Where to look for both income and growth

High-yield funds and shares can be a winning strategy, says Jenne Mannion

Equity income funds remain the investment of choice for British investors. Although sales of funds across the industry have been weak in general - both in and outside individual savings accounts (ISAs) equity income funds have been the best selling funds in each of the past eight months, according to Investment Management Association statistics.

Equity income funds remain the investment of choice for British investors. Although sales of funds across the industry have been weak in general - both in and outside individual savings accounts (ISAs) equity income funds have been the best selling funds in each of the past eight months, according to Investment Management Association statistics.

Their popularity follows strong performance in recent years, and the fact investors are waking up to the importance of dividends in delivering both income and growth. A further advantage is they typically carry less risk than non-income funds as the dividend provides a cushion against stock market falls.

In other words, if there were a bear market and the stock market was to fall by say 5 per cent in a year, losses are mitigated by the dividend. If the dividend was 4 per cent, you are only 1 per cent behind, while losses in a non-income fund would be far steeper.

As the name suggests, equity income funds hold a portfolio of shares that will deliver a strong income stream. To be classified as equity income, a fund must yield 110 per cent of the FTSE All Share yield, the income on offer for the price you must pay to access it. The All Share is currently yielding 3.1 per cent, so an equity income fund must produce income of at least 3.41 per cent to qualify. On top of that there will be capital appreciation from the underlying shares, the combined result being a strong and stable return.

Gavin Haynes, an independent financial adviser (IFA) at Whitechurch Securities, in Bristol, says equity income funds tend to hold traditional defensive stocks such as utilities and tobacco companies. They are in a position to pay dividends, because they are solid, cash-generative companies.

Such shares are very unlikely to deliver exciting, stunning returns like racy technology funds did in their hey day in the late 1990s or natural resource funds are doing now. But they are ideal investments for those seeking steadily growing income from a portfolio of shares. You can also reinvest the dividends for growth. This buys extra shares or units, and you can benefit from the cumulative effect. And unlike the more racy types of investment, you are unlikely to see performance implode. Mark Dampier, an IFA at Hargreaves Lansdown, in Bristol, compares equity income funds to a tortoise racing a hare. This is because, he says, equity income funds will plod away, but given time will beat others in the end.

Certainly, they have been the place for investors to be over the past five years, which has included both bear and bull market phases. Over five years to 21 March, the average equity income fund has delivered a positive return of 24.6 per cent, after all charges. This is substantially higher than the average UK growth fund, which has delivered a negative return of 6.7 per cent over the same period, according to figures provided by Standard & Poor's.

Alan Steel, an independent financial adviser at Alan Steel Asset Management, in Linlithgow, Scotland, adds: "I have been a financial adviser for 30 years, and from day one equity income funds have continued to deliver the goods. There have been short periods of underperformance - for example they were left behind in the tech rally of the late 1990s because they did not hold tech stocks. That ended up being beneficial when the tech bubble burst. I'm a fan of this asset class. I am a bit concerned that they are flavour of the month - everyone is talking about them - but in reality it is difficult to go wrong if you choose a good fund."

Their importance for growth investors should not be underestimated. This was demonstrated recently by the Barclays Capital Equity Gilt Study, one of the most respected pieces of research in the City, which showed that £100 invested in equities at the end of 1899 was worth just £170 in real terms (taking into account the effects of inflation) by the end of 2004 if you did not account for dividends. If you reinvested dividend income, however, the same amount would be worth £18,875.

George Luckraft, the manager of the Framlington Monthly Income fund, adds: "The low-growth, low-inflation environment we have been experiencing for the past five years looks set to stay. Lower total returns from capital growth will mean that dividends will play a more important role going forward."

And there is good news in that dividend growth is strong. Toby Thompson, manager of the New Star Higher Income fund, says many companies got themselves into good financial shape by reducing their overheads amidst the economic slowdown at the start of the millennium. Now they have extra cash to return to shareholders in the form of healthier dividends. Companies to substantially increase their dividends in the last year include Centrica, BT and Vodafone, to name just a few.

Despite the fact there are more than 80 funds to choose from, just a handful rule the roost and attract the most attention. These have managers who have proven themselves over the years. They include Artemis Income, managed by Adrian Frost; New Star Higher Income, managed by Toby Thompson; Rathbone Income, by Carl Stick; Invesco Perpetual Income, managed by Neil Woodford; Framlington Monthly Income, managed by George Luckraft; DWS UK Equity Income, managed by Graham Ashby; Schroder Income, managed by Nick Purves; and Jupiter Income, managed by Tony Nutt. Quickly emerging into these ranks is F&C Stewardship Income, an ethical fund managed by Ted Scott.

Steel likes also to look beyond the heavyweights of the sector to new blood. Likening the choice of equity income managers to a football team, Steel says the "Wayne Rooneys" are Karen Robertson, manager of the Standard Life Equity High Income fund, and Michael Barnard, of Marlborough UK Equity Income. Because these funds are not well known, they are quite small, at £58m and £26m. Many better-known funds are far larger, with many worth more than £1bn.

He adds: "Robertson and Barnard are very good managers - apparent by their stonking performance. The fact they have smaller funds means they can be nimble and do not face liquidity constraints."

In particular, he likes the fact Robertson will hold both growth companies and higher yielding shares within her portfolio, the overall effect being a combination of shares that complement each other and work well. This is a method used successfully by Framlington's George Luckraft, for many years. "Karen Robertson is one of the stars of tomorrow, but investors should be considering her fund today," Steel says.

THE SHARES

You need not buy a fund to get strong income and potential for capital growth. You can also hold shares directly. We asked investment managers for their top high-yielders.

* AstraZeneca: Yield 2.4%

Alasdair Mundy, the manager of Investec Cautious Managed, says this company has suffered a number of mishaps in the recent past but he believes much of the negative news has been genuine bad luck. "The top selling drugs in the portfolio are growing very quickly, near-term margin improvements are virtually guaranteed."

* Severn Trent: Yield 5.2%

Neil Cumming, a private client manager at Hichens Investment Management tips Severn Trent, a water utility, following a regulatory review that is upgrading its infrastructure and passing on costs to customers in the form of higher water bills. Additionally it has Biffa Waste Services, which is gaining market share.

* Boots: Yield 4.8%

Jonathan Barber, the manager of the Threadneedle UK Monthly Fund, considers Boots undervalued given the strength of its brand name and strong cash flow. Boots issued its second profits warning earlier this year. Barber says: "The market has missed the fact that Boots the Chemist only accounts for around 85 per cent of the business with the balance accounted for by Boots Healthcare International. A sale of this business would raise around £1bn."

* Cable & Wireless: Yield 2.6%

Mundy says C&W has suffered a number of mishaps. But new management has been in place for about two years. "There is now a strong balance sheet (more than 50 per cent of the share price is cash). Meanwhile, market expectations for profitability have been very low, due to fears of increased competition. If management proves the outlook is better than expected, sentiment could turn sharply."

* Legal & General: Yield 4.5%

Cumming says: Trading conditions for UK life assurers are improving. "Stock markets have recovered from the destructive low values of early 2003 and the need for savings and pension provision in an ageing population is clear. This should continue to be a profitable company with a growing dividend."

* Pearson: Yield 4.1%

Stuart Fowler, the manager of Axa UK Equity Income, says Pearson is probably best known for owning the 'Financial Times' and Penguin books. But it earns most of its profits from publishing education books in the US, where demand is expected to increase.