Spread the risk with global equity income funds

In these uncertain times, it makes sense to invest in companies that pay dividends. Julian Knight reports

Just because the idea of investing in companies in order to scoop the dividends they pay is an old idea doesn't make it any less valid. "Studies show that over the long term – we're talking 30, 40 or 50 years, between half and two-thirds of the returns investors can expect to have from a share investment come from dividend payments," said Darius McDermott, the managing director of Chelsea Financial Services. "Funds that invest in firms with the object of achieving high dividends – called equity income funds – or solitary share investment in big blue chip firms plays a major part in our client portfolios and should probably in yours."

Equity income funds don't quite have the glamour of emerging market investment or the potential to make a killing from the relatively recent explosion in commodity and precious metal prices. They are generally steady-as-she-goes investments, but at a time when cash savings accounts pay no more than 3 per cent, steady as she goes is not to be sniffed at.

"A lot of share prices in these big dividend-paying companies are much unloved. People seem more interested in mining, for example, which traditionally doesn't pay much of a dividend," said Ben Yearsley, an investment manager at independent financial advisers Hargreaves Lansdown.

"Take shares in a blue chip company like GlaxoSmithKline. Five years ago it was trading at around £20 a share while now it's £12. However, Glaxo still pays a really good dividend seemingly year in year out. That hasn't gone down – it's just a question of investment fashion. If you can get a share at around half the price it was five years ago but it's paying 4 or 5 per cent income – or invest in a fund which holds such dividend-paying companies – then surely that's got to be a strong option for anyone choosing what to do with this year's individual savings account allowance."

And investors looking to take advantage of this year's ISA allowance have only until Tuesday. Up to £10,200 can be invested in a stocks and shares ISA this tax year. Alternatively, the £10,200 allowance can be split between shares and cash savings. "ISAs are one of the few tax freebies we can all benefit from, but don't invest purely for the sake of making use of the allowance. The investment has to be right for your financial position and attitude to risk," said Mr McDermott.

Yet Mr McDermott believes that equity income can be a good starting point for investors. "Most equity funds invest the bulk of their money in a handful of shares. If they are designed to go into the UK market – these mega blue chips include the likes of BP, Shell, Vodafone, HSBC, Glaxo and AstraZeneca – this is both a good and a bad thing. Big companies should be more robust which is good, but at the same time a lot of the funds in the equity income sector are similar."

One fund manager tends to dominate any discussion of equity income funds and that is Invesco Perpetual's Neil Woodford. Mr Woodford has in the past called the technology bubble and reduced his investment in banking in the run-up to the financial crisis. Such contrarian and ultimately successful investment plays have made his reputation and grown his fund into one of the biggest in the country. However, both Mr McDermott and Mr Yearsley say that there is much more to the sector than one giant fund or manager.

"Mr Woodford has had a tepid couple of years, but we are still sticking with him. It highlights there is more to the sector," Mr Yearsley said. In particular, Mr Yearsley likes the Artemis income fund run by Adrian Prosser. "The fund invests up to 20 per cent overseas so if the manager prefers, say, the Swiss pharmaceuticals firm Roche, he buys that rather than, say, AstraZeneca in the UK. I like the fund's flexibility."

It used to be the case that UK and US companies were the chief payers of dividends, but the practice is now widespread. "Investors should look more globally to diversify their risk and expand the possible investment opportunities," said Talib Sheikh, manager of JP Morgan's Multi Asset Income Fund.

"The BP difficulties of 2010 reinforced the point that many UK income funds are overly concentrated on a limited number of names. Investing on a global basis offers 10 times as many stocks with a dividend paying over 3 per cent compared to purely concentrating on the UK. We see attractive dividend opportunities in emerging markets and Europe. We are much more cautious on valuation in the US," Mr Sheikh added.

However, despite banging the drum for a global approach to finding dividend-paying firms, Mr Sheikh is not a pessimist as far as the UK stock market is concerned. "The outlook is positive over the next couple of years; the dividend yield on the FTSE 100 is currently just over 3 per cent and slightly above long-term averages. We see opportunities for companies to increase dividends given high levels of free cash flow generation. The financial sector is likely to increase dividend payments as capital levels are rebuilt and regulatory pressures ease," he said.

Investors wanting to steer clear or limit the number of mega blue chip stocks could find bargains among UK small and mid-cap companies, says Martin Brown, the manager of the Ignis UK Equity Income Fund. "Many companies that stopped paying or cut their dividends during the last few years are now returning to the dividend list. And not just in a token manner. There are nearly five times as many small and mid-cap stocks paying an average or above market dividend than there are large-cap (FTSE-100) stocks," he said.

Traditionally, so-called defensive stocks such as tobacco, utilities and oil firms have been strong dividend payers. Fund management group M&G highlights Centrica (owner of British Gas) as a good bet for long-term dividend returns. However, with uncertainty in many parts of the economy, Mr Brown says some sectors of the stock market are best avoided.

"The outlook for the UK retail sector remains tough and I expect to see muted dividend growth in this sector, with a number of stocks being forced to cut their dividends," he said. "If you hold three or four shares in firms that pay a high dividend, then it takes only a little bad news to hit your returns hard. But if you have a fund you can expect the manager to have spread the money between 80 or 90 individual company shares."