Dividend drought hits income seekers

Investors smitten with Britain have faced a rough ride in recent months

Barclays' decision this week to reinstate its final dividend payment will be music to the ears of investors and fund managers alike.

But investors seeking income from the UK's equity income and income & growth sectors now face a tough choice after a number of funds failed to sufficiently negotiate the banking sector's dividend drought over the past 18 months.

Until 2008, around a quarter of FTSE 100 yields had been coming from the banking sector, but the credit crunch swept through the market leaving a trail of devastation. Barclays cut dividends and HSBC followed suit, albeit more modestly. The only London-listed bank not to do so was Standard Chartered.

By the end of 2009, analysts at ING said that they did not expect to see dividends returning from Lloyds Banking Group or Royal Bank of Scotland until 2011 because of banks' increased capital adequacy requirements and the deterioration in the wholesale funding markets.

This impacted equity income funds because they invest primarily in London Stock Exchange-listed companies, and pay an income to investors from the dividends that they receive from the various companies.

Despite this, renewed interest in equity income has come about because companies are now showing signs of coming out of recession and interest rates from cash savings accounts on the high street remain appalling.

However, a gulf exists between the very best and worst funds in terms of both income and capital growth. Nowhere is this more evident than in the IMA equity income & growth sector.

In terms of capital growth, a £1,000 investment in the worst performing fund over 10 years – Henderson UK Growth & Income – would have lost £306. That is a world away from the best performer; Invesco Perpetual's Income fund, which would have increased the initial investment to a massive £2,499.

Investors may well be familiar with the Invesco Income fund, managed by Neil Woodford, as it has been the most consistent funds of recent years.

What is less well known, however, is that Mr Woodford also manages the St James' Place Higher Income fund. While both funds are stellar performers over a longer period in capital growth terms, holders of the St James' Place fund are justified in asking why, based on a £1,000 initial investment, this fund returned £529 less over 10 years than the Invesco High Income fund.

Invesco says this is because the fund only came under management by Invesco in November 2001. In addition, the St James' Place fund has no overseas holdings within it and so would not have gained from the contribution from Mr Woodford's US tobacco industry selection.

It is worth noting, though that the yield on the Invesco Income and High Income products have been around the sector average for the past three years. Looking at yield alone, the Rathbone Blue Chip Income & Growth fund has the highest three-year average (mean) dividend yield at 5 per cent within the income & growth sector. Each of its performances over the past three years has been near enough on the sector's average yield. Neptune's Income and Halifax's UK Equity Income funds currently offer the highest yields in this sector at 4.7 per cent.

Of course, investors in this sector may be less concerned about the yields. For those investors for whom yield is more important, they may wish to opt for the IMA equity income sector. The highest yield in this sector is 7.4 per cent, while the highest in income and growth is just 4.7 per cent.

Newton is arguably the best all-round performer in yield terms. It is also one of the largest funds at £2.7bn in assets under management. It is seventh based on the average yield over the past three years, but is also a strong performer in total return terms. Over 10 years it would have returned £883 on top of the initial £1,000 investment.

Fund manager Tineke Frikkee explains that the fund has been cautiously invested for most of the past 24 months. In 2008, the fund avoided banks and mining stocks and reduced the number of holdings from 65 to 50, although it has since returned to 63.

With a period of significant volatility predicted for markets, the general consensus is that stock-picking will be more important than sector-tracking over the coming 12 months as there will be large winners but even bigger losers.

This research is taken from the forthcoming 'Has Britain Got Talent?' survey in the March issue of What Investment magazine.

Fund sector focus: UK equity income

UK equity income funds are designed to provide a regular income of at least 110 per cent of the average FTSE All-Share yield, according to the Investment Management Association (IMA) rules. These funds also aim to grow an investor's initial investment. Similarly, equity income & growth funds aim to provide a slightly lower income (around 90 per cent of the FTSE All-Share yield), but target greater capital growth.