Will 2018 prove to be a bad year for UK income investors?

There are many reasons for holding a UK equity income fund, but a large proportion of investors rely on their fund’s regular payments to support their lifestyle in one way or another. Some use them in retirement, or to supplement their wages, while others just like the security of knowing they have a dividend payment coming.

In my view, many of these investors are at risk of disappointment in the coming years, and must think hard about whether or not their equity income fund is giving them what they need. This is for two main reasons. First, the backdrop for UK equities and particularly UK income on a one- to three-year view is extremely challenging; and secondly, the interests of many UK equity income funds and their income-seeking investors are no longer aligned.

Falling yields and risky dividends

In March 2017, the Investment Association (IA) took the decision to lower the sector’s yield target from 110 to 100 per cent of the FTSE All-Share’s yield. Only when a fund’s yield falls to 90 per cent or less of the FTSE All-Share is it removed from the sector.

The unforeseen consequences of this for income investors are likely to be hugely damaging; indeed, we are already seeing a worrying trend just a few months after the rule change.

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The problem is that a number of income managers appear to have reacted to the yield change by deliberately reducing their yield, presumably in an effort to boost their growth potential. According to Morningstar data, the percentage of funds in the IA UK equity income sector yielding 110 per cent of the FTSE All-Share has fallen from 87 per cent in September 2016 to just 48 per cent in September 2017. The percentage of assets yielding 110 per cent of the index has fallen from 73 to 33 per cent.

Some funds now don’t even yield as much as the market. At the end of September 2017, the percentage of funds in the sector yielding 100 per cent of the FTSE All-Share had fallen from 96 to 81 per cent, with the percentage of assets falling from 100 to 73 per cent.

It is true that investors use equity income funds for different reasons. Some use them to generate a regular income stream, while others use them for their total return potential by reinvesting the dividends. If you fall into the latter camp, these lower-yielding funds certainly tick the box, but should they be in the UK equity income sector? Should a fund that yields less than the market really have the term ‘income’ in its title? Arguably, the IA UK all companies sector is a more suitable home for funds that prioritise growth over yield.

My fear is that many investors with equity income funds are not aware of these huge changes. This is concerning as so much of the money in the sector was invested before the IA changed the yield target, at a time when many funds were yielding significantly more.

High level of dividen risk in the UK

The high level of dividend risk in the UK market compounds the problem. Many of the funds that have sacrificed their yield adopt a ‘barbell’ approach, holding a handful of high-yielding stocks and a long tail of growth stocks to boost total return. Such funds are heavily reliant on a small number of companies to generate their yield. This means that if a stock falls on hard times and is forced to cut its dividend, the fund’s ability to maintain or grow its dividend comes under threat.

The Neptune Income fund is committed to maintaining a yield target of 110 per cent of the FTSE All-Share index, which we believe is in the best interests of our investors. Moreover, the fund’s equally weighted portfolio, with each of the 33 stocks meaningfully contributing to total yield, provides a consistent and diversified income stream whilst minimising single-stock risk. The current trends we are seeing across the IA UK equity income sector suggest we may be in the minority in the coming years. 

Robin Geffen is founder and chief executive of Neptune Investment Mangement.

This article is one of our Original Thinker pieces, which are showcased in Money Observer’s annual wealth creation guide. The January 2018 issue of Money Observe now on sale at WHSmith, selected Tesco and J Sainsbury supermarkets and many independent retailers. To order online and ensure you pay the lowest rate per issue, visit our subscription page.

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