Equity income funds are proving popular with investors who have become disillusioned with the lacklustre rates of interest on offer from high-street banks and are willing to embrace at least an element of stock market risk. These funds often invest in large, blue-chip stocks that are considered quite defensive because they provide goods or services that people still buy – such as tobacco and pharmaceuticals – irrespective of what is happening in the wider global economy.
Such firms can also usually be relied upon to pay regular dividends, which can mark them out as being solid, reliable and well-managed businesses. After all, any firm that is willing to hand money back to shareholders is making an upbeat statement.
Roy Durrant, a chartered financial planner at Almary Green Investments, believes this is behind the rise in popularity of equity income funds over the last few years – and insists the continuing volatility around the world means this is unlikely to change any time soon. "Investing in companies that have good earnings and which pay reasonable dividends is a safer bet in the current climate than putting your money into some of the smaller, growth-orientated companies."
The latest statistics illustrate this. During July, UK retail investors invested £101.7m of fresh money into the IMA Global Equity Income sector and just over £96m in the IMA UK Equity Income sector, according to the Investment Management Association. But the disparity in results achieved by such funds operating in the UK Equity Income sector can be remarkable. Depending on which fund and manager they have chosen, investors have either made fantastic returns over the past five years – or lost an awful lot of money.
So how can prospective investors go about deciding whether an investment in equity income makes sense? We asked a number of leading independent financial advisers, investment experts, and fund managers for their insights into this fast-growing area.
Who invests in equity income funds?
The type of investor drawn to equity income funds has changed. Traditionally they were favoured by investors who wanted a regular and rising income, with capital growth being a lesser requirement. Now, they are considered by those focused on capital growth who reinvest any income generated for better longer-term returns.
These funds are particularly good at meeting the needs of older investors, according to Mark Dampier, head of research at Hargreaves Lansdown. "Very few asset classes give you the potential for capital growth and a rising income, and this can be particularly attractive if you're coming up to retirement," he says. "You could consider buy-to-let, as rents are going up, but it's a hassle, and the outlook for residential property isn't great."
How have equity income funds performed?
The average return achieved by the sector over the past five years is a modest 7.64 per cent, according to data compiled by Morningstar to 7 September this year. However, 55 have made a profit and 21 have lost money.
Digging deeper, 30 funds in the sector have achieved bumper double-digit returns, while six have double-digit losses. There is also a 72 per cent difference between the best and worst, with Unicorn UK Income up 46.94 per cent and Henderson UK Strategic Income down 25.11 per cent.
Many of those at the bottom end of the table may have been affected by exposure to the banking sector, which bore the brunt of the financial crisis during 2008. But there are still big differences between the best and worst performers during other periods.
Since September 2009, for example, the best funds have returned more than 60 per cent, while the worst are up by just under 20 per cent. During the last 12 months, meanwhile, there's a gap of around 20 per cent between the top and bottom funds. Patrick Connolly, head of communications at AWD Chase de Vere, is not surprised that performance figures vary so enormously, pointing out that funds in the sector can adopt vastly different approaches"
How do you choose the right fund?
Some of the fund management industry's most legendary names ply their trade in the IMA UK Equity Income sector and offer a combination of experience and consistency, according to Darius McDermott, managing director of Chelsea Financial Services.
"There are lots of managers who have been running equity income funds for a long time, such as Neil Woodford at Invesco Perpetual, Leigh Harrison at Threadneedle and Adrian Frost at Artemis," he says. "Over a long period of time these experienced names generally outperform."
So what's hot?
Adrian Frost concentrates on analysing the strength of the free cash flow of a business – and assessing its ability to both pay and grow dividends over time – when he's picking stocks for his Artemis Income fund. "The fund's positioning has not changed significantly over the last few months," he says. "We continue to maintain a defensive stance, with significant underweights in mining and banks and a large overweight in pharmaceuticals & biotechnology, industrials and utilities, due to their high-paying dividends."
Matt Hudson, whose Cazenove UK Equity Income has been the best performer over the past year with a 24.01 per cent return, according to Morningstar to 7 September 2012, has been focusing on adding to holdings in financials, as well as consumer cyclicals such as Howden Joinery, Cineworld and Carphone Warehouse. He has also been reducing his oil holdings, so he doesn't have BP or Shell.
Stephen Message, manager of the Old Mutual Equity Income fund, likes to see evidence of potential for shares to be re-rated. "The UK market offers a tremendous opportunity to invest in some very good franchises that are also in an early stage of their growth."
And the future?
There are challenges, admits Geoff Penrice, a chartered financial planner with Astute Financial Management. "Markets are unsettled by world events such as the euro crisis, ongoing problems with banks and the slowdown in China," he says. "Bank shares were often a key component of equity income funds, and the loss of these shares has limited the pool of high-yielding shares. On the plus side, the world economy is still growing and there is, and will continue to be, the potential for returns to be made."
According to Patrick Connolly, the prospects depend on how the wider stock market performs. "Equity income funds still have the potential to perform well and produce consistent dividends," he says. "However, they might get left behind if stock markets pick up strongly, and there is also the risk they could be hit heavily if markets fall."
Depending on which fund and manager they have chosen, investors have either made fantastic returns over the past five years – or lost an awful lot of money