The lowest interest rates since 1955 have put the spotlight on stock market funds investing for income, but the shock news that Prudential intends to cut its dividend next week for the first time in 89 years shows these funds are not a straightforward replacement for bank deposit accounts.
Any equity income fund that had gone to sleep on the Pru, taking it for granted its dividend would continue to land as surely as night follows day, is in for a severe shock. And it may not be the last in what could be a rocky half-year results season. All eyes will be watching Lloyds TSB on Friday, when it too may cut payment to shareholders.
Further admissions by previously reliable dividend payers will dent confidence in these funds, which enjoyed growing popularity this year as the stock market recovered and the search for income became more intense.Income or high-yield funds hold a portfolio of stocks that produce an income through dividends. Investors seeking absolute growth can also opt to have that income reinvested in the fund, to accelerate growth.
Equity income funds are often used by retirees who need regular income to add to their pension, while hoping for capital growth. The funds are also useful for investors seeking a lower-risk element to their portfolios.
Take the example of George Birt, an 83-year-old in Harrow, Middlesex, who enjoys travelling. He retired from London Electricity Board in 1981 and put £3,000 into M&G Dividend fund. He is very happy with the growth to £18,000, despite falling markets, and the extra £700 that helps pays for his annual trip to Australia to visit relatives. He also has other investments with income.
Juliet Schooling, an independent financial adviser at Chelsea Financial Services, says equity income funds typically hold shares in larger, more established companies, with a level of earnings that allow them to pay dividends. These companies are deemed relatively safe investments, as are the funds that hold them. Hence the destabilising effect of the Pru's forthcoming dividend cut.
Over the past three years (to 16 June), the average equity income fund has lost 17 per cent of its value. But the average fund in the UK all-companies sector, which consists of growth funds, lost a far more painful 31 per cent after charges. Ms Schooling said that in an environment of low interest rates, equity income funds offer a yield similar to that of a building society.
The FTSE All Share yields 3.4 per cent, comparable to many of the better-paying bank and building society accounts. An added bonus of equity income funds is that, unlike a building society, there is also potential for capital growth if share prices rise. This is not guaranteed.
Some of the best known are Liontrust's Jeremy Lang, Invesco Perpetual's Neil Woodford, New Star's Toby Thompson, Jupiter's Tony Nutt, Rathbones' Carl Stick and Adrian Frost, of Artemis. Another big name in equity income funds is Bill Mott, of Credit Suisse, who recently stepped back and is no longer a lead manager. His colleague, Leigh Harrison, who financial advisers say is just as talented, has taken the reins of the £924m Credit Suisse Income and £285m Monthly Income funds. Mr Mott will remain at Credit Suisse as strategic adviser, but will work mainly from home.
Tony Nutt runs the highly successful £1.3bn Jupiter Income Trust with a unique investment style that demands patience. He hunts unloved, undervalued companies whose share prices are likely to rebound in 12 to 18 months.
Crucial to his fund's success is careful stock-picking, which in turn depends on thorough research. Mr Nutt relies on detailed analysis and regular interviews with senior executives to decide whether to invest in a company..
"Quality is important," Mr Nutt said. "A company must have good cash flow and reliability of earnings. It must also be cheap. There is no point buying something where the rating already reflects the growth potential." Although his fund's objective is to deliver a yield for investors, Mr Nutt said it is not crucial that every company has a dividend. He may select companies for their growth potential. The dividendless BSkyB is a case in point.
The Jupiter Income fund tends to have a strong bias toward companies in the mid-cap area, while avoiding the mega-cap stocks at the top of the FTSE 100 index. Mid-caps, he said, are where the best value is to be found among dividend-paying companies.
Another secret of Mr Nutt's success is that he is prepared to go against the grain. Many of his competitors will slavishly follow stock market indices, but Mr Nutt is far more independent in his views and there is no requirement for him to hold stocks or sectors he does not like just because they are an important component of the index.
His top five are Associated British Ports Holdings, Liberty International, Royal Bank of Scotland, Northern Rock and Persimmon. But the five biggest holdings in his more conservatively managed High Income fund are UK Treasury Loan 8.5 per cent, Treasury 5 per cent, Anglo Irish Bank, P & O and Aviva. Mr Nutt has no exposure to the pharmaceutical sector, because he expects returns of companies such as AstraZeneca and Glaxo Smith- Kline will continue to be negatively affected by pressure on healthcare budgets.
Neil Woodford, another top equity income fund manager, runs Invesco Perpetual's £2.1bn High Income and £738m Income funds. He likes to marry top-down macro-economic analysis with in-depth stock research. He said: "In an environment where profits are under pressure, the sustainability and growth potential of dividends is of increasing importance. I aim to focus my portfolios toward stocks that offer high, sustainable and growing dividend potential."
Mr Woodford said he will continue to focus on undervalued companies that have the resilience and financial strength to see out the current weak economic environment. "We invest in selected companies with secure finances and which have the potential to deliver over the longer term," he says.
Equity income funds are starting to offer more concentrated portfolios to capture better returns. The DWS UK Equity Income Plus fund, launched in February, holds a portfolio of only 40 stocks, although most mainstream portfolios tend to hold 100.
The fund is managed by Graham Ashby, who also manages the broader UK Equity Income fund. Mr Ashby says the new fund was launched following a string of dividend cuts by major companies over the past few years.
He believes the freedom to focus on a narrow band of stocks, with the financial strength and management ability to grow their business, should bode well for stronger returns.
Some experts believe the worst may be past. Adrian Frost, manager of the Artemis Income fund, who does not hold Prudential in his portfolio, said: "The environment for dividends has improved in six months. Companies have been working hard in a difficult _environment to improve their financial affairs and as a result this has led many being able to maintain their dividends.
The real pressure point in dividends was nine months ago. At that point, in addition to tough economic conditions, companies had to cope with substantial rises in insurance premiums and higher pension contributions. Most have adjusted to that now."
But even Mr Frost agreed that further surprise dividend cuts may be pending.
* Artemis Investment Management 0800 092 2051 www.artemisonline.co.uk
* Credit Suisse Asset Management www.csam.com
* DWS Investments 0800 917 0005 www.find.co.uk
* Invesco Perpetual 0800 085 8677 www.invescoperpetual.co.uk
* Investment Management Association 020 7831 0898 www.investmentuk.org
* Jupiter Asset Management 020 7314 7600 www.jupiteronline.co.uk
* Liontrust Asset Management 020 7412 1700Reuse content