Call for cap on largest income funds

The largest equity income funds should be capped to protect investors from concentration risk, according to RWC Partners’ Ian Lance.

Speaking at the Investment Week Global Income Focus 2011 conference, the co-manager of the RWC income portfolios said yield requirements are forcing the largest funds into a narrow selection of stocks, putting them at risk of blow-outs similar to BP’s recent sell-off.

“The equity income sector is £54bn in size and over half the assets are managed by four funds,” he said.

“Yield restrictions force exposure to big dividend payers and creates commonality between the funds.”

The figures make worrying reading, especially with regards to the FTSE All Share index. To be included in the IMA UK Equity Income sector, funds must hold 80% in UK equities and yield 110% of the FTSE All Share’s income.

But this index is very restrictive, Lance said, as just three sectors – energy, materials and financials – account for 50%. Worse, only seven stocks pay out over 50% of the available income.

The size of some funds – in particular Invesco Perpetual’s two behemoth income funds – reduces their investible universes further, and Lance said it means managers are taking unnecessarily large positions in single stocks.

Lance’s solution is to keep funds smaller and allow alternative ways of generating income.

RWC will cap its £70m Enhanced Income fund when it reaches £500m AUM, while the managers will also add income by writing call options on the fund’s holdings.
Lance claimed this last strategy will generate 4% in income for the fund per annum, allowing it to pay out 7% to investors.

Nonetheless, some yield must be found outside of derivatives and that can mean considering non-conventional options.

Lance dismissed bonds as more risky than is popularly thought, pointing out a buyer of UK bonds in 1946 lost 73% of value in real terms by 1974 and did not break even until 1993 (according to data from Credit Suisse).

Along with commodities, bonds are also at peak prices, again an unattractive characteristic.

One area where Lance sees value is among blue chips, particularly overseas. This sector has become cheaper recently as investors look towards emerging markets and smaller companies for growth.

His co-manager Nick Purves gave the example of Johnson & Johnson -which has grown its earnings per share by 186% since 2000 and increased dividends per share by 211%. Despite this, its P/E ratio is at its lowest level for 20 years.