The UK equity income sector has long been a popular choice for investors, but there has been much press comment about this sector in recent months for different reasons. One of the main news-stories has concentrated on the clampdown by the Investment Management Association (IMA) on those funds that do not achieve the necessary yield target to warrant inclusion in the sector. The UK equity income sector yield target is that funds need to aim 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.
This clampdown on UK equity income funds has been broadly a response to long-standing criticism from selected investment groups that the IMA had not been strictly enforcing the yield target rule. Much of this criticism was owing to the fact that a number of the sector's top performers were funds that were not achieving the yield target and were based more on a total return methodology, not that many investors would have been concerned about this issue.
As a result of this stricter enforcement of the yield target, the IMA launched the new UK Equity Income & Growth sector earlier this year. The yield rules for this new sector are not as strict as funds, they aim to have a historic yield on the distributable income in excess of 90% as opposed to 110% of the yield of the FTSE All Share Index. Following the launch of this new sector, the IMA removed from the UK equity income sector all funds that failed the yield test based on a 12 month look-back on 31 December 2008. However, it should be noted that most of these funds chose to transfer to the new sector, thereby permitting the retention of their track records.
As we move deeper into this year, those funds remaining in the UK Equity Income sector are likely to find hitting their yield target no easier than in 2008. It is not only banks that are failing to pay dividends, but the yield on the FTSE All-Share is expected to fall by around a third and as a result, some managers are looking at corporate bonds to boost their income.
However, the outlook for the UK Equity Income sector is not just a negative one. The most obvious point is that investors can now invest in these funds at a much lower level than last year while the exposure to 'bad' banks will also have been reduced in many cases. In addition, as already mentioned equity income managers will often focus on large cap companies that have stronger balance sheets and these can often be defensive in nature and, therefore, maybe more suited to times of recession.
Also, with the current bank savings rates at very low levels, equity income funds offer potentially much greater income yields, even if they do fall somewhat from current levels, although it should of course be noted that the risk to capital is also much higher, particularly in the present volatile market conditions.
The historic attraction of UK equity income funds has been that they can succeed in both bull and bear markets, delivering capital growth in the good times and protection in the bad, as there is often a focus on strong companies that provide regular cash-flows in order to maintain dividends. Although they have found the current bear market difficult, there are still funds such as the Newton Higher Income Fund that have continued to grow its dividend in returns for more than a decade regardless of the economic conditions.
It is difficult to overstate the long-term value of an above average and rising level of distributions within a portfolio. There is much research available that can demonstrate how long-term returns can be greatly enhanced through the re-investment of dividends with this income proving ever more valuable the longer the time period used. Alternatively, for income-seekers, UK equity income funds can often provide an above average level of income with the prospect of long-term capital growth. Furthermore, these dividends often prove to be of the greatest use in times when capital returns are negative.
To promote 'long-term investment'
Switching 'hard and expensive'
Smaller funds still packing a punch
To drive progress