UK Equity Income – The Best of All Worlds?

by | Apr 30, 2015

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Dividend yields in the UK Equity sector can exceed 3.5% per annum, but there is further upside for investors who can accept more risky. Nick Sudbury reports.

UK Equity Income funds have been the best-selling sector of the market for a staggering eight months in a row. The Woodford effect has undoubtedly had a lot to do with it, although the strong demand also reflects the increasingly desperate search for yield.

In spite of its enduring popularity, a number of high profile constituents have recently moved out of the sector including funds run by Invesco Perpetual, Henderson’s and St James’s Place. The reason for this unusual move was the unwillingness to comply with the high income requirement at the cost of compromising on the capital growth.

All the funds in the sector are required to invest at least 80% in UK equities and to achieve an historic yield on the distributable income in excess of 110% of the FTSE All-Share yield at the fund’s year end. The test is applied over rolling 3-year periods with the current income benchmark being around 3.6%.

There are about 60 funds in the sector that are paying out at least this amount, but the risk is that they are effectively being forced to invest in high yielding blue chips that have been bid up in value. This makes it more important than ever to assess the investment process and to satisfy yourself that the manager is up to the job.


The Midas touch

CF Woodford Equity Income

In its first 6 months Neil Woodford’s new UK Equity Income fund has attracted a staggering £4.7bn in AUM. This remarkable achievement is a testament to his success running a similar mandate at Invesco Perpetual and also reflects one of the highest profile marketing campaigns the investment world has ever seen.

Woodford’s Invesco Perpetual Income fund generated an annualised cumulative return of 14.3% over his 23-year tenure, which was a full 500 basis points more than the sector average. It will not be easy to replicate this sort of outstanding performance, but he has started well, with his new venture up more than 15% since launch compared to the 2% increase in its FTSE All-share benchmark.

The portfolio is massively tilted in favour of the Healthcare sector, with a 33% allocation comprising holdings such as AstraZeneca, GlaxoSmithKline and Roche. Its other main overweight position is in Industrials, where companies such as Capita and BAE Systems make up a 17% exposure, which is well in excess of the 10% representation in the benchmark. The main underweights are Oil & Gas, Financials, Consumer Services and Basic Materials.

It’s an interesting portfolio, because although the top 10 blue chips make up almost 50% of the fund there are plenty of smaller holdings to provide long-term capital growth. These include several biotech firms, the peer-to-peer investment trust, P2P Global Investments, and the active investment fund Crystal Amber. Other holdings such as Game Digital and Drax have struggled, but have been retained because the business case remains intact.

Woodford is very much his own man and not afraid to be different – which should ensure that the fund is relatively uncorrelated with the rest of the sector. As with his previous mandates, there is a big emphasis on capital preservation, and clients will also appreciate the fact that the new fund is targeting a competitive starting yield of 4% with quarterly distributions.

The CF Woodford Equity Income fund has attracted a massive amount of capital in a very short space of time, but it is up and running in impressive fashion. Woodford has shown himself to have a safe pair of hands and there is no reason to doubt that he will continue to deliver. It is difficult to see what could go wrong unless something was to seriously undermine the global healthcare sector.

Fund Facts

Name:                                                  CF Woodford Equity Income Fund

Type:                                                   UCITS (UK)

Sector:                                                UK Equity Income

Fund size:                                           £4.7bn

Launch Date:                                      June 2014

Yield:                                                  4%

Ongoing Charges:                               1%

Manager:                                             Woodford Investment Management

Website:                                             www.woodfordfunds.com


Hidden Gem

Evenlode Income fund

One of the best performing funds in the sector is the little known Evenlode Income, which is up 95% in the last 5 years. It is run by Wise Investment, a firm based in rural Oxfordshire, and has just £252m in AUM. Since it was launched in October 2009 the fund has achieved an annualised return of 13.8%, a full 500 basis points ahead of its FTSE All-Share benchmark.

Hugh Yarrow, the lead manager, who looks remarkably like Hugh Grant, looks for good quality companies that are asset-light. He aims to identify businesses with high returns on capital and strong free cash-flow that can generate sustainable real dividend growth. The portfolio bears very little resemblance to the index with holdings retained for the long-term.

At the end of January there were just 31 positions, with the top 10 accounting for 52.1% of the fund. These included the likes of Unilever, GlaxoSmithKline, Diageo, Sage Group and AstraZeneca. The largest sector allocation was the 34.6% weighting in Consumer Goods, followed by 15.7% in Healthcare and 10.9% in Media stocks. Almost three-quarters of the money is invested in blue chips, with the balance in mid-tier companies, although for most of the period since launch there has been a significant small cap exposure that started off around the 50% mark.

Yarrow is conscious of the fact that the higher valuations mean that future returns are likely to be lower than in the recent past. He believes that revenue growth is harder to come by, and that this makes it more difficult for companies to grow their dividends. That is why he looks for businesses with sustainable free cash flow, as these have a safety buffer to protect them against a slowdown in the economy or any company or industry specific setback.

