Rule change may lead to dividend cuts for UK equity income funds

Reducing the dividend yield requirement for UK equity income funds could result in dividend cuts and a change in approach towards "capital gains over income", a report has warned. 

The latest Sanlam income study, which over the past two decades has run the rule over the performance and income generation of UK equity income funds, says that while the Investment Association's (IA) decision to lower the yield hurdle (explained below) will "satisfy many fund groups, the income investment landscape is likely to change as a result, and the industry and investors will have to adapt".

As a result of the rule change introduced earlier this year, UK equity income funds no longer have to yield more than the FTSE All Share index.

Previously, in order to be housed in the IA's UK equity income sector, a fund was required to achieve a yield in excess of 110% of the FTSE All Share index yield at its year end.

In recent years a growing number of funds, 21 in total since 2013, have failed to meet the yield target, and as a consequence have lost their place in the sector.

One of the fund managers ejected from the sector - Carl Stick, who oversees the Rathbone Income fund - argued he would be increasing risk in pursuing shares with high yields in order to remain in the sector.

Another concern was that fund managers who grow the capital of their fund can be penalised - as we explain in a worked example at the bottom of this article.

Those on the other side of the fence - namely those fund managers meeting the yield requirement - argued that income funds should be generating more income than the index.

Sanlam's report expresses concerns that watering down the rules is not necessarily good news as far as income investors are concerned.

The report says: "In the short term, a lower dividend target might even lead to dividend cuts from some equity income funds. Given all the potential uncertainties, investors must assess their funds' intentions regarding future relative dividend yield targets. In the medium to long term, we may witness a shift of emphasis as funds pursue capital gains over income in order to outperform the index."

Other commentators, however, disagree. Gavin Haynes, of wealth manager Whitechurch Securities, says he would be surprised if dividend cuts materialised.

"I think it is quite unlikely dividends will be cut, as fund groups are fully aware of the high demand for income in this continued low interest rate environment. I would also be surprised if there was a move away from income towards capital - what investors want more than anything is to see dividend growth go up each year, so I think the main focus will still be on generating income."

The report adds that the changes offer fund managers the chance to spell out clearly what their income funds are setting out to achieve. It says: "We may even see some managers sticking with higher-yield targets than the new IA hurdle rate, to differentiate their propositions.

"For those that do not, it is perhaps worth questioning whether just meeting the market yield makes enough of a distinction between funds that are managed on a true income basis and those managed with more of a total return approach. This is especially pertinent in a world where the industry should arguably, now more than ever, be trying to highlight the particular merits of active investing over passive."

In terms of reliable income fund performers, Sanlam's 'white list' ranked CF Miton UK Multi Cap Income, Slater Income and MI Chelverton UK Equity Income in the top three.

The bi-annual income study looks at a number of factors. These include the absolute income generated by the fund over the past five calendar years, capital growth for each of the past five 12-month periods and volatility over the past five years.

From this the firm compiles its white, grey and black lists of over-achievers, middling constituents and serial underperformers.

How growing capital penalised fund managers under the old rules

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.

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.