Yielding Income: A Sector in Focus

Posted by Fiona Liu in Seeking Income category on 10 Jun 16


Equity Income Sector 

Where investors are increasingly searching for income in a low interest environment, we will have a look at the sector that is designed to meet the needs of providing income.

What is the UK equity income sector?

The UK Equity Income sector is part of the Investment Association (IA) and was established to allow investor to easily differentiate UK income orientated funds out of the plethora of funds in the universe. The official definition of the IA Equity income sector is: “Funds which invest at least 80% in UK equities and which intend to achieve a historic yield on the distributable income in excess of 110% of the FTSE All Share yield at the fund’s year end”.

Why are people investing in this sector?

According to IA, it’s been the best selling sector since 2014 but the Targeted Absolute Return sector has taken its spot since January 2016. A reason could be due to the volatility of the market at the start of the year and investors wanting to protect their money in real terms. Contrary to the wider population, at Willis Owen, the Woodford Equity Income fund was the best selling fund in 2015 and the trend continues into 2016.

There are a large proportion of investors that are income seekers e.g. to support them through retirement. However, in a low interest environment where the Bank of England’s base rate has remained at 0.5% since March 2009, it is logical that investors may choose an income orientated fund. The criteria given to funds to stay within the UK equity income sector should give confidence that funds in this sector will aim to exceed the FTSE All Share yield which has been around 3-4%* in the past few years. In addition to this, investors have a home bias as they prefer to invest in companies that are familiar to them.

One of the most popular funds that many investors are familiar with is the Woodford UK Equity Income fund. Woodford launched his own fund in 2014 and the current fund size is £8.8bn, making it one of the largest funds in the sector. The inflows into the Woodford fund (and the Invesco Perpetual Income fund that he previously managed) have no doubt contributed to the reasons why UK Equity Income sector has been popular over the years.

Funds within this sector

Although funds in this sector aim to provide income, fund managers have different approaches to achieve this. The Woodford Equity Income fund which is coming to its 2nd anniversary has maintained a “buy and hold” strategy, investing into companies that produce high dividend yield – his biggest holding is in Imperial Brands which has a historic yield of 3.86%.

Some fund managers such as Standard Life UK Equity Income Unconstrained focusses mainly in mid cap companies (typically companies that reside in the FTSE 250 index) so rewards often come at higher risk than large cap counterparts. Using derivatives as a strategy to enhance income is seen in the Premier Optimum Income fund but also comes with higher risks.

Funds such as Marlborough Multi Cap Income invest in a broad spectrum of companies (though it primarily focuses on medium and small cap companies) which can help spread risk. Income is usually paid out quarterly or twice yearly but Columbia Threadneedle Monthly Income fund is one of the few that pays income monthly which pensioners may prefer as they live off the income. Others such as the Liontrust Macro Equity Income fund will have overseas exposure (around 18%) which may provide them with opportunities that are not seen in the UK – especially as we see FTSE 100 companies cutting their dividends.

The table below shows the historic yield (12 month rolling basis) and the different approaches the funds mentioned above have to seek income:

Fund name Historic Yield
Premier Optimum Income C Inc 7.10
Marlborough Multi Cap Income P Inc  4.72
Liontrust Macro Equity Income I Inc  4.68
Threadneedle UK Monthly Income Z Inc  4.30
Standard Life Investments UK Equity Income Unconstrained Ret Inc  4.00
CF Woodford Equity Income C Inc  3.66
Source: FE Analytics (as at 01/06/16)

From the table, although Premier Optimum produced the highest historic yield, it uses derivatives to sell some of the stock which meant capital growth was limited. On the contrary, the Woodford Equity Income fund has had attractive capital growth which meant a reduction in dividend yield.

The example below illustrates this point:

£100 is bought into Fund A at 100p and pays out 10p income at year end (price of fund at year end is 110p)

Income yield = 10p/110p = 9%

£100 is bought into Fund B at 100p and pays out 10p income at year end (price of fund at year end is 150p)

Income yield = 10p/150p = 6.7%

From this example, we can see that both the funds pay out the same income but as Fund B has had more capital growth, the income yield is reduced.

Although looking at the yield is important when considering an income fund, it is also important to consider the capital growth as both contribute to the total return which the investor receives (it correlates with the amount of income paid out from the fund).

Income funds that are expelled from this sector

To remain in this sector, one of the criteria is “funds in the sector will be tested over 3 year rolling period by taking a simple average of the yield figure achieved for each fund at its year end. Funds that fail to meet the 110% average yield for each 3 year rolling period will be removed from the sector”.

A few notable UK equity income funds have been expelled from the sector due to the failure of achieving 10% more than the FTSE All Share yield and were moved to the UK All Companies sector. Some examples include the Invesco Perpetual Income and High Income, Schroder Income and Rathbone Income. The UK All Companies sector only specifies that funds have to invest at least 80% of its asset in UK equities. There are significantly more funds (around 250) in this sector than the UK Equity Income (around 80) and so it may be harder for investors to realise that there are some income funds in this sector. You can find some of these funds (though not inclusive) by filtering sector “UK All Companies” and type in “income” in the search bar on Fund Space. By doing this, you will find the funds displayed on the table below:

Fund name Historic Yield
Schroder Income A Inc  4.44
Rathbone Income R Inc  3.63
Invesco Perpetual High Income Z Inc  3.20
Invesco Perpetual Income Z Inc  3.14
Source: FE Analytics (as at 01/06/16)

One thing to note is that their expulsion doesn’t mean these funds are “bad” performers but it reflects their fund approach is no longer compatible with the sector’s criteria. With these funds, we often find that they have had significant capital growth which ultimately affected their dividend yield. There is currently a consultation to change the definition of UK Equity Income sector which means some of these funds may re-join the sector in the future.

Conclusion

With interest rates remaining low, we expect income oriented funds to be of interest to investors. Understandably, a proportion of investors are worried about Brexit and are leaving money in cash before the referendum results which may explain the decrease in inflows into equity funds at the start of the year. Volatility and politics are some of the factors that will always be influential to stock market conditions which make it more important to invest for the long term and to regularly review your portfolio so that it remains in line with your objectives.

As part of our “searching for income” series, a further blog on whether equities are the best place to sustain and grow income will be published soon. You can read the first part of the series; In pursuit of income: investing the opportunities.

* data extracted from IA’s Yield figures for the UK Equity Income sector

Important Information: We do not give investment advice so you will need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact a financial adviser.

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