Why changes to the equity income fund sector rules could hit investors hard

In March, the Investment Association (IA) announced that from last week, it would be lowering its UK equity income sector yield hurdle from 110% to 100% over a three-year rolling period.

As a UK equity income manager, I have to say I'm somewhat surprised by the decision. In the context of a sector named 'income', it seems counterintuitive that there is no longer a requirement for funds to yield more than the market, especially given that under the new rules, a FTSE100 tracker fund - which has not been designed for income - could technically now be classified as part of the sector.

We don't yet know what the long-term impacts of the change will be, and whether these will prove to be helpful; however, there are certain repercussions that I foresee.

More choice but more confusion

Over the last few years, a lot of funds have been forced to exit the sector as they have struggled to meet the 110% yield target. However, now that the yield target has been lowered, we will likely see these funds re-applying for entry, alongside a whole list of new players coming into the market. While this will give income investors more choice, it will arguably lead to a more diluted offering.

We believe this has the potential to be confusing for investors, who may find that their income expectations are no longer being met. With the previous target, it was clear that all funds in the sector needed to yield at least 10% more than the market over three years - helpful for people seeking income especially those in retirement.

There will now be a much wider range of yields, with some funds yielding as low as 90%. In my view, the income sector will no longer do what it says on the tin. 

An overall fall in yield

I fully appreciate that reaching the 110% yield target has sometimes proved to be very difficult, especially in the current environment, with only a handful of companies such as Shell, BP, HSBC and Vodafone producing the majority of the yield.

However, there are ways for investors to make up the yield if they don't want to be overweight in these companies. For example, managers could look to invest in these stocks, but keep their positions underweight and then top up the dividend with high-yielding stocks such as those in the utilities and pharmaceuticals sectors.

Of course, the new rules will give managers more flexibility to run their funds in a different way and invest in a broader range of stocks and sectors. Whether this move will prove to be good or bad for long-term performance remains to be seen.

What we do know is that historically the equity income sector, as defined by the 110% rule, has performed well. That is likely because there has been pressure to maintain a higher yield, so managers have stayed disciplined to buying into stocks that are less 'in vogue' and yielding more than the market, and then selling them when the yield drops.

Going forward, fund managers won't have to do that. They will be able to run stocks for longer, with less concern for yield fluctuations, and will not need to buy the higher-yielding stocks to stay in the sector.

As this pressure is taken away, managers could find that they are not yielding as much anymore, and worryingly, the likelihood is that the yield of the sector overall will fall.

We will also no longer be comparing like with like, as funds will have a variety of objectives and can allocate a higher proportion of their portfolios away from yield-producing stocks.

Growing the dividend

The long-term impacts on income sector performance (be they positive or negative) will not be realised for some time, but with regards to how we run our own fund, the IA reclassification will have little impact.

Our strategy will remain the same and we will continue to focus on growing the dividend yield year-on-year, with the 110% target still very much front of mind, an important element that we are very proud of when we look at the track record since the inception of our fund.

As the saying goes: 'If it's not broke, why fix it?'

Colin Morton is portfolio manager of the Franklin UK Equity Income fund.

This article was originally published in our sister magazine Money Observer. Click here to subscribe.

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.