Investors are turning to income funds, but is a trick being missed?

Investors are back on the hunt for income, but funds in this sector remain out in the cold, despite offering higher yields.  

Dividends are back in fashion on the back of investors turning more cautious in response to the volatile backdrop for stock markets.

Year-to-date, UK equity income and global equity income funds have weathered the market storm, with average returns of 0.3% and -1.8%.

Both sectors have held up notably better than funds prioritising total return over dividends. The average UK All Companies fund is down 6.4%, while the average global fund has declined by 9.5%.

This marks a reversal in fortunes, as over the past couple of years both income sectors have lagged.

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While far from guaranteed, the prospect of a company paying a dividend gives investors greater confidence in terms of its valuation versus firms that are reinvesting cash back into businesses for future growth. With inflation and interest rates on the rise, investors have become more mindful of valuations. In turn, this has benefited dividend stocks, which have seen higher demand.

However, when it comes to funds there’s been a clear preference to go global. The latest sales figures from the Investment Association (IA) show that global equity income was the bestselling fund sector in April, with £678 million invested. It was the fifth consecutive month of inflows for the sector.  

In contrast, UK equity income funds remained out in the cold, with £31 million withdrawn. Yet this was an improvement, as £211 million was pulled from the sector in March. Over the past year, the sector has posted outflows every single month.

Investors could be missing a trick. The UK stock market has many high-yielding stocks, including those in the mining, energy and banking sectors. This makes it one of the top yielding markets in the world.

As a result, UK equity income funds have higher yields than their global rivals. The median yield in the sector is 3.8% compared to 2.4% for global equity income funds. 

Beyond funds that enhance their dividends through buying derivatives, the fund with the highest yield generated naturally by the underlying investments held is the passively managed Vanguard FTSE UK Equity Income Index, yielding 5.2%, according to FE Fundinfo.

For active strategies, interactive investor Super 60 member Man GLG Income has a yield of 5.1%, followed by income of 4.9% and 4.8% for VT Downing Small & Mid-Cap Income and abrdn UK Income Unconstrained.

In contrast, for the conventional approaches in the global equity income sector, the highest yields are 3.7%, offered by both FTF ClearBridge Global Equity Income and Morgan Stanley Global Brands Equity Income. The next biggest highest yielders, at 3.6% and 3.5%, are abrdn World Income Equity and Overstone Global Equity Income.

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The same pattern plays out among investment trusts and UK strategies have higher yields than their global counterparts. Recent research by Stifel, the stockbroker, found that a large proportion of the 25 equity investment trusts yielding above 4% invest in UK shares.

However, despite offering investors the prospect of higher income today, there are no guarantees that this will result in market-beating returns from a total return perspective – when both capital and income are combined.

Moreover, dividend growth may also turn out to be more subdued versus a lower yielding trust. In addition, dividends can be cut or cancelled without notice. The risk is that a high yield today could lead to a disappointing outcome tomorrow.

Therefore, investors who want to spend their dividends (so are therefore focusing on yield), but also grow their capital at the same time, need to think hard about how to balance those objectives. One approach could be to hedge your bets by investing in a couple of income strategies that invest differently.

Why the UK market is being given the cold shoulder 

The UK market has been out of favour among fund investors since the UK voted to leave the European Union in June 2016. At the time, uncertainty over how Brexit would pan out and the prospect of the UK walking away from the EU without a deal, unnerved investors. 

More than two years on from Brexit day, sentiment towards UK funds has not improved.

The continued apathy towards the UK has left various fund managers perplexed. Nick Train, for example, manager of Finsbury Growth & Income (LSE:FGT) investment trust, told interactive investor’s head of markets Richard Hunter in an interview earlier this year that “the UK market has been unfairly neglected in recent years”, despite UK companies being “undervalued relative to their global peers”.

Simon Brazier, fund manager of Ninety One UK Alpha, a member of interactive investor’s Super 60 list, told our Insider Interview video series that Brexit uncertainty is still holding back investors.

He said: “I speak to many investors across the world and some of them are still worried about Brexit because we still haven’t seen the full outcome play out. For example, we are still not imposing checks on goods coming into the UK from Europe, and that’s something that’s [been] thrown at me by some of my investors worrying [about] what will the outcome of that be.”

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Brazier points out that it is human nature to “buy when things go up rather than when they’re going down”. As a result, he hopes the recent outperformance that the UK stock market has enjoyed versus overseas exchanges will continue and prove to be the catalyst for investors to increase exposure. 

He added: “Many of my clients are under-represented in UK versus their benchmarks. So, I think if you saw a bit of a tailwind here, you could see that money flowing back in.”