Don’t be shy, ask ii…why don’t more fund managers like 10% dividends?

No question is a stupid one, so whether you want to find out what you need to do to start investing or how the stock market works, don’t be shy, ask ii. Email yours to: ask@ii.co.uk

Mr Pearce asks:why don’t more people and fund managers invest in stocks offering dividend yields of 10% or more?

Kyle Caldwell (pictured above), collectives editor, interactive investor, says: some fund managers do invest in shares with high yields, but only when they feel the dividend is sustainable – an approach that should also be followed by private investors.

As share prices and yields have an inverse relationship, a high yield more often than not is a sign that a stock, for whatever reason, is out of favour. It is therefore crucial to do some digging to check whether the yield on offer is sustainable. Among the things to examine are whether its dividend cover and return on capital employed (ROCE) have been rising or falling. If it is the latter, alarm bells might ring as this implies that the dividend could be under threat.

On the whole, though, it is rare to see a share with a super-high yield making up a meaningful position in a fund. We asked Morningstar to run the data for three shares that were handpicked by my colleague Lee Wild as his speculative dividend picks for 2021. The trio - Diversified Gas & Oil (now Diversified Energy Company (LSE:DEC)), AEW UK REIT (LSE:AEWU) and M&G (LSE:MNG)- achieved an average yield of 9.9% last year. The respective share price returns were -6%, 42% and 1%.

According to Morningstar data, of the 1,325 equity open-end funds domiciled in the UK, 92 hold M&G, 57 have a position in Diversified Energy Company, and eight have exposure to AEW UK REIT.

• Read more of our content on funds and trusts here
• 12 funds for the £10,000 income challenge in 2022
• Watch our latest share tips here and subscribe to the ii YouTube channel for free

For most of these funds, the position sizes are very small. For M&G, just nine funds have a weighting of over 2%. The fund with the biggest position, at 3.6%, is BMO UK Equity Income. In the case of Diversified Energy Company, 10 funds hold 2% or more. Quilter Investors UK Equity Income is the top holder, with 5.2%. For AEW UK REIT, the eight funds, which are all passively managed, hold a minuscule position of less than 0.009%.  

My view is that when considering risk versus reward, fund managers err on the side of caution with companies that have very high yields. If they make the right call and dividends are paid, then it will provide a nice income boost to the portfolio and there could also be some capital gains. But if the fund manager makes the wrong call and dividend proves unsustainable, then it will reduce the amount of income the fund generates. In addition, the fund’s overall performance (combination of capital growth and income returns) could be harmed further if a high yielding share cuts its dividend, as this is often looked on unfavourably by the market and negatively impacts the share price.

• 11 investment trusts to earn £10,000 income in 2022
• Friends & Family: ii customers can give up to 5 people a free subscription to ii, for just £5 a month extra. Learn more
• Discover more Don't be shy, ask ii questions here

Given that UK equity funds tend to yield between 3.5% to 4%, fund managers can afford to be cautious. They don’t need to hold the high yield shares to achieve a fund yield within that range. Instead, funds typically invest in 40 to 60 companies with a range of different yields.

A DIY investor, on the other hand, is unlikely to hold this many shares. Therefore, a high yield share is likely to appeal more. But it is worth re-emphasising the importance of doing your homework to assess whether that dividend looks sustainable or is just too good to be true.