UK equity income: your questions answered

Staci West 17/04/2024 in Income investing

First, what is UK equity income? UK equity income funds primarily invest in a diversified portfolio of equities issued by companies listed on the London Stock Exchange. The aim is to generate income for investors through dividends paid out by these companies. In addition to providing income, UK Equity Income funds also offer the potential for capital appreciation as the value of the underlying stocks fluctuates over time. Investors looking for a balance of income and growth within the UK market often turn to these funds as a key component of their investment strategy.

How have UK equity income funds performed relative to other UK sectors?

Probably not as badly as investors fear. The UK has been unpopular, but over the past three years, the UK equity income sector has outpaced the UK All Companies and UK Smaller Companies sector. The average fund has risen 15.9% compared to 6.7% for UK All Companies and a grim 17% fall for UK Smaller Companies funds*.

UK Equity income tends to be more focused on large cap, steady companies with predictable earnings and dividends. These have fared well in a climate of uncertainty, particularly some of the energy and mining companies. The large cap banks have also benefited from rising interest rates. The FTSE 100 is around 32% ahead of the FTSE 250 over three years*.

Does that mean UK equity income funds are just a boring range of oil majors and banks?

It depends. In the UK, the top five dividend companies – HSBC, Shell, Glencore, British American Tobacco and Rio Tinto – pay 33% of all dividends**. Add in the next 10 companies and that accounts for 59% of all dividend payments**. That is marginally less concentrated than, for example, in 2020 when the same figure was 68%**, but it’s still quite focused.

However, the sector also has plenty of multi-cap options for investments. The IFSL Marlborough Multi Cap Income fund has none of these dividend-paying behemoths in its top 10 holdings, preferring companies such as 3i, Chesnara, Bloomsbury Publishing, and Games Workshop***. The VT Tyndall Unconstrained UK Income is similarly eclectic, holding DS Smith Plc, Bodycote and Vistry***. This type of fund hasn’t performed as well as more large cap focused peers in recent history but may be due a comeback. The fact these companies are smaller also gives them greater scope for capital and dividend growth in the future.

Is my income safe?

For the time being, UK dividend payouts appear to be reasonably healthy. The latest Computershare Dividend Monitor – the industry’s main report on the state of UK dividends – showed underlying growth in UK dividends of 5.4% (to £88.5bn) in 2023 and forecast growth of around 2% in 2024**. This isn’t exciting, but active fund managers should be able to stock-pick their way to higher growth.

The UK remains a dividend hotspot. The FTSE All Share has a dividend yield of 3.75%, with dividend cover (the extent to which dividends are covered by earnings) of 2.2x****. Dividend cover has significantly improved since the pandemic. For context, the only other developed markets that come close to the UK on dividend yield are European large cap (3%). Emerging market large cap (3%) and Latin America (7%)****, but all come with higher risks.

It is true that the sector make-up of equity income funds has created problems; notably during the banking crisis, but also during tough periods for commodity markets. Equity income funds across the world have also been on the wrong side of the technology boom. The technology giants don’t tend to pay dividends, so equity income funds have missed out on that growth.

Is the outlook good for UK equity income funds?

The environment today is one that should favour UK equity income funds. Interest rates are higher, but stabilising. The UK economy may have flirted with recession, but now appears to be on the path to recovery. Corporate distress has been relatively limited, confined to certain sectors and markets, meaning company dividends look secure.

Simon Murphy, manager on the VT Tyndall Unconstrained UK Income fund, says: “We would expect a continued broadening out of equity market participation away from the narrow leadership that has characterised market moves recently. In this respect we see encouraging signals, although it is relatively early days.” His greatest concern is that the ‘euphoric’ valuations of some parts of the US could prompt a wider market setback.

How does equity income compare to bonds and cash?

Equity income has had a higher hurdle rate as higher interest rates have pushed up the income available from cash and fixed income. However, with an equity income fund, the income and capital can grow. This is increasingly important at a time when inflation is proving persistent.

Carl Stick, manager of the Rathbone Income fund, says that his fund competes with growth stocks when interest rates are low, and fixed income and cash when interest rates are high, but his argument remains the same: “We offer an attractive income yield and most crucially, an excellent record of growing that income. People forget that interest rates on cash are only locked in for a year or two, if at all. When central banks start to cut rates, you’d expect cash rates to slump dramatically. Income, and the growth and reinvestment of that income creates a substantial proportion of our total return.”

Why are dividends so important for investors?

The importance of dividends can work in two ways. In the short term, it can be used to pay for monthly bills amid the increasing pressures of the cost of living crisis – with inflation reaching multi-decade highs in 2023.

Longer term, the role of compounding interest is possibly the most important concept people can learn about when it comes to their finances. Investments that generate an income can work even harder for you. By using the income to buy more shares, bonds or units, your pot grows bigger, and you earn interest on that interest again.

For example, take an investment of £1,000 in the FTSE All Share between 1 January 2012 and 28 September 2022. Based on share price changes alone, that £1,000 investment would have produced a notional return of £1,337 before fees. When dividends are included, the return rises to £1,969 before fees – an increase of 47%***.

Learn more about compounding dividends

Should I go global or stay at home?

There is an argument for including both in a portfolio. While the income available in the UK market is high and consistent, global income funds bring additional diversification and will allow investors to access markets and sectors that aren’t available in the UK market. The Trojan Global Income fund, for example, has Microsoft, Nintendo and PepsiCo among its top 10 holdings^. The UK market has almost no exposure to technology companies, which is a big miss in an increasingly digitised world. Global equity income funds can introduce areas such as semiconductors, payment solutions or gaming.

A final thought…

UK equity income funds may have a reputation for being dull, but the flipside is that companies committed to paying consistent dividends to shareholders tend to have strong capital discipline, good cash flow and sound governance. The discipline required to pay a dividend often prevents reckless M&A activity and presents a strong hurdle for capital investment. These should be the kind of companies that investors want to hold over the long-term. With this in mind, UK equity income funds still have their place in a portfolio.

*Source: FE Analytics, total returns in sterling, 15 April 2021 to 15 April 2024

**Source: Computershare, UK Dividend Monitor, Q4 2023

***Source: fund factsheet, March 2024

****Source: Morningstar, 12 April 2024

^Source: fund factsheet, February 2024

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