Richard Troue: 'So savings rates stink but shares look dangerous. Here's a solution'

Richard recommends building a diversified portfolio of equity income funds

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The Independent Online

Here we go again. Last week Mark Carney, Governor of the Bank of England, suggested interest rates could rise in the UK "at the turn of the year". There followed plenty of speculation about the exact timing of a rise and the implications for the general public.

Despite some suggestions a higher bank base rate would be a welcome reprieve for savers, any impact is likely to be negligible. Mr Carney hinted future interest rate rises will typically be in smaller increments. So when rates rise, it is likely to be by a mere 0.25 per cent. They are also likely to peak at lower levels than before the financial crisis, perhaps 2 per cent to 3 per cent at most. Any rise would be better than nothing, but for those with cash savings, the struggle to earn a decent return is likely to continue for some time.

Even if the current pace of economic growth and wage increases is sustainable (which is a big if), there is no escaping the fact that the economy is still fuelled by debt.

UK households are among the most heavily indebted of any big economy. A whole generation of borrowers has never experienced a rate rise. Anyone who bought their first home in the past eight years will never have had to fork out more for their mortgage payments. Some might even have seen them fall. To these people, a rate rise of even 0.25 per cent might not seem so negligible. The same goes for anyone with borrowings where the interest on repayments fluctuates with interest rates.

Given that there are more borrowers than savers in the UK, it is hard to see the Bank of England being in a position to raise interest rates by the end of the year.

This leaves those who need to generate income from their capital in a dilemma. They can continue to accept negligible returns on cash deposits, or consider taking some risk by investing in the stock market. Given the strong run that the stock market has been on since the dark days of the financial crisis – and the threat to that progress posed by the Greek crisis and the economic troubles in China – some are understandably nervous.

Some cash should of course always be kept in reserve for a rainy day – enough to cover living expenses for at least three months is generally considered sensible. For capital above this, short-term fluctuations in value should be less of a concern if there is the potential for growth over the long term and you have a healthy dividend income.

At the time of writing the UK stock market yields in the region of 3.4 per cent, with many equity income funds offering more.

The beauty of these funds is their simplicity. Equity income managers typically seek companies in robust financial health and that generate strong and consistent cash- flow. This enables them to pay attractive dividends, which have the potential to keep growing. Companies that can demonstrate a record of consistent dividend growth are often rewarded with a rising share price.

It is an approach that has stood the test of time. Equity income funds can look dull when markets are rising strongly and investors are focused on areas perceived to be more exciting, but they can also fare better during tougher times, given their focus on cash-generative companies with reliable earnings.

Building a diversified portfolio of equity income funds, focusing on companies of different types and sizes, can be a good approach as each should perform well at different times. For exposure to undervalued, defensive companies with strong balance sheets and high cash flow, the Artemis Income and CF Woodford Equity Income funds could be considered. By contrast with many peers, the JOHCM UK Equity Income fund currently offers exposure to more economically sensitive companies; and the Marlborough Multi-Cap Income Fund tends to have a bias towards smaller and medium-sized companies, bringing some spice to an equity income portfolio.

Finally, while the changes to dividend taxation announced in the recent Budget should have an impact only on those with large portfolios, it is worth remembering the importance of fully utilising tax wrappers such as Isas and Sipps, particularly for income-generating investments.

Richard Troue is head of investment analysis at Hargreaves Lansdown. For more details about the funds included in this column, visit www.hl.co.uk

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