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Time to put your money back into equity income funds, experts say


Whatever happened to the UK equity income fund? Once a stalwart of most investors’ Isa and pension portfolios because of its attractive offering of income and capital return, the UK equity income fund is currently about as unpopular as a fox on a chicken farm.

Just look at the facts. The UK equity income investment sector has clocked up 14 consecutive months of outflows as investors have looked for better value elsewhere.

In total, investors have pulled almost £5billion out of these funds over this period – £18billion since 2016. But by leaving, they have missed out on a bull run.

The UK equity income sector generated an average return of 27% in the 14-month period 

Laura Suter, head of personal finance at wealth platform AJ Bell, points out that the UK equity income sector generated an average return of 27 per cent in the 14-month period.

This compares to the 18 per cent gain registered by the FTSE 100 – the index comprising the largest companies listed on the London Stock Exchange.

Jason Hollands, managing director at wealth platform Tilney, describes the equity income fund sell-off as ‘quite shocking,’ adding that the funds were ‘historically a cornerstone’ of private portfolios.

He adds: ‘I don’t think investors should give up on UK income funds – far from it,’ he says, pointing out that, over the long run, most of the gains in UK equities tend to be down to dividends.

Ian Lance, co-manager of income-focused investment trust Temple Bar, says that investors who have sold out of the sector could regret it. ‘Many could come to rue their decision to give up on the equity income sector at exactly the wrong time,’ he warns.

Whether you believe it is time to get back into the equity income sector depends on your view of the health of UK Plc and its ability to restore a healthy stream of dividends.

Yet many experts believe that investors could benefit from picking up a UK equity income fund or two at the current price.

Protect your dividends from the new tax rate 

The Government’s decision to add 1.25 percentage points on to the dividend tax rate has implications for many investors who are seeking income through dividends.

While everyone is allowed to receive £2,000 of dividends a year tax free, after that the dividend tax rate is 7.5 per cent for basic rate taxpayers and 32.5 per cent for higher-rate taxpayers.

This will rise to 8.75 per cent and 33.75 per cent respectively in April next year. It means basic rate taxpayers will pay £263 in tax on £5,000 of dividend income – up from £225 – while higher rate taxpayers will pay £1,013, up from £875.

This means that those who receive dividends through income friendly funds should be locking as much of their investment away into tax-free wrappers as possible. Dividends paid when investments are held in either pensions or Isas are free from dividend tax and do not count towards the £2,000 annual allowance.

Currently, everyone can pay £40,000 into a pension per tax year – and £20,000 into an Isa. A ‘bed and Isa’ strategy, where you sell investments and then buy them back in a tax wrapper, can help you mitigate dividend taxes, while married couples should ensure they use both partners’ Isa and pension allowances to protect dividend payments from the taxman.

The rise and fall of equity income

UK equity income funds would seem to offer the Holy Grail in the current low-interest rate environment – regular income from shares that should rise in value over time. So what has gone wrong to prompt huge investor outflows?

Dzmitry Lipski, of investment platform Interactive Investor, suggests that part of the recent sell-off is due to the UK’s ‘dividend drought,’ where companies cut their payouts to shareholders due to Covid-19.

‘This was very much a pandemic theme,’ he says.

But there were other issues at play as well. The high-profile failure of Neil Woodford’s giant equity income fund, which is yet to be wound up, has massively diminished confidence in the sector.

Then, there was Brexit uncertainty, which depressed UK shares, and a trend towards ‘growth’ stocks during the pandemic – as tech company valuations took off at the expense of duller dividend-paying stalwarts.

Many experts believe the sector’s unfavourable reputation is unfair and the funds undervalued.

‘You might expect there would be greater investor demand for this sector which provides investors with an annual income in the region of 3.6 per cent yield,’ says Annabel Brodie-Smith, communications director of trade body the Association of Investment Companies.

Darius McDermott, managing director at fund expert Chelsea Financial, also confesses he doesn’t entirely understand the equity income fund exodus.

‘I’m not sure why investors seem to be shunning this sector,’ he says. ‘It could be because the UK stock market is just so unloved at the moment – and people are perhaps diversifying more these days into global or regional equity income funds.’

He adds: ‘It’s still an obvious investment choice as far as I am concerned. The UK is the most mature dividend market in the world and has one of the highest dividend levels even after the pandemic. As fund scrutineers, we still believe in the sector.’

Why dividends are now set to rebound  

The dividend drought in the UK now seems to have ended. Simon Gergel, who runs income investment trust Merchants, says that income in the investment universe was ‘savagely hit in 2020, with sharper and deeper cuts in dividends than we have seen in any crisis previously.’

But he says the worst is over. ‘That hit is being matched by an equally sharp recovery, with 2021 dividends expected to be not too far from their 2019 peak across the market.’ The UK stock market is now offering investors an income equivalent to three per cent.

Job Curtis, who runs investment trust City of London, says this is ‘significantly more than rock bottom bank deposit rates or government bond yields.’ 

Curtis is now bullish on the prospects for dividend-paying UK stocks, believing that the stock market will continue to rebound, with takeover bids from private equity firms and overseas companies indicating that there is value to be had.

Wide variety of funds… and performance 

Once you’ve decided on the investment virtues of a UK equity income fund, there’s a bewildering number of funds – more than 80 – to choose from.

The range of performance in the sector is wide.

The top performer over three years, a multi-cap income fund from Gresham House, has returned 38.6 per cent and yields 3.4 per cent, while at the bottom of the table, funds such as UBS Equity Income have generated losses.

Interactive’s Lipski recommends Royal London UK Equity Income, which will be run by current deputy Richard Marwood when lead fund manager Martin Cholwill retires later this year.

The fund’s largest sector holdings are in industrials, financials and consumer discretionary stocks. It yields more than three per cent and has generated three-year returns in excess of 14 per cent.

He also recommends Diverse Income Trust, which can invest in UK companies of any size, but has a bias towards medium-sized and small companies.

The trust currently yields 3.1 per cent and its shares have advanced in price by 30.4 per cent over the past three years.

Chelsea’s McDermott recommends Threadneedle UK Equity Income and Jupiter Income.

He says the Threadneedle fund, managed by Richard Colwell, has a ‘pragmatic approach targeting both capital growth and income, rather than prioritising the latter like some income funds’.

It has made profits of 12.7 per cent over the past three years. The fund currently has big positions in AstraZeneca (7.8 per cent); Electrocomponents (6.8 per cent); Rentokil (5.1 per cent); and GlaxoSmithKline (5 per cent).

It also has five per cent invested in supermarket company Morrisons, currently subject to a bidding war.

Jupiter Income is down 2 per cent over three years, but over the past year, it has delivered a return of 30 per cent.

Ryan Hughes, at fund platform AJ Bell, likes Temple Bar Investment Trust. Its big holdings include Royal Mail, ITV and Anglo American.

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