Mark Dampier: Don't let dividends become an obsession in equity income funds

Regular readers of this column will know I am a great fan of equity income funds, and have been for a long time. Most aim to increase the value of investor's capital over the long term and provide a growing income. This tends to appeal to investors at or approaching retirement, but for those reinvesting dividends from a younger age total returns can be very good as well.

Equity income funds are not without risk, though. Companies often cut dividends during recessions and the ups and downs of the business cycle means companies will experience challenging periods from time to time.

With a fund your investment is spread across many different companies so there is less chance of seeing a total wipe-out. Yet from time to time funds run into problems, as I was reminded recently when looking at the Newton Higher Income Fund.

In a nutshell, under previous management too much emphasis was placed on growing income. This ultimately made the level of dividend unsustainable, resulting in a significant cut, while the capital value was also hit. My advice to equity income managers has always been to protect capital first and worry about the income second; without capital you cannot possibly protect and grow the income in the long run.

Newton Higher Income has seen its level of income drop each year for the past three years. Christopher Metcalfe, who recently took over as manager, is hoping this will be the end of the cuts. He will aim to begin growing the dividend again over the long term, but not necessarily on a year on year basis. This is a more sensible approach.

Mr Metcalfe does not expect much growth in the UK market in the short term, believing interest rates will remain low throughout 2015. He thinks high levels of debt, higher energy costs and globalisation could contribute to a period of deflation, or falling prices.

At the company level Mr Metcalfe's focus remains on sectors and stocks with high cash flow, from which they can continue paying and growing dividends. He is overweight in healthcare and feels we have passed the peak of patent expirations and are entering a period of exciting new products, with potential blockbusters in the pipeline.

He's also keen to use the 20 per cent allowance for holding non-UK listed shares. Where he struggles to find yield among large UK companies he would rather look overseas.

The portfolio is currently quite concentrated at 52 holdings and he anticipates some turnover as he continues to realign the fund towards income-generating stocks that he believes can offer more protection on the downside. He is also likely to reduce the technology exposure that was introduced under the previous manager, as most don't pay enough income. He cites Microsoft and Apple as examples, but he remains keen on Sage and plans to continue holding the company.

So far he is about two-thirds of the way through the restructuring, so the remaining changes will mostly be at the margins; he thinks the portfolio is in good shape overall.

Investors have had a difficult time with this fund over the past few years. Given that Newton is a well-known income house this is also a poor reflection on them. That said, I do think Christopher Metcalfe is the right manager to be running this fund and in my view it is a shame he wasn't put in charge previously. If you are an investor and have been patient for this long, I think it is worth giving Mr Metcalfe a little more time.

Mark Dampier is head of research at Hargreaves Lansdown, the asset manager, financial adviser and stockbroker. For more details about the funds included in this column, visit www.hl.co.uk