For those curious enough to look, the evidence is there in black and white - Autif's UK Equity Incom...
For those curious enough to look, the evidence is there in black and white - Autif's UK Equity Income sector has not been putting on a good show. Income levels have dropped and now appear to be stagnating at the lower end of the spectrum (see table). What is more, over the year to 31 March 2000, average total returns were -3.83% - worse than the -2.41% achieved in the year to 31 March 1999.
There is no denying those managing equity income funds face a tremendous challenge and there are two key reasons why this is the case.
The first goes back to 1997, when the Government announced its decision to abolish the ACT tax credit available on dividends.
While the withdrawal of the tax credit did not directly affect unit trusts, it did decrease the dividend income on tax exempt funds like pension schemes, charities and Peps (it occurred prior to the launch of Isas). In effect, it knocked 20% off the dividend yield on any stock for gross investors.
Instead of FTSE companies trying to make up the shortfall by paying out even larger dividends, they have started to look at other ways of providing shareholder value. In particular, capital restructuring through share buybacks has become an attractive alternative.
As a result, the emphasis has shifted and institutional investors have relaxed the pressure previously exerted on companies to pay high dividends. Equity income funds are therefore finding it harder to achieve their yields.
Bullish about growth
The second issue facing equity income funds is the ongoing bull market for growth stocks. Growth stocks have been in favour for some time now, with technology stocks stealing the performance headlines around the globe.
Despite the fact that the dramatic first quarter rise of so-called Technology, Media and Telecom (TMT) sectors has fallen back and the market has broadened out, the outlook for growth sectors over the medium term still looks good. Any sectoral rotation into old economy stocks continues to favour growth sectors such as engineers.
What is more, even within the currently out of favour TMT sectors, there are still quality growth stocks to be found that are well placed to outperform over the medium to long term. But the bull market for growth stocks is not a new or unusual aspect of the market. While value sectors such as mining and many cyclicals have been known to come to the fore from time to time, history shows that any outperformance of value stocks relative to growth stocks is generally short lived - as was the case last year.
The conundrum facing equity income funds is that growth stocks by definition tend to have a lower dividend yield than value stocks. The bull market for growth stocks has increased this gap between the two further - as prices have increased in growth sectors, dividend yields have inevitably fallen.
So, while growth sectors have contained some of the best performing stocks in the All-Share, a low dividend yield has made it difficult for equity income funds to take advantage of their outperformance.
These issues combined have seen the pool of high yielding equities diminish in size over the past two years. Those sectors that have tended to produce a high yield in the past have generally been either low growth sectors such as food producers, defensive sectors such as utilities or heavy cyclical plays such as steel.
The problem for equity income funds is that if they now focus on these sectors in order to maintain a target income, the quality of their equity portfolio can be compromised and the capital risk increased. Even among better quality value stocks with a good dividend yield, capital appreciation remains limited while value stocks are out of favour.
An appropriate mix
But it's not all doom and gloom - there is a solution. Within the UK equity income sector there are a few funds that have always generated a large part of their income from fixed interest holdings.
Others are in the process of restructuring in this direction. By generating income from fixed interest content, the strain of generating income is relaxed for the equity portion of the portfolio. This allows the fund to focus on higher quality (and usually lower yielding) equities that deliver a good overall performance.
In this way, equity income funds can reap the benefit of growth stocks (which should help the capital side of the equation), maintain exposure where appropriate to higher yielding value stocks in order to generate a degree of income but generate most of their yield from fixed interest holdings. Now, more than ever, this would seem to be an appropriate mix. It enables growth stocks such as Sage, a leading supplier of accounting software and related products, to be held in the portfolio. This company has outperformed the FTSE All-Share by 192% over the 12 months to the end of March 2000.
At the same time, quality value stocks that are likely to pay out a higher yield, like Imperial Tobacco, could also be bought. Imperial has outperformed the All-Share by 5% in the first quarter of this year.
You have to remember, however, that the income challenge is not unique to equities. Bonds have also been struggling to maintain yields (see table 4).
This is because low inflation and low interest rates have kept yields down. At the long end of the gilt market excess demand from pension funds trying to match their long term liabilities has not helped matters either as it has kept prices high.
So while fixed interest income levels have been higher than those achieved by the equity income sector, they are still considerably lower than they were a few years ago.
What is interesting is that the approach being taken by fund managers tackling this issue in the fixed interest sector could also help equity income funds.
Over the past year or so, a number of high yielding fixed interest funds have been launched that make us
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