Do you need to be looking into alternatives to Equity Income Funds?

Article updated: 1 November 2017 at 10:00am Author: Pascal Dowling

With Equity income funds and stocks becoming increasingly expensive, Kepler Trust Intelligence’s Pascal Dowling has been looking at various, alternative routes to income.

Equity income funds and stocks have become increasingly expensive as investors, starved of income from traditional sources like bonds and deposit accounts, and liberated pensioners searching for an alternative to crummy old annuities, have turned to equity income to make up the shortfall.

Moreover – because companies know that the higher the dividend they offer, the more support their share price will get – companies are paying out as much as possible and leaving themselves with little in terms of dividend cover for a rainy day, making them increasingly vulnerable.

To add yet another layer of complexity, because certain types of company tend to pay dividends while others don’t – concentration amongst the funds that invest in these increasingly fragile equity income stocks has become a significant issue.

According to the latest Capita Dividend Monitor, published in July, the top five dividend paying companies in the FTSE All-Share accounted for 34% of all the dividends paid in the entire index. When we examined the UK equity income sector earlier this year we found that out of the 22 direct equity trusts in the sector, 81% of them held BP – which at the time had dividend cover (profits as a multiple of underlying earnings) of 0.43 times. That means the company is only generating enough profit to pay or ‘cover’ half a year’s dividend payments.

The issue here is that should profits fall, they would not have to fall by a long way before the dividend would need to be cut. When this happens it’s called a write-down. The impact of concentration risk we have seen in glowing technicolour in the last few weeks as it emerged that Neil Woodford and his successor at Invesco, Mark Barnett, had been affected by write-down at Provident Financial.

With this in mind we have been looking at various alternative routes to income, which are not correlated to the fortunes of this sector.

Correlation shows the relationship between a fund's performance and that of the reference index. If something has a correlation of 1 that means it does exactly what the index does. The lower the correlation, the less sensitive to the index a fund is. A fund with a correlation of 0.5, for example, would (in theory) lose half as much as the index when the index lost ground, and gain half as much when it was in the ascendant.

We have recently been working on research looking at the UK commercial Property sector as an alternative to traditional equity income, where we see comparable yields, backed up by long lease lengths and low correlation to the FTSE at a time when the index appears to be defying gravity.

UK Commercial Property Trust

In this research we highlight UK Commercial Property Trust, managed by Will Fulton at Standard Life, The trust offers a yield of 4.14%, well ahead of the average yield in the equity income sector, and has low gearing and significant exposure to more defensive industrial sites – with almost no exposure to Brexit sensitive central London. Over three years the trust has a correlation of 0.56 to the FTSE 100, and 0.64 to the FTSE All-Share.

Standard Life Property Income

The trust’s sister fund – Standard Life Property Income – also offers a strong yield (5.68%), low gearing and high exposure to industrials which make up nearly half the portfolio, but trades on a significant premium to NAV. This trust has a correlation of 0.47 to the FTSE 100 and 0.55 to the All-Share over three years.

Another trend we have been following is the growing willingness of boards to take advantage of the investment trust structure, which allows a trust to draw some of the income it pays from capital, and here again we see a viable route to diversification away dependence on traditional equity income. The AIC has begun to track this trend and revealed in August that 21 trusts were now paying, or plan to pay, income from capital.

There has been much discussion over whether this is a good thing or a bad thing, but in our view it is fairly clear cut; as long as the trust makes it clear and the investor understands the implications – namely that by converting some of it to income this will eat into some of the trust’s potential capital growth – there is no reason why trusts shouldn’t use this flexibility to satisfy the need for income by adopting what is effectively a ‘total return’ approach.

Among these trusts, International Biotechnology Trust managed by Carl Harald Janson, is one which we have examined recently. The trust has generated annualised returns of 21.9% under his stewardship, and now offers a yield of 4% - all of which is drawn from capital. Its fortunes, given its heavy US focus and specialised theme, have very little relationship with those of the FTSE.

Invesco Perpetual UK Smaller Companies, whilst still a UK focused fund, is another ‘left-field’ choice for income offering diversification away from the usual, highly concentrated, suspects. A UK smaller companies fund, it announced in 2015 plans to pay an income supported by the capital account, and it now offers a yield of 3.4% - just behind the average yield on offer from trusts in the UK Equity Income sector.

Paying income from capital is not for everyone, and investors must approach it with their eyes open to the implications, but we think that – given the increasingly precarious nature of traditional income strategies – it is a welcome innovation.

These views are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees.

Pascal Dowling portrait photo
Pascal Dowling

Marketing & Communications Director, Kepler Partners

Pascal oversees marketing and PR activity at Kepler Partners and runs Investment Trust Intelligence, an online research hub for professional and private investors. His background is in financial journalism and he used to manage retail fund research website, FE Trustnet.

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