Turning an income fund into capital return

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The Independent Online

It is not uncommon for fund managers to come from a stockbroking background, but Adrian Frost, the manager of Deutsche UK Equity Income, freely admits that his time in broking was not very successful.

It is not uncommon for fund managers to come from a stockbroking background, but Adrian Frost, the manager of Deutsche UK Equity Income, freely admits that his time in broking was not very successful.

"I have been an investment manager for 20 years, 18 of them at what was Morgan Grenfell, now Deutsche Asset Management," he says. "Prior to getting into fund management, I spent two years trying to become a stockbroker and I must be one of the only people who ever tried but failed to do so." He puts this failure down to not appreciating what broking really involved. "I thought stockbroking was more scientific than it actually is. I thought that 90 per cent of it was analysing information on a company and 10 per cent was speculation, whereas, in reality, it is 10 per cent information and 90 per cent speculation." Mr Frost found the analytical demands of fund management much more to his liking. "The way I invest means you have to know a lot about a particular company before you take the plunge and invest in it. The emphasis is on "bottom-up" stock picking. It is our job to sort out the wheat from the chaff."

Mr Frost has been responsible for the Deutsche UK Equity Income fund since its launch in 1988, but he also heads up Deutsche's 30-strong UK equity team, with overall responsibility for the group's UK invested unit trusts, investment trusts and institutional pension funds. "As a team, we manage about £40bn in UK equities which represents about 1.5 per cent of the entire UK equity market," he says.

The goals of the income fund have changed subtly since its launch. "In its early years, the fund set out simply to be the best in its peer group, but at its most basic level, we want to beat the performance of an index tracker after costs, while, at the same time meeting the criteria for an income fund," he says. "We are charging a fairly hefty active management fee and need to achieve at least that to justify it."

The fact that he uses the performance of index-tracking funds as a benchmark is significant, because such funds are focused on total return while Deutsche UK Equity Income is classified as an income fund. Its objective is to generate a yield of at least 110 per cent of the average yield on the stocks in the All Share Index. But Mr Frost argues that, given the current trends within the UK stock market, the distinctions between income and growth funds are breaking down.

"One day, the income sector will become absorbed into the general funds, and rather than let that situation sneak up on me I have faced it full on. Although investors might be attracted by a high yield on a fund, what they are really interested in is capital return. On top of that, our unitholders expect above average performance for limited volatility."

The point about volatility is particularly important at the moment, since Mr Frost detects growing movement in the UK market. "We are going through one of those periods where we are probably going to be moving from steady growth to recession to recovery in the space of six weeks," he says.

Given that the fund is relatively large (over £850m) and that Mr Frost and his team are running a range of both retail and institutional funds, the investment policy is relatively conservative. "Most of the investments that we put into the fund are what we would also put into our pension funds," he says. "We have a very strong team, in which everybody both analyses companies and chooses stocks."

With markets becoming more volatile, the balance of the portfolio has to be kept under close scrutiny. "In mid 1998 I changed the mix of the portfolio, moving away from what I call the 'dark value' area of the market, the traditional heavy-yield type of companies, as these were simply going down in value, and broadening the range of stocks we held. That brought it back on track after 18 months of poor performance."

This has meant venturing into sectors of the market, and individual companies which do not seem obvious candidates for an income portfolio. The emphasis has been on looking for stocks with strong future prospects, either because they have solid growing businesses which, in turn, should generate cash, or because something has happened within an out-of-favour company that will turn it around.

"Probably our most notable success over the past 12 to 18 months has been Lonmin, the old Lonrho," Mr Frost says. "Everyone had this stock on their 'no go' list, but it is the type of company we like, where things are changing for the better. Lonmin was a company where changes were happening under everybody's noses and it has done very well for the portfolio.

"We have also done well in ports companies, such as Associated British Ports and Powell Duffryn and have made money from property companies like Canary Wharf and Piller Property," he says. "Another good one has been Bunzl. Generally speaking, these type of stocks have been good, steady growth counters."

The dominant theme within the stock market for the past year or so, however, has been the rise of technology stocks, many of which pay little or nothing by way of dividends. This has presented Mr Frost and his team with a dilemma.

"We have been through interesting times over the past six to 12 months. There have been periods when you could own any tech stock, indeed, any 'new economy' stock, for that matter, and it didn't really matter which one it was as they all went up. But now we are going through a very gradual process of seeing which tech stocks actually have products and services that make money and which don't. We are also still keen on media companies, like Pearson and Carlton. At the same time, the market has been ignoring a lot of the more conventional stocks, which is good news for a fund like ours as it means that by sticking with things like Bunzl there is some excellent value in our portfolio."

At the same time, there is a more actively managed element of the portfolio concentrated on smaller stocks. "There is a small dark corner of the market housing companies of around £400m or less with some very promising stocks on a short term view," Mr Frost says. "So I have kept a corner of the portfolio for companies like Senior Engineering, Vitec, Laird and Glynwed. If am still holding these in five years time I will probably be in a very different institution to this one, but on a 12- to 18-month view they are very interesting and, at the moment, this is the part of the portfolio I am most keen to own".

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