The fund offers a decent 3.58% yield with quarterly distributions, and despite its relatively small size it has a competitive ongoing charges figure of 0.99% for the clean share class. It is an interesting offering and Yarrow’s willingness to move between large caps and small caps differentiates it from many of its peers. Would make a decent diversifier to one of the larger funds in the sector.

Fund Facts

Name:                                                  Evenlode Income

Type:                                                   OEIC

Sector:                                                UK Equity Income

Fund size:                                           £252m

Launch Date:                                      October 2009

Yield:                                                  3.58%

Ongoing Charges:                               0.99%

Manager:                                             Wise Investments

Website:                                             www.evenlodeinvestment.com


Ticks All the Right Boxes

Trojan Income

Most of those investing in the sector typically want to be able to rely on a steadily increasing income stream with long-term capital growth and as little volatility as possible. Clients that fit into this profile are likely to find that Trojan Income from Troy Asset Management ticks all the right boxes.

The £2.15bn Trojan Income fund was launched in September 2004 and by the end of January had achieved a cumulative return of 164.6%, which was comfortably ahead of both the sector average and the FTSE All-Share at 117.9% and 127.3% respectively. Its annualised volatility of 9.4% was well below the 13% plus recorded by both benchmarks, and the maximum drawdown a full 20% less. Calculations by FE Analytics suggest that it has one of the best risk-adjusted performance records in the sector.

Trojan Income has successfully raised its dividend every year since it was launched with the annual payments going from just over 4 pence per share in 2005 to around 6.5 pence in 2014. This represents an average annual increase of 5.1%, which is particularly impressive given that it straddles the period encompassing the 2008/09 financial crisis. The fund now has an attractive net yield of 3.9%, although the distributions are only made twice a year rather than quarterly like some of its peer group.

Francis Brooke, the manager, invests in solid businesses with good cash flow and sustainable yields. This is a fairly diversified portfolio with 42 holdings, and with the largest, Unilever, only making up 4.1%. The rest of the top 10 include the likes of Imperial Tobacco, GlaxoSmithKline, BP and HSBC, and together they represent just under a third of the fund.

Its largest sector allocation is the 22% exposure to Financials, followed by 21% in Consumer Goods, and 14% in Utilities. There is also a 9% holding in cash.

This solid, no nonsense approach, has generated consistent, market beating returns, at a much lower level of volatility than the benchmark. The last 12 months were particularly good, with the 14% gain elevating it into third place in the sector, but it will not always top the table like this. The fund would make an ideal core portfolio holding for income seeking clients with a reasonable level of risk aversion.

Fund Facts

Name:                                                 Trojan Income

Type:                                                   UCITS

Sector:                                                UK Equity Income

Fund size:                                           £2.15bn

Launch Date:                                      September 2004

Yield:                                                  3.9%

Ongoing Charges:                               1.02%

Manager:                                             Troy Asset Management

Website:                                             www.taml.co.uk


 Keeping Up Appearances

 Schroder Income Maximiser

Clients who are willing to give up some capital growth in return for additional yield may be interested in an innovative product like the Schroder Income Maximiser fund. This consists of two elements. There is a value-based UK equity portfolio that provides a yield of 3.5% with the potential for long-term capital growth and an option overlay strategy to take the yield up to the target level of 7%.

The fund was launched in November 2005 and has attracted a creditable £1.2bn in AUM. Over the intervening 9 years the accumulation units are up around 100%, which is well in excess of the FTSE All-Share, but the income units are broadly unchanged. These have paid out the target yield of 7% each year with the dividends distributed on a quarterly basis.

Thomas See, the manager, has put together a predominantly large cap portfolio of 46 holdings of which the 10 most significant make up 45.6% of the fund. These include companies such as GlaxoSmithKline, Friends Life, Vodafone and BP. The key sector exposures are 29.8% Financials, 20% Consumer Services and 17.4% Healthcare.

In order to increase the yield he is allowed to sell short dated call options in the underlying securities. This covered call strategy generates upfront premiums from the sale of the options, but limits the potential capital gains. He can also sell out-of-the-money put options on securities or indices not held by the fund, which is another way of boosting the income.

It is interesting to note that although the way derivatives are used should reduce the risk, the fund has in fact recorded an annualised volatility of 10.5%, which is slightly above the sector average. Less surprising is the higher than usual ongoing charges of 1.66%. This is most likely because of the extra cost of buying and selling the options.

The manager invests in robust businesses with the prospect of sustainable dividend growth. His aim is to sell just enough capital growth across the portfolio to meet the high income requirement, while still benefitting from the first part of any share price appreciation. It is a tough balancing act, but income investors should be pretty pleased with the performance to date as it is hard to think of any other sustainable way of earning a 7% yield.

Fund Facts

Name:                                                  Schroder Income Maximiser

Type:                                                   Unit Trust

Sector:                                                UK Equity Income

Fund size:                                           £1.2bn

Launch Date:                                      November 2005

Yield:                                                  6.98%

Ongoing Charges:                               1.66%

Manager:                                             Schroder Unit Trusts Ltd

Website:                                             www.schroders.com

 

 

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