economy.

Many investors looking for capital growth from their stockmarket-based holdings have done very nicely in their first year of ISA investment. Not only have they had a global range of funds from which to choose - and some specialist regional funds have rocketed in the last 12 months - but they have also had the opportunity to cash in on the volatile but spectacular rise of the technology-driven New Economy.

But while growth is great, many investors - particularly those approaching retirement or already retired - also need an income stream to supplement their earnings; and they have had a less fruitful time over the last year. Not only are interest rates still pretty low, but equity income funds have had a rough ride.

If you're looking to generate a steady income from your ISA investment in stocks and shares, you would normally expect to look at equity income funds, which not only pay a tax-free yield based on the dividends paid out by the companies whose shares they hold, but also (in the good times) tend to grow in value as those companies perform well and prosper.

Even if the yield is not large to begin with, as capital values increase over the years, the amount of yield generated will also rise. For example, if you invested £1000 in an equity income ISA paying a 4 per cent yield, then you'd expect a payout of £40 from it. But if after five years it had doubled in value to £2000, then that 4 per cent would be worth £80 - and that's ignoring the possibility that the yield could increase over that time, as dividends paid by prospering companies rise.

Why, then, was the worst-selling fund sector in March the Equity Income sector, according to Autif figures, with investors moving out of equity income funds to the tune of almost £80 million in total?

The problem is that in the course of the last year, not only have yields been nothing to write home about - the sector average is around 3.25 per cent, - but capital values for most funds in the sector have actually shrunk. £1000 invested in the Norwich UK High Income fund grew to a measly £1014 in the year to 1st May - and that's the third-ranking fund out of 94 in the sector. All the funds below it in the table are worth less now than in May 1999, according to Lipper data.

Why? Many equity income fund managers have had their hands tied to some extent - their mandate is to generate an income for investors, which means focussing on the kind of well-established - often blue-chip - companies which are generating profits and dividends. Few of the stellar growth companies have seen any profit at all yet, and dividends are several years down the line, so they are non-starters as far as income is concerned.

Moreover, many stockmarket investors, being fickle creatures, pulled their money out of conventional blue chip stocks in the course of 1999 in order to cash in on the technology boom - pushing blue chip values down in the process. Even prospering companies showing steady performance have found their share prices slipping because they weren't fashionable. But many equity income fund managers couldn't simply reallocate their holdings in the same way, because of their need to produce income.

So if you're looking for an income stream from your investment, is it worth even considering an equity income fund these days? Yes, as part of a mixed portfolio of income-producing investments. For a start, falling FTSE share prices have had a very good effect on yield values.

Not only are the kind of stocks core to traditional equity income funds good buying opportunities at present, but some fund managers themselves have been rethinking their whole strategy to take account of changing opportunities. For example funds such as Jupiter Income and Gartmore UK Growth and Income balance holdings in good-quality high-growth companies against fixed income bond holdings. The fixed interest element is there to provide a decent and reliable yield, against a backdrop of longer term capital growth and dividend prospects.

Independent Partners; request a free guide on NISAs from Hargreaves Lansdown

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