Time to shore up with defensives

Equity income funds are expected to regain their strength and achieve higher returns if stock markets falter and defensive stocks advance.

When investors moved into cyclicals and out of defensives late last year, equity-income funds were dealt a blow and many are still suffering.

Even long-standing, top performers such as Invesco Perpetual’s Income and High Income funds and Newton’s Higher Income fund have fallen to the bottom of the league tables since markets began rising in March.

But analysts believe that the recovery is nearing its end and investing in sectors offering stable returns year-on-year, such as tobacco, pharmaceuticals and utilities – the mainstay of most income portfolios – will be preferable to buying into riskier sectors.

While miners, financials, property and other cyclical shares – whose fortunes tend to hinge on the ups and downs of the economic cycle – have out-performed non-cyclicals by some 50 per cent this year, a correction is likely and high-yielding defensives may move ahead, advisers say.

Adrian Lowcock, an investment adviser with Bestinvest says: “Expectations are that we will see weak or anaemic recovery. So, considering where the market is now, equity income looks attractive in the short to medium-term.”

Effectively, managers of equity income funds are value investors who seek out companies with low share prices relative to their net assets.

The objectives of these funds are to deliver both an above-average income for investors and capital growth. To be included in the equity income sector, a fund must maintain a dividend-yield portfolio that is at least 110 per cent that of the FTSE All-Share index.

Equity income funds have historically achieved strong returns in the long term, as their capital growth and yields have outstripped inflation.

In the last decade, the equity income fund sector outperformed both the FTSE 100 and All-Share indices. The sector reported a 50.7 per cent return over the period compared with a 31.35 per cent return by the All-Share index and a 20.3 per cent return by the FTSE 100.

But Brian Dennehy, an adviser with Dennehy Weller, warns that in shorter, more volatile periods, high-yielding shares tend to underperform. Last year, for example, the average equity income fund lost 29 per cent, according to the advisory firm Towry Law’s calculations.

“But invariably such periods are time to buy,” Dennehy adds.

Income funds appeal to investors looking to take profits in ten or 20 years. And the rewards of putting money in these funds tend to outweigh the risks over the long term.

Analysts claim that five to ten years should be enough time to ride out short-term turbulence in equity markets. In order to generate income, some advisers suggest that medium-risk investors should have about a third of their portfolios in equity income funds, and the remainder in bonds and commercial property. Cash should also play a key role in an income portfolio, they add.

But Andrew Wilson, head of investments with Towry Law, and Jason Butler, an investment adviser with Bloomsbury Financial Planning, both warn that investors should maintain portfolios, with a mix of assets in case of market surprises.

“I don’t know what the future holds and whether equity income or defensive funds will do better than growth or general equity funds,” says Butler. “There is no way to consistently outwit the market.”

Investors may also now consider UK-based equity income funds that invest in Europe and the Far East.

Asian income funds are likely to be more biased towards investing in financial stocks, as banks and asset management groups in the region tend to pay dividends more readily, advisers say.

While dividends offered by UK equity income funds are typically between 3 to 4 per cent (net of basic rate tax), they tend to vary more widely across Europe and Asia.

For investment income, managers usually deploy two approaches. The more traditional one is to pick higher-yielding value shares or well-established companies with strong cash flows and dividend records.

The other style is the “barbell” approach – here, managers invest in a combination of high-growth stocks and high-yielding income stocks.

The approaches of equity income fund managers vary widely. Adrian Frost, who runs the Artemis Income fund, invests in a range of small, mid and large-cap companies and the focus is investing in companies with good cash flow and recurring revenues. Rensburg’s Equity Income fund, by contrast, is focused on FTSE 100 stocks and aims to offer dividend growth that is 25 per cent above the FTSE All-Share index.

However, income funds’ recent underperformance has taken its toll and forced the managers of some income funds to cut dividend payouts.