Fund Awards 2013: UK Income Growth

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Best larger fund: Henderson UK Equity Income

Investors who need their capital to generate income over the long term have historically been well served by UK equity income funds.

The best of these funds have provided not just a regular but an increasing income along with capital growth, helping to protect investors from inflation. Some funds have a greater focus on income than growth.

For this award we measure funds in terms of total return, as we believe income investors can also dip into capital growth to supplement their income if they need to.

Henderson UK Equity Income is run by the very experienced James Henderson. This £408 million fund is run on a similar basis to Lowland Investment Trust, with a core of large companies but a bias towards medium and smaller businesses. He looks for under-analysed companies with strong cash flow and the potential for growing dividends.

Most traditional income funds invest in larger companies but Henderson believes diversifying beyond some of the obvious areas of equity income investing may be where some of the best opportunities lie.

He explains: "Large companies might be responsible for a hefty portion of UK dividend income but that is simply a reflection of their size. Lower down the market capitalisation scale are plenty of companies paying attractive yields. Some of the small and medium-sized companies often dominate niches ignored by larger companies and it is easier for revenue growth and market share gains to have a meaningful difference on earnings, in turn lifting share prices and dividend payouts."

In addition to exposure to smaller companies, other factors also helped performance, says Henderson. "In terms of sectors, the fund's major overweight to industrials contributed significantly to performance. Meanwhile, strong stockpicking within the basic materials sector provided a boost."

Henderson believes it is well structured for the future. "We have positioned the fund to have an overweight exposure to export-led industries that have the capacity to grow and add significant value for shareholders and companies where earnings growth can readily translate into higher dividends."

Highly commended larger fund: Rathbone Income

The consistency of Rathbone Income, our highly commended income growth fund, is underlined by the fact that it was last year's winner in this category. Its attractions for income investors include the fact that it aims for an income yield that is 20% higher than the FTSE All-Share and that it has managed to increase its total income payouts in all but one of the past 10 years.

One of the key elements in its success nowadays is that fund manager Carl Stick takes risk very seriously. He explains: "Our investment discipline focuses on the identification of 'risk' - price risk, business risk and financial risk."

He looks for quality companies with high returns on capital, balance-sheet strength, sustainable margins, strong cash generation and competent management. His approach is to buy shares he thinks are undervalued. Although the fund has a focused portfolio of 40-50 mainly UK shares, they represent a wide spread of economic activity across market capitalisations and sectors. It does not conform to a particular benchmark.

Stick also has a strong sell discipline and will remove companies from the portfolio once their valuations look rich, fundamentals worsen, or if better opportunities emerge.

Explaining the £476 million fund's success over the past three years, a period that has generated a 47% return, Stick says: "The key to our investment process is to maintain the balance of the fund, keeping a very keen eye on risk, and especially on price - staying true to this discipline has helped outperformance over three years."

He believes the approach adopted in the running of the fund over the past three years shows that he and his team have the capability to deal with the most testing conditions the market might throw at them in future.

"Running an income fund is not a matter of hitting sixes," he says. "It is the investment in good businesses at the right prices, for the harvesting of generous and growing streams of dividends.' This is the discipline he intends to maintain in future.

Best smaller fund: Unicorn UK Income

Measured by Money Observer's exacting criteria, Unicorn UK Income beat all other funds, large and small, in the UK Income Growth category for its consistent performance over the past three years.

Yet it is considerably less well known than many of the UK's larger income funds. It is not only smaller in size at £146 million, but also rather unusual in that a large proportion of the fund is invested in smaller companies. In fact it holds no large FTSE 100 companies.

Its manager is John McClure, founder of Unicorn Asset Management. Besides avoiding large companies, he also restricts the fund's portfolio to holding no more than 50 stocks. In order to achieve its objective of consistently delivering 110% of the FTSE All-Share yield, the portfolio is constructed so that there is even dividend income from its investments.

Unless an investee company meets or exceeds the target dividend yield at the point of investment, then it typically will not get into the portfolio. In the event that an investee company cuts its dividend, that holding is sold from the portfolio.

However, as a traditional long-term investor McClure hopes that when investments are acquired, they will be held for five years or more. So portfolio turnover is low.

When seeking out potential investments, he looks for "businesses operating in niche markets, selling specialist products and services that are not easily replicable and, where they can, create genuine barriers to entry and/or distinct competitive advantages. If such businesses are able to demonstrate significant growth potential in multiple overseas markets, so much the better."

A key aspect of the fund's success over the past three years has been investing in businesses with significant international exposure that have benefited from exporting their products and services into faster-growing economies such as those in the Far East and South America. He has avoided those companies that have an over-reliance on the UK economy.

McClure is confident that he will be able to continue to deliver the same consistent performance that the fund has achieved in recent years by applying "the same philosophy, approach and process".

Highly commended smaller fund: PFS Chelverton UK Equity Income

Like our winner in this category, our highly commended smaller fund, PFS Chelverton UK Equity Income, eschews investment in large companies. Its parent company, Chelverton Asset Management, specialises in small and medium-sized company investing. Apart from this £15 million fund, it also runs two investment trusts that focus on the smaller-companies end of the market.

The fund managers are David Horner, founder of the company, and David Taylor. They define their universe as UK small and mid-cap shares with a yield of at least 4% on a 12-month view. Their aim is to deliver a relatively high level of income that can grow in real terms over the long term.

The managers also believe this approach helps to deliver capital growth and the return over three years has been a very impressive 79%. They see the ability of a business to pay a dividend as the key driver of a share price over the long term because it is a tangible measure of the underlying cash flow.

Horner and Taylor look to exploit the pricing inefficiencies inherent within the small and mid-cap sectors. When selecting stock they seek to identify three differing types of yield opportunities. They explain: "First, high and stable yield, where we expect no dividend growth over the short term but where there is a propensity to increase when appropriate. Second, high-yield recovery where a stock has fallen dramatically, usually the result of a short-term earnings setback, to a level where the cash-flow prospects are not reflected in the price.

"Finally, steadily growing dividend - which is the core of our portfolio - where the ability to consistently increase dividend payments in real terms is not reflected in valuations. This last category represents our most compelling opportunity."

They find these opportunities through their analysis of companies' cash flows and balance sheets and regular meetings with management.

Fund Data
Name1 Year (%)3 Years (%)5 Years (%)Rating
Janus Henderson UKEqInc&Gt1.5112.1643.301 star(s)
Lowland Investment Company2.0521.0244.452 star(s)
MI Chelverton UK Eq Inc12.2233.4280.434 star(s)
Rathbone Income-0.0016.9043.302 star(s)
Unicorn UK Income1.0720.9757.613 star(s)

The annual Money Observer Fund Awards recognise the actively managed funds that have delivered consistently good, low-volatility returns for investors. Who were the 2013 winners, and can they continue to prosper?

Money Observer's Rated Funds aim to put you on the path to prosperity in 2013 and beyond. Find out which ones made the grade in: Money Observer Rated Funds: UK equities.