Investment industry

Choosing the right income funds to help meet client goals

Guest authors

Equity income funds have had a tough three years, but the right funds can play an important role in helping to meet clients’ goals, especially in retirement. We asked Robin Geffen, Head of Liontrust’s Global Equity Team, about the performance features of equity income funds and the outlook for them in 2020.

Portait of Robin Geffen

Robin Geffen, Head of the Liontrust Global Equity Team

Choosing the right income funds to help meet client goals

There’s no doubt that it’s been a challenging three years for most equity income funds. But these funds can play an important role in helping to meet clients’ goals. So what’s ahead for this much needed approach, and what should advisers look for when choosing an equity income fund?

We posed these questions and more to Robin Geffen, Head of Liontrust’s Global Equity Team. As we hear, choosing the right income fund is about more than attractive yield; it’s also about prioritising future income growth without sacrificing capital.

Why has it been a tough few years for equity income funds?

UK equity income funds have, in general, endured a difficult time over the past three years. Very few have been able to outperform the FTSE® All-Share Index. Clearly, certain top-down forces such as Brexit have created a more challenging backdrop. However, we would argue the trend within the market to chase yield has been the main driver.

Many popularly held UK income stocks have a high yield because their share prices have fallen considerably. This is largely because there’s uncertainty whether those companies will be able to grow their dividends given slowing earnings.

This means funds can appear attractive because they have a high yield – but this may be achieved by risking both investors’ future income and capital growth. Given that a high proportion of UK income funds’ yield is generated by companies with low dividend cover, we believe it’s vital advisers focus on funds that don’t just aim to deliver an attractive yield but are prioritising future income growth without sacrificing capital. Dividend cover illustrates the amount of a company’s earnings paid out in dividends to shareholders. Dividend cover of less than one suggests the company is either using last year’s profits or debt to pay its dividend, both of which are unsustainable.

How do equity income funds deal with market volatility?

Historically, during more challenging market conditions, equity income funds have tended to outperform growth funds, such as in 2008, 2011 and 2018. In simple terms, this is because equity income funds invest in companies that pay dividends to shareholders, and there are defensive characteristics associated with those types of stocks. For example, a management team being careful about allocating company money.

However, for investors, the key reason is that equity income funds offer a more evenly weighted total return, comprising both capital growth and income. Growth funds’ returns, by nature, are almost entirely driven by capital growth alone, making them more susceptible to periods of market underperformance.

Although equity income funds aren’t immune from market downturns, the income they generate from the dividends they receive can help to offset these. Investors can then either choose to receive this income, or reinvest those dividends and benefit from the power of compounding.

How can equity income funds help advisers to meet client goals?

Equity income funds can be highly effective for advisers to help meet client objectives. Because they can offer capital and income growth, they can be used in lower and higher risk portfolios.

Using equity income in a long-term, growth-orientated portfolio is a good example. It gives investors exposure to equity markets and, via accumulation share classes, means they can compound their overall return by reinvesting the dividends they receive.

How can equity income funds help support clients’ longer retirements?

Given demographic shifts, the need for income-producing investments is becoming ever-more important. People are generally living longer, so advisers have to work harder than ever to make sure their clients have enough savings to enjoy their well-earned retirement.

Unfortunately, this task is made considerably more difficult by the fact that previous go-to income-producing asset classes are offering record low levels of yield. This is where equity income funds can fill the void. A carefully managed portfolio of dividend-paying equities can offer clients not only an attractive level of income, but one that can grow over time.

They also offer clients the opportunity for capital growth. Of course, equity income is generally viewed as riskier than bonds or cash. However, we’d argue that too many investors equate (particularly short-term) volatility to risk rather than focusing on longer-term goals. For example, while shorter-term fluctuations in capital values are painful, not having enough savings, or supplementary income, to fund one’s retirement is considerably worse.

In choosing an equity income fund, what should advisers look out for?

Choosing the right equity income fund is no easy feat. Effectively, the perfect equity income fund would achieve three outcomes: an attractive yield, income growth and capital preservation/growth. However, we believe there has been far too great a focus in our industry on yield, while the latter two have been ignored.

A high yield is only attractive if it’s sustainable. The risk of yield not being sustainable is illustrated by many high-yielding UK stocks, such as Vodafone, having to cut their dividends due to poor operational performance. This reduces their shareholders’ income as well as their capital, as dividend cuts are usually followed a fall in the share price.

But how do you know if an equity income fund’s dividends are sustainable?

We believe the answer lies in making sure the underlying portfolio is balanced. Many funds concentrate their assets in just a small number of high-yielding stocks to produce their income and then in a larger number of lower-yielding stocks in an attempt to power capital growth. The net result is that the portfolio’s overall income is highly dependent on just a handful of companies.

Another focus should be on finding funds that prioritise companies with adequate levels of dividend cover: not only is high dividend cover a very good indicator of income sustainability but an imperative precursor to future dividend growth.

What are your views on the outlook for 2020 and how are you positioned to deal with this?

While Brexit uncertainty will continue to be a source of volatility, our concerns surrounding the UK primarily stem from more structural issues facing the economy. These include slowing and polarisation of productivity growth, with only a small proportion of UK firms able to keep up with global peers. Therefore, we’re likely to retain our international bias.

While we continue to find attractive UK-listed, dividend-paying stocks, we think “dodging bullets” will be just as important for equity income investors over the coming year. For example, many popular UK stocks offer threadbare levels of dividend cover (including the tobacco majors, telecoms and utilities). This means that unless their operational performance improves remarkably, which would take significant capital expenditure, they won’t be able to maintain their current dividend levels.

In summary, our outlook for 2020 can be described as cautiously optimistic and we’re confident in the underlying income and capital potential from the portfolio. Nevertheless, we believe taking an active approach to UK equity income will be vital, as in 2020, like in 2019, it will be just as important to avoid the losers as picking the winners.

The Standard Life platforms offer access to a wide range of mutual funds from different fund managers. As part of our topical market updates to advisers, we invite the views of investment experts from these fund managers. This content is not paid for. It’s purely a way to share a range of insights from across the industry.

The views expressed in this article are those of Liontrust, as at November 2019 – and not Standard Life Aberdeen. Standard Life Aberdeen accepts no responsibility for advice that may be formulated on the basis of this information.

Please remember that the value of your client’s investment can go down as well as up and may be worth less than was paid in.