Adapting to equity income change

RWC’s Ian Lance highlights the benefits and challenges of a UK income strategy.

The benefits of an income-based investment strategy are widely understood and have been explored in a myriad of academic papers such as the annual research from Professors Dimson, Marsh and Staunton, the Barclays Gilt Equity Study or various papers from Rob Arnott.

The advantages of such a strategy can be summarised as follows:

• Income investing as a strategy produces excellent long-run returns
• Historically, the majority of equity returns has come from dividend income not growth
• In the past, returns from dividends have been in excess of those from inflation, change in valuation and growth in dividends combined
• The key to building long-term wealth is to reinvest dividend income
• Historically, returns from the highest yielding part of the equity market have exceeded those of the relevant index in all major geographies
• The strategy also has the capacity to provide significant capital appreciation
• It should be a more stable, predictable source of total return

Given these attributes, it is no surprise that the UK equity income sector has been successful over the long term and has rewarded investors who have stuck with it.

However, there are now significant challenges facing UK income investors:

A victim of its own success

The sector has, to some degree, become a victim of its own success and, having attracted considerable flows, is now extremely large. We estimate there is in excess of £54bn invested in the UK equity income sector but more importantly, it is dominated by a small number of very large funds with more than half of the sector’s assets being managed by just four firms.

The focus on the UK creates issues as the FTSE All Share index is now quite heavily skewed and thus, restrictive. Specifically, energy and materials now represent a third of the index despite many of the sector’s constituents deriving most of their income from outside of the UK. With the addition of financials, these three sectors represent more than 50% of the index.

The situation is even worse for income fund managers who face the problem that a mere seven stocks pay out more than 50% of income available.

Finally, managers in the sector are further restricted by IMA sector limitations which stipulate that funds must be 80% invested in UK equities and must yield 110% of the FTSE All Share index.

This creates a number of problems for investors within the sector, particularly those running the larger funds.