Equity income is a get rich slowly approach to investing

Posted by Adrian Lowcock in Portfolio management category on 27 Jun 19

Equity Income funds, investing in companies which pay out a large part of their profits in dividends to their shareholders, have been in the spotlight for all the wrong reasons recently with the suspension of the Woodford Equity Income Fund.

The equity income sector has also been fairly unpopular in recent years as it has been overshadowed by investing for growth, whether that is the quality growth favoured by the likes of Nick Train and Terry Smith or the rapid growth which has characterised the giant technology companies such as Amazon or Netflix.

However equity income investments should not be ignored as they offer some long term benefits for patient investors. The power of dividends and compounding means the sector continues to hold its own over the long term.

It isn’t a get rich quick approach but the investment strategy can produce steady returns for investors. It is hard to know when the companies with high dividend yields, particularly those that are domestically based, will return to favour but in the meantime investors can benefit from receiving or reinvesting the income.

The long-term track record for investing in equity income remains sound and it is not just for those looking to earn and draw an income on their investments. The compounding of any dividends reinvested means that growth investors can also benefit.

On average, the Investment association’s UK Equity Income sector has achieved returns of more than 145% in the past 10 years, compared with the 136% return achieved by the FTSE 100. (Source FE Analytics, 31st May 2009 to 31st May 2019). The best performing equity income fund during that time, the Unicorn UK Income fund delivered nearly 2.5 times the returns of the FTSE 100 if dividends were reinvested, although past performance shouldn’t be a guide to the future.

In the UK there are a number of equity income funds to choose from and it is important to pick a fund which is well managed but also fits in with the other investments in your portfolio. When looking at equity income we have set out five points you should consider:

The dividend yield - Given an equity income fund objective is to deliver an income for its investors, it makes sense that the fund should pay a dividend yield at least the same as the index or more likely slightly higher. If an equity income fund has a low yield then it might have more of a growth focus to it and could be riskier. Likewise a very high yield could suggest investments in companies where dividends are not secure and again be riskier. If the yield on a fund is skewed to one extreme compared to their peers it should be a warning that you need to look deeper into the fund.

Consistency of dividends - For income seekers a dividend yield which is consistent is often a sign of a manager being focused on investing in companies which protect their dividends and are well covered by earnings. Likewise, they are also likely to be focused on potentially lower risk investments.

Diversified income - The UK market is dominated by a small number of very large companies which pay out the lion’s share of income to investors. As a result most UK equity income funds share some similarity in their top holdings. For anyone seeking an income from their investments it is important to make sure that the sources of your income are well-diversified so there is little impact on the income you get should a company cut its dividend. Therefore, it is important to look beyond the FTSE 100 and indeed beyond the UK when investing for income.

Consistent style – As with any investment fund an equity income manager should have a style which is well-defined and strictly adhered to. This can be more important in equity income as the asset class requires a lot of discipline to focus on only those companies which meet the investment criteria and are often not what investors would call exciting businesses.

Don’t ignore capital gains – Companies which are committed dividend payers are often well managed and if they are able to grow that dividend then that in turn could help drive share prices higher. The combination of sustainable dividends along with some growth can increase the prospects of good long-term returns for investors.

For those investing in equity income funds outside of ISA and pension wrappers, it’s important to consider the impact of tax on any dividends. Although tax rules may change in the future, any dividend income you receive which exceeds the tax-free dividend allowance (currently £2,000), is currently subject to income tax.

For more information you can visit investing for income as well as some of our featured income funds.