Wait: they will come out of their shells

Steady growers rather than top performers, equity income funds still have an impressive track record in good times and bad. Jenne Mannion considers their attractions for ISA investors

Each spring, in the run-up to the end of the tax year, fund managers launch a flurry of ads to try to persuade us to invest our £7,000 individual savings account (ISA) allowance with them.

Each spring, in the run-up to the end of the tax year, fund managers launch a flurry of ads to try to persuade us to invest our £7,000 individual savings account (ISA) allowance with them.

There has usually been a theme running through each of these so-called ISA seasons. Popular funds hyped by managers in the past have included European (1999) and technology (2000) funds, with exotic hotspots such as Japan, Latin America and China cropping up along the way.

Although this year's season has yet to take on a distinct character, one type of fund that has proved perennially popular is sure to feature: UK equity income. The name might be convoluted but these funds have two simple objectives.

The first is to deliver an income stream for investors - who can choose to take out their money or reinvest it - and the second is to grow capital via a higher share price.

In a nutshell, the income investors receive comes from dividends paid by those companies in which the manager has invested. So, a wise manager's choice should yield healthy dividends each year.

Rising dividend payouts may also indicate a rise in profits at the companies concerned. If this is the case, prices for the shares held in the fund manager's portfolio are also likely to rise, increasing the value of investments for their clients.

"UK equity income funds are excellent long-term holdings, whether an investor needs to take the income or has it reinvested," says Tim Cockerill of independent financial adviser (IFA) Rowan & Co. "The key is that these funds do both jobs."

A major study published last week confirms that, over the longer term, investing in companies that pay dividends is one of the best ways to get healthy returns. Barclays Capital's Equity Gilt Study - now in its 50th year - reveals that, had you invested £100 in UK equities back in 1899, it would have been worth just £170 in real terms at the end of last year. But if the income generated had been reinvested, the portfolio would have grown to £18,875.

After the technology bubble burst in 2000 and during subsequent bear markets, equity income funds held up well in comparison with many others. However, Mark Dampier of IFA Hargreaves Lansdown points out that they will not always deliver the best returns over a shorter period.

"Equity income funds are like the tortoise rather than the hare - they may go slow, but they are steady. There will be times when they are left behind but they will eventually catch up and overtake, as history has indeed proven," he says.

One reason for the funds' robust long-term performance is that, by nature, dividend-paying companies tend to be mature and well-established. You will find very few racy, speculative shares such as those associated with hi-tech science, nestling inside them. Instead, expect to see steady growers such as tobacco, oil, telecoms and power companies.

"British companies increased their dividends by an average 7.5 per cent last year but in certain areas of the market the dividend growth has been far stronger," says Anthony Nutt, manager of the Jupiter Income fund. One example is Vodafone, which doubled its dividend payout in 2004.

Another reason for the funds' success is the dividend itself. Mr Dampier says the average equity income fund returns a dividend of 3.5 per cent a year. This gives such funds a head start on those in other sectors; even if the stock market were to move sideways over the year, investors in equity income funds would be 3.5 per cent ahead.

Adrian Shandley, an adviser at Premier Wealth Management, describes the dividend as an insurance policy: "In falling markets you are getting a safety net; in flat markets you are getting some return, and in rising markets the dividend is an added bonus on top of the share price growth."

A handful of equity income funds have been consistently strong performers over many years. Mr Dampier's recommendations include those from Jupiter, Artemis and Invesco Perpetual. Both Mr Shandley and Mr Cockerill like Newton Higher, Rathbone and Schroder.