Over the past three years, defensive and value stocks have helped equity income portfolios outperform but there are signs funds are becoming overexposed to such stocks at the expense of growth companies
UK equity income funds have been popular over the past year or two and are likely to remain so this Isa season.
As an UK equity income fund manager I am well aware of the merits of the sector both recently and over the longer term. The combination of income and capital appreciation that has more than matched the more growth-orientated areas of the market in the past, meets most investors' basic requirements.
However, after three years of bear markets in which investors have become less confident about the total returns available from equity investment, another argument has been touted for investing in high-yielding equities. There is now almost universal agreement that equity returns will be more modest in the future. Strategists suggest that investors should not expect more than 6.0% to 8.0% per annum.
They arrive at these forecasts of sustainable returns via a variety of means. One method is to take the current dividend yield (say 3.5%) and to add to this the assumed growth rate of dividends (4.5% per year) giving 8%. Another would be to take the dividend yield and then add the growth in both GDP (2.5%) and inflation (2%), which to all intents and purposes is also a good proxy for the likely growth in dividends.
Given these lowered expectations, the supporters of yield argue that as a greater proportion (3.5%) of the total return (8%) comes from dividends, income is accordingly more important than during a bull market. I am inclined to think an economist came up with this observation because it screams their usual caveat all other things remaining equal, which is exactly what will not happen
While the proponents of yield are obviously not suggesting annual returns will be precisely 8% per year, they do need to see returns come in close to this level. If the actual returns on an annual basis vary significantly, then even over short time periods the prospect of capital gain or loss becomes a far more pressing issue.
But is history on the side of those that expect modest and sustainable returns from equities? Given that in the very long-term equity returns are driven by economic fundamentals, it is not unreasonable to expect historic annual equity returns to have been similar to what is now regarded as a sustainable rate.
The reality is rather different. Over the past 23 years, the UK equity market, as measured by the CSFB Equity Gilt Study, has only produced a return within a 5%-10% range once, in 1987, the year in which equities initially soared 50% only to fall back 30% in the October crash.
In fact if you plot the returns from the UK equity market going back decades, you end up with more of a barbell distribution than a bell curve. For much of the 1970s and 1980s inflation was considerably higher than it is today but even if you go back to similar periods of low inflation, the sustainable return is the exception rather than the rule.
Investor sentiment and the operational gearing of companies to the economic cycle appear far more important drivers of equity markets in the short-term leaving economic fundamentals to exert a reversion to mean influence. With investor sentiment having been shot to pieces after three years of bear markets, I do not see this as presaging a period of investor calm. Indeed, it would have been quite remarkable if after the excesses of the bull market in the 1990s the correction in equity markets had been restricted to a return to the mean rather than have involved some element of undershoot.
This obviously raises the question of whether the lows witnessed in July and September sufficiently low? In the UK in isolation, the answer is possibly yes but I am certainly not convinced about the US. That market unfortunately continues to hold sway in terms of global sentiment where the scale of the monetary and fiscal easing has limited the extent of the market adjustment. Accordingly, I think further wild swings in sentiment and hence equity markets is the most likely outcome.
So where does this leave income funds? For the first two years or so of the bear market, value and income stocks significantly outperformed growth stocks. Since May however, as the market fell from its previous trading range of 5,000-5,300 on the FTSE 100 index to around 4,000, the disparity in performance has been less obvious with key constituents of the growth sector such as Vodafone recovering sharply.
Income stocks are well represented in the consumer-orientated sectors of the economy where growth in personal consumption has exceeded GDP growth for the past six years. Historically, consumption has only tended to lead overall economic growth for two or three years at a time before monetary policy has squeezed consumption.
Although domestic interest rates are unlikely to move much, I am unconvinced investors should continue to rely on private investment to lead the market next year.
If personal consumption does slow relative to overall GDP growth, other constituents of final demand will, if only by default, pick up the baton although it is not obvious that business investment, trade (exports/imports) or government expenditure in aggregate favours growth stocks over income stocks or not.
One of the great dangers to investors is getting sucked in at the top of markets or cycles. Private investors are particularly prone to doing this but professional investors have allowed index considerations to force them into investment decisions that are not always based on fundamental assessment of relative value. Although income funds are far less prone to the sentiment swings associated with, for example, technology funds, there are still grounds for worrying that some income funds have become overly reliant on the defensive/value stocks that have led the market over the past three years.
For this reason alone, I think it is prudent to have a more balanced portfolio. Within my own funds I have spent the last year or so gradually lightening my exposure to traditional income stocks and looked instead for opportunities among the growth sectors.
Here, falls have been sufficiently savage in many instances to leave companies yielding enough to warrant inclusion in the portfolio yet potentially offering far better total return opportunities. I would much rather buy a growth stock off a yield of 3.0% with sentiment against it in expectation of price appreciation reducing the yield to under 2.0% than buy a traditional income stock off a 5.0% yield if it normally trades within a yield range of 5.0% to 8.0%.
This is not a barbell approach but simply a recognition of the natural cycle in investment, both at the stock level and at the market level.
One of the dangers of investment is to be bound unnecessarily to rigid principles that subsequently limit the freedom to move.
The habit of classifying funds within specific sectors and the need to have a marketing message that differentiates a fund from its competitors are both unintentional methods of imposing such restrictions. To counter this, fund managers need to be alert to the opportunities presented to them in the wider investment market.
There is now almost universal agreement that equity returns will be more modest in the future
Income stocks are well represented in consumer-orientated sectors of the economy where growth in personal consumption has exceeded GDP growth in recent years
One of the dangers of investment is to be bound unnecessarily to rigid principles that limit the freedom to move
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