Why high-yielding income funds got riskier
16th May 2016 14:54
Rules that govern one of Britain's most popular investment sectors are putting pressure on fund managers to hold "risky" shares, experts have warned.
Some fund managers have refused to play ball and have been shown the red card by the Investment Association (IA) for breaking the rules. Introduced six years ago, the rules require funds to yield 10% more than the FTSE All-Share index over a rolling three-year period.
Many, however, have fallen foul. In total 18 funds have been eliminated from the UK equity income sector, including some high-profile names: James Henderson, manager of the fund, and Mark Barnett, who oversees the and funds.
Last month they were joined by Carl Stick, manager of .
Smaller pool of high-yielding shares
A review of the sector's rules is now underway. There are three options on the table: scrap the rule altogether; keep the rule but require funds to produce more detailed income statistics for investors; or lower the yield target, so that funds are required simply to produce more income than the FTSE All-Share.
Below, we explain why so many funds are breaking the rules, and whether those that are toeing the yield line are handicapped.
Experts are concerned that fund managers are being pushed towards a shrinking pool of shares, because shares offering above-average yields are in short supply. Yield is calculated by dividing the annual dividend by the current share price.
At the start of the year analysis by French bank Société Générale found the number of shares that yield more than the market had hit its lowest level in 25 years. The bank based its findings on analysis of the FTSE 100, which generates the vast majority of dividends.
According to data firm Capita Asset Services, £14.2 billion was paid in dividends by UK-listed companies. Of this figure £12.5 billion was from constituents of the FTSE 100.
Around one in four shares in the FTSE 100 currently have a higher yield than the index average, which is around 4%.
The reason for the shortage is down to the fact that since the financial crisis, when interest rates were slashed to near zero, income-hungry savers have been pouring money into the stockmarket.
The hot money has been favouring high-quality businesses such as consumer goods firms and , which pay sustainable dividends. In turn, this has boosted their share prices, lowering their dividend yields.
Dividends far from guaranteed
But this is where the problem lies. The vast majority of the big dividends are being paid by banks, miners, oil firms and drug companies.
The trouble is that each sector is under the cosh, facing various headwinds. Dividends, therefore, are far from guaranteed. Yet, despite this, fund managers who want to stay in the sector have to invest in some of these high-yielding stocks, thereby increasing risk.
Stick says: "The current yield offered by the FTSE All-Share is distorted by the dividends paid by a number of mega-caps, yet we understand that many of these payouts are precarious.
"The market is distorted. If we were to use yield as our primary target, we would both put our own growth in distribution under some threat, and be taking on far too much risk."
Darius McDermott, managing director of broker Chelsea Financial Services, agrees that fund managers should not be forced to invest in these "risky" names, in order to just remain in the sector.
''Having a target is one thing, but I believe that managers shouldn't be forced to buy certain companies or sectors just to achieve a certain level of yield."
The dividend cover scores shown in the table highlight the fact that dividends for the majority of these big names look vulnerable on the basis of dividend cover. This is a measure that calculates the degree to which the dividend payment is exceeded by the company's reported profits.
has the highest dividend cover, two. , and , however, stand out like a sore thumb, scoring below one.
A score of two is considered healthy, while those with a figure of one or below are viewed as risky because the business is likely to be paying out more in dividends than it earns.
The alternative - for those fund managers who think these high-yielding stocks are unsafe - is to leave the sector.
Success stories
(5.2% yield) and (4.2%) have gone for safe and growing dividends.
Both funds have performed strongly over the past five years to the end of April, returning 97% and 84% respectively, putting the funds in first and second place in the sector. The sector average return is 45%, according to fund analyst FE Trustnet.
Both portfolios specialise in buying smaller businesses, found outside the FTSE 100, that are capable of growing their dividends for years to come. Both funds have evidently been finding enough opportunities - shares with sustainable above-average dividend yields.
Other funds, however, are hitting the target by blending the two styles: buying some of the big dividend payers while also fishing for mid and small caps, some of which will have low yields capable of growth over the years.
One example is , which is yielding 4.5%. Stephen Bailey, the fund's co-manager, says he does not feel that his hands are tied in meeting the sector's yield requirement.
"It is true the market is incredibly polarised, so there are less high-yielding shares out there, but I totally disagree that it is a difficult target to achieve.
"I have no miners or oil companies, yet the fund I manage is still able to yield ahead of the index. We have three years to meet these rules, which is plenty of time," says Bailey.
"There are high-yielding shares outside the FTSE 100, as well as good opportunities within. So I do not feel that I have to take on more risk, not in the slightest. Areas I am favouring that offer high yields where I think dividends are sustainable include telecoms and pharmaceuticals."
Another concern is that fund managers who grow the capital of their fund can be penalised.
For example: fund A starts the year at a price of £1 per unit and ends the year at £1.10 per unit, while producing an income of 5p over the year. The historic yield of the fund is therefore calculated as 4.55% (5p/110p).
Fund B, meanwhile, starts the year at a price of £1 per unit and ends the year at £0.90 per unit, producing an income of 5p over the year. The historic yield of the fund is calculated as 5.56% (5p/90p).
While the manager of fund A has done a good job of increasing the fund's capital and hence its price, this has the effect of lowering the yield. This, in turn, means the fund is more likely to get kicked out of the sector.
Should the rules be changed?
Yes: Daniel Godfrey, former head of the IA
"Some funds that have done a great job have been forced to leave the sector, and the fact that so many have chosen to leave is a reflection of the fact that the sector rules have been broken by the very long period of low interest rates.
"Instead of having a mathematical rule, I would prefer the sector definition to say that funds need to have a clear income objective. There are so many different strategies.
"Some income funds prioritise growing their dividends, some look to produce a high dividend yield, while others focus on total return.
"I think consumers would like to see fund groups being clear and spelling out what they are trying to achieve."
No: Gary Potter, multi-manager at BMO Global Asset Management
"Income has been the flavour of the month for a couple of years now, and naturally the UK equity income sector has regularly been the top-selling sector.
"I appreciate that it has become tougher: there were a sizeable number of dividend cuts last year and the amount of money companies are returning to shareholders has become less generous.
"But I think it is important the rule remains because it promotes a discipline, which ensures the fund manager focuses on generating income.
"After all this is why the sector is so popular. I also think the dividend picture will improve from here; some parts of the market, such as the banking sector, will be stronger payers over the next couple of years."
This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
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