If an investor wants a fund that generates income from equities, the logical place to start would be the Investment Association’s Equity Income sector, right? Not necessarily. A number of high profile Equity Income funds have left the sector, saying that the criteria for inclusion have become onerous and potentially damaging to their long-term performance. This begs the question of whether those that remain are compromising their investment strategy to do so.

Long-running issue

This issue has been rumbling along for some time. The Investment Association (IA) requires that for inclusion in the Equity Income sector, funds must yield 110% of the FTSE All Share over a rolling three-year period. That doesn’t sound particularly demanding. After all, funds that claim to target higher dividend-paying companies should naturally end up with a payout higher than the wider market.

Except it’s not quite that simple. Income figures are historic. If a company is listed as having an income of 8%, it simply means that its last year’s dividends are equivalent to 8% of its current share price. That’s a little different to a guaranteed 8% income. Worse, it may be that the income looks high because the share price has fallen. The share price may have fallen because investors are expecting a cut in the dividend. In this way, it is an imperfect science.

Laith Khalaf, senior investment manager at Hargreaves Lansdown, points out the problem for investors: ‘The way yield is calculated means that fund managers are punished for doing a good job of growing an investor’s capital. If the capital goes up, the yield goes down. On the other hand, if a manager loses 20% of your money, the yield on his fund would look very good. Which situation would you be happy with as an investor?’

Dividend growth

It is, in essence, a tussle between the past and the future. Those that have left the sector say they do not want to be tied to a handful of high-yielding stocks that may only look that way because they are about to cut their dividends. They would rather be free to target higher growth companies with the potential to grow their dividends over time. They point out that growth in dividends and capital is far more potent for investors over the longer term.

Why has the problem arisen? James Henderson is manager of the Henderson Income and Growth Fund (GB0007493033), which has recently moved from the Equity Income sector to the All Companies sector. He says the composition of the index is at fault. He adds: ‘Very few stocks are yielding more than the index because the likes of Shell are such big components of the index. There are issues in moving to the All Companies sector - people may not find their way to the fund - but we want to protect existing investors. We grew our distribution to unit holders by around 9% last year. We believe this is more important than absolute yield.’

He points out that a year ago stocks such as Tesco (TSCO), Centrica (CNA) and some of the miners looked like high yield options. Equally, dividends for the current higher yielding companies such as Royal Dutch Shell (RDSB) and GlaxoSmithKline (GSK) have, on occasion, looked vulnerable, though the prospects for both have strengthened more recently. He adds: ‘I’m pleased we’ve got freedom. High yield shares are often not growing their dividend. You need a business that’s got the potential to grow, otherwise it’s a value trap.’

High profile departures

Plenty of high profile managers have agreed with him. The equity income funds of Neil Woodford of Woodford Investment Management or Mark Barnett of Invesco Perpetual are no longer in the sector. Rathbone Income (GB0001229045) and Schroder Income (GB0007648909) are other high profile casualties.

But does it really matter for investors? Certainly, it means that they lose the ability to compare all equity income funds in one place, but it’s not difficult to uncover those funds targeting income - they’re mostly called ‘equity income’ for a start.

The real risk is that fund managers start to change their behaviour to accommodate the needs of the sector. Adrian Lowcock, investment director at Architas, says: ‘The question is whether you get caught in a value trap if you target the higher yield. It looks cheaper on the surface, but is the dividend sustainable? Most people don’t want too much volatility in their income.’

Lowcock believes it may become more of a problem if dividends start to fall in the wake of Brexit: ‘We may not have seen the end of dividends falling. Superficially, dividends have risen since the beginning of the year, but there have been some significant cuts - some of the miners, for example, Morrisons (MRW); SAB Miller (SAB) is in doubt following its merger. There are still more to go, so this could reappear as an issue.’

‘Dividends tend to be skewed to the latter half of the year and the impact of Brexit may start to be felt.’ He points out that while the weaker currency could ultimately be an advantage for some dividends, its benefits are likely to come later. He adds that the most successful fund managers in recent years, such as FundSmith (GB00B4M93C53) and Lindsell Train (LTI) have been those that look for good companies that are growing their dividends. Although they are not insensitive to valuations, they would rather buy something good than something cheap.

That said, while the problem has hung around for a while, it can be cyclical: For example, Henderson points out that at the height of the dotcom bubble utility PowerGen (no longer listed) was yielding 10% and growing its dividend. Investors’ attention had simply fallen elsewhere. It is not necessarily the case that high yielding companies are weaker.

Turning sentiment

Indeed a number of more ‘value’ focused managers would argue that a higher yield stocks can indicate that a stock is unloved and ripe for reappraisal by the market. This type of approach has been out of favour for some time, but sentiment can turn relatively quickly.

The IA is consulting on whether it needs to change the current rules and is currently conducting research with consumers and financial advisers through YouGov (YOU). There are currently a number of options under review. The first would see the current 110% hurdle replaced with a requirement to generate a yield higher than the FTSE All Share over 3 year rolling periods, while retaining the 90% yield requirement over 1 year. The second would remove the yield requirement, but require certain specific disclosures relating to income. The third would be no change. Results are due by the end of this year.

Another option is to consider an investment trust. Henderson says that the Association of Investment Companies’ classification is a ‘bit more relaxed’, looking at dividend growth and current yield level in categorising funds. Certainly, investment trust managers - many of which also appear in the IA sector - have not been ejected from the sector in the same way and the ability of investment trusts to reserve income in boom times to pay it out in leaner years is an advantage.

Under the bonnet

In the meantime, it highlights the importance of investors not being seduced by the high yield on some equity income funds. They need to look under the bonnet a little and assess whether that high yield is a result of poor performance, or holding companies with some measure of distress. Equally, they should not confine their search to the Equity Income sector alone; there may be some gems lurking elsewhere.