by Dewi John.
U.K. Equity Income was a favourite category for investors, seldom out of the three-top Investment Association sectors. It was solid, dependable, not too racy—the family estate of the equity world. It was something that Dudley Moore’s honest ad man in the 1990 film Crazy People would have described as ‘boxy but good’.
Earlier in September, we took a look at how the various U.K. fund sectors had fared over the course of the COVID-19 pandemic. U.K. Equity Income has seen notable outflows, which is perhaps counterintuitive when you consider its reputation as a defensive equity play. Given this, and the huge popularity the sector has experienced over the years, it’s worth taking a closer look as to why.
There’s been a lot of focus recently on how COVID-19 has forced companies to cut their dividends, with a slew of such announcements in the first half of the year. Dividend stalwarts Royal Dutch Shell and BP cut payouts by more than half, so amplifying further the miseries of energy sector investors. In March, as the country went into lockdown, the Bank of England ordered banks and insurers to suspend dividends and share buybacks for the year. The U.S. Federal Reserve and European Central Bank made similar announcements in June and July, respectively.
However, while U.K. dividend payments have been more adversely affected than their global peers, the country has one of the higher dividends historically, and has actually extended its global lead over the past decade (see chart 1).
Source: Refinitiv Datastream
What’s more, some U.K. dividends are already being restored, including BAE Systems, Smurfit Kappa, and Land Securities. Still, given that COVID-19 restrictions are spiking once more, this may well be a temporary reprieve, and it would be prudent to expect more cuts as companies defend their balance sheets.
But the sector’s problem retaining assets goes back well before the miseries inflicted on it by COVID-19. With a couple of modest exceptions, U.K. Equity Income flows have been persistently negative since the first quarter of 2016 (see chart 2).
Source: Refinitiv Lipper
It’s been a long, slow fall from grace for U.K. Equity Income. On the face of it, the reasons aren’t obvious. Indeed, important elements of economic policy could favour the sector.
Extraordinary monetary policy such as quantitative easing depressed bond yields, compelling investors to look elsewhere. One alternative is share dividends. This is no accident—QE was supposed to move investors up the risk curve, and it has certainly done that. To cater to this demand, companies have found that the low cost of capital in the aftermath of the financial crisis has made borrowing to fund share buybacks and dividends an attractive strategy.
As a result, whereas bond yields have declined significantly, the FTSE’s dividends are in line with where they were 10 years ago. Using the iShares Core £ Corp Bond UCITS ETF as a proxy, corporate bonds are offering a yield of just 2.2%—beating inflation, but not much to get excited about. In contrast, investors get an average 3.9% dividend yield on the FTSE 100.
Ultimately, however, while investors will compare yields, they still won’t see equity income and corporate bond sectors as a like-for-like trade off. While professional investors may be able to tweak their portfolios to exchange some bond income for equity, the wiggle room is likely not much.
For those looking for a steady income, the sector should be a good bet on these terms. So why have investors increasingly shunned the sector?
Certainly, the structural problems with how companies raise the cash to pay their dividends have mounted over the past decade. There’s also the issue that the bulk of dividend payments are concentrated on relatively few stocks—something that many investors are becoming increasingly mindful of, whether it being because of the danger of crowded trades, or dependencies on the questionable largesse of companies such as BP.
Another factor is that of style. Value has been out of it over the past decade, and the stocks favoured by equity income funds tend to have more of a value bias. This has been reflected in the parting of ways in performance terms mid-decade between U.K. All Companies and Equity Income, a trend that has been reflected in flows.
The major driver, however, seems to not be with grand sweeping macro moves, but at the fund level. From 2017 onwards, the sector was hit by the implosion of its giant, the Woodford Equity Income fund managed by Neil Woodford. The fund was eventually suspended in June 2019, following a run of redemptions. This aligns with negative sector flows over the same period. When assets exit funds of that magnitude, they won’t necessarily relocate within the same sector, given that the prime attraction for the investor was likely an individual name.
The sector’s two most punishing months this year were January and June. The reasons, again, were to be found at a very granular level. One fund accounted for all those losses, plus a little on top, in the former month, and almost a third of them in the latter. From January to July, this one fund accounted for about three-quarters of the sector’s lost assets.
On the other hand, the sector’s second-largest incumbent has seen inflows of almost £500m year to date. The portfolios look very different, with the latter considerably lighter on the financial and energy exposure that has punished investors over the year. Its overweight to consumer staples seems to have served it well at a time when bare supermarket shelves have testified to their importance.
How well U.K. dividends fare as the economic effects of COVID continue to bite remains to be seen, but the reasons that the sector has seen outflows stretch back to a time when we thought the disease was just a misspelled member of the crow family.
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