The great dividend re-set: how UK equity income funds will fare

There are signs of light at the end of the tunnel for dividends, with fund managers optimistic for the rest of 2021.

Investing for income has been no easy feat over the past year. Since Covid-19 took hold and the economic outlook grew uncertain, many companies took the difficult decision to cut or cancel their dividends. This resulted in a 41.6% fall in payments over the 12 months to the end of March, according to Link Group’s Dividend Monitor. 

Investors who rely on these distributions – either directly from companies or from UK equity income funds – are likely to have seen their incomes plunge. While 79 out of 82 UK equity income funds cut their dividends in 2020, figures from the first quarter of this year also paint a depressing picture: 66 strategies paid lower dividends compared with the previous year, while only three bucked the trend with increases, according to data from the Association of Investment Companies.

It was a different story for investment trusts, however, which are able to hold back some of the income they receive and use their reserves to top up dividends in challenging periods. During the first quarter, only six out of 23 UK equity income trusts paid out lower dividends in comparison to the previous year, while 16 kept their payments consistent and one (Chelverton UK Dividend Trust) increased its payout.

When it comes to the scale of the cuts across ‘open-ended’ UK equity income funds, Morningstar analysis shows the average dividend dropped by 32% over the year to the end of April. JOHCM UK Equity Income featured at the bottom of the list, with a 54% drop year-on-year, while Liontrust Income proved resilient with a decline of only 2.2% - representing the only fund that recorded a single-digit fall.

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The outlook for UK equity income funds

David Clark, manager of the TB Saracen UK Income fund, describes 2020 as “pretty catastrophic across the board”. Nevertheless, he feels optimistic about the second half of this year. 

“What has been surprising is the speed of the comeback. Quite a lot of companies that initially cut their dividends are speaking positively about reinstating them,” says Clark.

“They realise they have navigated their way through lockdown in better shape than they expected. Some companies have put through restructuring as a result of the lockdown, which they were planning anyway but it would have taken them longer, so they have managed to save money and have a better cash balance.”

The TB Saracen UK Income fund’s dividend fell by around 60% last year, which Clark puts down to its small and mid-cap bias, as smaller companies were quicker to cut payments. He describes it as a “forlorn hope” to expect to see much of this come back this year.

“We are obviously going through a period of transition. There are some companies that will take longer to come back to the dividend list, and maybe not at levels seen previously. People need to pitch their expectations correctly to avoid disappointment,” he explains.

Nevertheless, he hopes the yield on the UK market will return to pre-Covid levels by 2023. Link, by comparison, suggests dividends are unlikely to return to their 2019 highs until 2025.

In light of the scale of dividend cuts across the UK market last year, Simon Murphy, manager of the VT Tyndall Real Income fund, says these payments now look more sustainable. He notes that certain parts of the market, particularly oil majors like BP (LSE:BP) and Royal Dutch Shell (LSE:RDSB), had over-distributed income for some time and were due a reset. Many companies, on the other hand, were not: they chose to cut or cancel dividends faced with the unknown when the pandemic first struck – and he hopes they will bounce back sooner rather than later.

“These companies should return to the dividend paying list relatively quickly as we hopefully make further progress in reopening economies and defeating the pandemic,” he explains.

While VT Tyndall Real Income fund’s dividend has fallen by 20% over the year to the end of March 2021, the fund manager hopes the fund’s distribution will return to pre-Covid levels over the next one to two years.

“We are seeing companies generally come back to the payment list a little faster than we initially expected and in general the dividend announcements are slightly more generous.

“It is also entirely possible that we get some quite significant special dividends in 2021, particularly from areas like the resources sector if commodity prices continue to stay high,” he says.

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Oil majors recalibrate

Anthony Willis, co-manager of the BMO Navigator Distribution fund (which invests in a range of income funds), expects to see dividends climb slowly during the second half of this year.

“I think the worst is over but that’s not to say we will see a V-shaped recovery. Various factors suggest that it will take several more years for dividends to reach their pre-pandemic levels.

“One of the biggest reasons is that the pandemic has been used by some of the major oil companies to recalibrate their dividend polices. As they are now paying structurally lower levels of income, this means there is a large hole to be filled. As confidence and profits return, we do see UK dividends recovering but this is a process that will take a number of years,” he says.

Once things do return to pre-Covid levels, he adds that history is likely to repeat itself: “Some companies will inevitably get to a point where dividends become unsustainable once again – and it is the role of the stock picking fund manager to avoid these companies.”

All of the UK equity income funds held in the Navigator Distribution portfolio cut their distributions last year. However, 12 months since the worst of the market turbulence, he is encouraged to see dividends growing once again.

“We would expect a recovery in the Navigator Distribution fund’s dividend over the course of the year. But as history tells us, companies are very quick to cut dividends but far slower to reinstate them,” he adds.

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New dawn for UK shares

Dean Cheeseman, co-manager of the Janus Henderson Multi-Manager Income & Growth fund, believes the UK market has reached a tipping point. As the economy reopens, following strong progress made with the vaccine rollout, he says the outlook for the UK economy is positive. And the good news is that after four years of being out of favour, overshadowed by Brexit uncertainty, the market looks cheap.

As the make-up of the dominant dividend-payers in the UK market changes, following cuts from oil majors, banks, miners and tobacco stocks, Cheeseman says active fund managers have an opportunity to thrive. While a passive strategy, like an exchange-traded fund (ETF) or index fund, will provide access to the highest dividend payers, he notes there is every chance that these companies fall foul of a growing awareness amongst investors of environmental, social and governance (ESG) factors in the future. This is particularly applicable to the miners, oil majors and tobacco stocks.

In contrast, it is easier for active managers to focus on companies that score well on ESG criteria, with strong free cashflow and a stable balance sheet. What’s more, active managers have the freedom to invest in businesses which have reset their level of income.

‘Steady Eddie’ income funds

So, which funds have the potential to deliver a sustainable income looking ahead?

Cheeseman highlights Trojan Income, managed by Blake Hutchins, Francis Brooke and Hugo Ure, as one of his top picks. While the fund’s dividend fell by 30% last year, the team had already signposted a cut before Covid-19 hit, as they believed the dividends paid by a number of the UK’s largest companies had become unsustainable. They then opted to take advantage of market volatility last year to sell higher yielding stocks with lower growth prospects in favour of companies with sustainable dividends and growth potential.

“They were prepared to do a one-off reset. Hutchins was very clear: his hope or intention was to make one cut from which he can then generate a sustainable level of income, which can grow into the medium and long-term. He did not want to subject unitholders to a variable income stream with no predictability,” Cheeseman explains.

Meanwhile, Jonathan Miller, UK director of manager research at Morningstar, highlights Artemis Income as a ‘steady Eddie’.

“Artemis Income has shown a fairly reliable income stream that has grown without fluctuating too wildly. At the same time, it has outperformed the FTSE All Share index over the long term,” he says.

There are four UK equity income funds in interactive investor’s Super 60 list. Three are actively managed: City of London (LSE:CTY), Royal London UK Equity Income and Man GLG Income. There’s also a passive option – Vanguard FTSE UK Equity Income Index.