by Dewi John.
Once upon a time, UK equity income funds were a—often the—cornerstone of a domestic investor’s portfolio. But times and fashions change. UK equity funds—and equity income in particular—have suffered years of outflows. In 2021 alone, UK investors dumped £8.2bn worth of equity income funds. With a couple of modest exceptions, the sector’s flows have been persistently negative since the first quarter of 2016.
In part, this has been a performance issue, with the British market lagging developed market peers such as the US for years. Another, perhaps more persistent, factor has been investors rebalancing their portfolios away from a strong domestic bias. That’s likely to be an ongoing phenomenon, particularly from large institutional investors.
Performance has turned since November 2020, however, rebounding after the suspending of many dividends earlier that year as a result of COVID. The yield on the FTSE 100 in February was 3.8%, and sector return for the 12 months to the end of February was 12.8%, as compared to 7.1% for IA Global—still the top seller.
There’s reason to believe that this turnaround may persist. A significant contributor to this is the return of value (as opposed to growth) as a style. For most of this century, we’ve lived in a world of accommodative monetary policy and low rates—historically low since the global financial crisis. That favours growth stocks such as technology, as it increases the value of future cash flows—expected growth—relative to current ones (dividends). Higher rates throw this into reverse. The dividend bird in the hand is worth two in the bush. Especially if that bush exists only in the metaverse.
Dividends have been an historically important part of UK equity market returns, although that’s been eclipsed with the domination of growth, as we noted back in October 2020, when the average yield on the 10 funds that had performed best year to date was 3.6%, below that of the FTSE 100. There was then a clear inverse relationship between level of dividend and performance with the sector’s funds, both year-to-date and over three years. So, in order to get return, managers were sacrificing a portion of income. The top 10 over three years still have a lower dividend than the FTSE 100, although over 12 months, the average is 3.92%, nudging ahead of the index. There’s therefore a chance the new normal will be a reversion to the old normal.
If we are seeing the retreat of globalisation and the consequent shortening of supply chains—in that’s still a pretty big ‘if’—then the de facto importing of deflation we’ve experienced, arguably already stretched, looks even more questionable.
Inflation expectations have certainly shifted, and fund management companies seem keen to talk about UK equity income, even if current flows show investors are yet to be convinced.
The leading fund over three years is Allianz UK Listed Equity Income. In January, its two largest holdings were tobacco companies, totalling more than 8% of the portfolio, and it had a 12.6% exposure to oil and gas. Conversely, ASI UK Income Equity, which led the field over three years to August 2020 had 3.2% in oil & gas back then and 4.9% this February. It has, though, underperformed over three and 12 months. This illustrates that matching strong sustainable dividend income to ESG objectives is something of a challenge, and UK Equity Income is certainly a sector that runs light on ESG funds.
Given the style rotation we’ve seen over three years, you get a better idea of which fund has ridden the return to value most effectively by looking at the three- and 12-month figures for the sector—which you can’t see from the table. And here there’s something of a surprise, because the leading fund in both instances is the Vanguard FTSE UK Equity Income Index fund, which has returned 11% and 24.6%, respectively. That may not be the case for long, however, as active managers adapt themselves to take advantage of the new conditions in a way that a tracker such as the Vanguard fund cannot.
What’s more, the $64 million (and the rest) question is whether the conditions that have boosted the sector will persist.
Table 1: Top-Performing UK Equity Income Funds Over Three Years (with a minimum five-year history)
All data as of February 28, 2022; Calculations in GBP
Source: Refinitiv Lipper
This article was originally published in Investment Week.
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