Written by Laith Khalaf, head of investment analysis at AJ Bell
Cash ISAs are definitely back on the menu this tax year, after a flurry of interest rate hikes. There’s absolutely no doubt that cash is a much more alluring asset today than it has been in the last decade, but consumers should think twice before throwing their longer term strategic savings plans out of the window as a result of improved interest rates.
Holding cash is perfect for short term needs, but in the long run, returns are likely to be higher from the stock market, albeit with greater volatility along the way. The joy of cash lies in its liquidity, but investors should consider combining this with riskier, return-seeking assets. That way their savings provide them with enough ready cash in the immediate term, while at the same time growing a nest egg for the more distant future.
In particular, investors shouldn’t ignore the potential of UK equity income funds. Almost all (96%) of UK Equity Income funds are yielding more than the 3.2% offered by the best easy access ISA, and almost half of all UK Equity Income funds (47%) are yielding more than the 4.25% offered by the best fixed rate ISA (ISA rates as compiled by Moneyfacts, equity income yield data from Morningstar).
Of course, the capital on an equity income fund is variable, as is the yield, though over time that actually means there is scope for the income and capital to increase. In any given year, dividends can be cut back drastically, and share prices can fall, as witnessed during the pandemic. But over the long term both share prices and dividends tend to rise, providing a double-barrelled boost to long run total returns. With dividends reinvested, the average UK Equity Income fund has returned 5.2% per annum over the last ten years.
That’s significantly more than cash, even if we compare it to current rates. The chart below shows the value of £10,000 invested in the average UK equity income fund over the last ten years, compared to the actual return from the average Cash ISA over this period. In both cases dividends and interest are rolled up. Also provided are comparisons assuming a Cash ISA paying 3% and 4% over the whole period, to give an idea of how the top current Cash ISA rates might compare. A comparison based on the current average variable Cash ISA, which pays a rate of 1.8% per annum, is included too. The volatility of a UK Equity Income fund compared to cash is clear to see, as is the higher long run return.
Of course, over a ten year period, Cash ISA returns don’t stay static. Those opting for an easy access ISA can find their rate changed at the drop of the hat, for better or worse. Those buying a fixed rate Cash ISA can be assured of their return for whatever term they have selected, but after that they are once again subject to market interest rates. The last year or so has seen Cash ISA rates cranking up from record lows, but recent signals suggest the interest rate hiking cycle is coming to a close. Markets are now expecting perhaps one more rise in the UK base rate, after which rates are expected to plateau, and then fall.
Markets don’t always get it right when it comes to interest rate predictions, but risks to the forecast lie in both directions. Cash ISA savers therefore need to accept that current rates may not be maintained indefinitely. Savers should also make sure they shop around for the best Cash ISA rate. While the best variable Cash ISA is paying 3.2% per annum, according to Moneyfacts, the average Cash ISA is paying just 1.8%, according to the Bank of England.
As a general rule of thumb, consumers should keep three to six months of their expenditure in cash to cover any unforeseen costs or circumstances. They may also want to add in any other items of expenditure that are looming large. For money that they won’t need for 5 to 10 years or more, they should consider putting that to work in the market in search of higher returns, provided they are willing to ride the ups and downs along the way.
The UK Equity Income fund sector was once a favourite of retail investors, but has suffered years of outflows, making it a contrarian investment call. It’s not been a vintage decade for the performance of UK Equity Income funds, as a lot of the companies that pay healthy dividends tend to be economically sensitive value stocks, which have been out of favour until the last eighteen months. But the tide has turned somewhat of late, thanks in large part to the return of inflation and higher interest rates. The result is that over the last three years the UK Equity Income sector is now ahead of the much more popular Global sector, posting a total return of 57% compared to 51% respectively.
UK Equity Income funds can be used by both income seekers and those looking to grow their wealth over the long term, as dividends can be re-invested along the way. It can also be used by pension savers as a segway into retirement, reinvesting dividends until the need for income arises, at which point the dividend taps can be turned on.”
UK Equity Income funds to consider
Man GLG UK Income – fund manager Henry Dixon invests across the market cap spectrum looking for unfashionable companies which he thinks the market has undervalued, and which are paying a sustainable dividend to investors.
Montanaro UK Income – an income fund with a difference, Montanaro UK Income looks for dividend paying opportunities amongst the UK’s small and medium-sized companies, which adds to its risk, but also provides greater growth potential.
Evenlode Income – this fund is a concentrated portfolio of quality companies that have robust balance sheets, high profitability, and which provide a reasonable portfolio yield when combined.