Top fund manager warns against chasing high yields

UK equity income funds are having an increasingly tough time in meeting the required dividend yield for the sector, according to Carl Stick, manager of Rathbone Income, a Money Observer Rated Fund.

He points out that the Investment Association (IA) stipulates a minimum yield of 110% of the FTSE All Share index over a rolling three-year period, which amounts to 3.6%, for members of the IA UK equity income sector.

Although the mega caps dominating the index are on the whole impressively high yielding, with six out of the top 15 yielding more than 5%, they give a misleading impression of the income available from the index as a whole. The median All Share yield, discounting investment trusts, stands at just 2.35%.

Stick points out that bond yields continue to be suppressed by a combination of demand from a growing population of retiring baby boomers, stubbornly low inflation and quantitative easing measures.

Risks

As a consequence investing for income is becoming riskier, as investors are more likely to chase yield from higher-risk assets, for example.

He identifies three types of risk that need to be balanced in selecting any stock: price risk (overpaying for the stock), financial risk (company carries too much debt) and business risk (competition and other macro economic factors).

The trick is never to confuse "predictable" companies - offering high quality with lower business and financial risk, but higher price risk - with "safe" ones, he says. "We like predictable stocks, but a lot of them are not safe because they have become so expensive at the moment."

He points to Unilever as an example, showing the close correlation between its share price and government bond yields. "If rates go up, what happens to this kind of stock?"

The difficulty is that because income seekers' appetite is so voracious in the current low-yield environment, there is also a danger in missing out on grounds of price risk, as rates remain low and quality stocks continue to rise beyond expectations - price distortion, in effect.

Distored asset prices

"Already asset prices have been distorted, creating the curious situation where many high-quality dividend-paying stocks are now simultaneously absolutely expensive but relatively cheap," says Stick. Reckitt Benckiser is an example that he considers worth holding at a price.

Against that, higher-yielding stocks (for example financials, miners and energy) continue to be "a poor strategy", so "we need to be very selective". The right ones offer lower price risk, because they are cheap, but some - most notably oil producers - don't have the free cash flow to cover the dividend they are paying.

Some miners, however, despite the continuing unpredictability of global prospects for commodities, have been cutting expenditure for some time and therefore a much better cash flow profile. Stick likes Rio Tinto and BHP Billiton.

It's a matter of diversifying the different types of risk, he explains. "We have to get a balance between business, financial and price risks across our portfolio."

The £1.035 billion Rathbone Income fund has a 3.53% yield and has returned first-quartile performance within the UK equity income sector over one, three, five and 10 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.