The UK equity income sector is one of the most popular areas for the retail investor, but it has come under scrutiny following disappointing results from many of the funds.

The sector grew to a staggering £57bn in May, according to the Investment Management Association, second only to the all-companies area. It was one of the top two sectors for new investment every month in the last year.

But research from Bestinvest for the FT shows that only two of the 96 funds outperformed the FTSE All Share index growth of 9.6 per cent in the year to date.

As well as disappointing total returns – the combination of capital growth and dividends – income performances have not been as strong as many would hope.

According to Lipper earlier this year, up to half the funds failed to meet their income target of 110 per cent of the FTSE All Share index.

Typically, income funds return between 2 per cent and 4 per cent per year, and, while many will grow dividends over time, the lower-yielding funds look weak when rising interest rates make saving accounts attractive.

Mark Dampier, head of research of Hargreaves Lansdown, admits yields have become less important to many investors than searching for growth in the current bull market.

“The sector has certainly struggled as a whole against the All Share as stocks that pay big dividends have not done well.”

Many underperforming funds have been exposed to stocks such as banks, which pay good dividends but have lack-
lustre share prices.

On the flip side, funds have also been penalised for not investing in some growth stocks – particularly in the commodities and mining sectors – that offer strong share performance but low income.

Dampier believes that there are no more than 15 funds that are worth considering. These are very good, he says, but the rest are “mostly awful”.

It is no surprise the better performing funds are those that offer many of the characteristics of a growth fund.

For example, one of the top performing funds is Invesco Equity Income, run by Neil Woodford, which does not hunt down high yields. Meanwhile, underperformers, for example New Star Higher Income, employ screens prohibiting investment outside high- yielding stocks.

Research this week from Principal Investment Management again shows many of the better performing funds are those that seek growth as well as income from stocks.

But Invesco’s Woodford says criticism of the sector is unfair on short- term performance as it should be regarded as a longer term investment category

He says the All Share index has recently performed well because of the growth of mid-cap stocks, which are not at the heart of many income funds.

Artemis fund manager Adrian Frost says the income philosophy of the sector will ensure a longer-term outperformance, and points to recent weakness as a result of rising inflation, interest rates and bond yields, all of which affect income funds.

Overall performance aside, says Gavin Haynes, investment director at Whitechurch Securities, the main reason to invest in the sector is the potential for income multiplication.

For example, he says, if you start off with an income of 3.2 per cent per year and assume that it grows at 6 per cent then your income will have grown to 4.3 per cent of your initial investment in five years’ time.

This makes these funds ideal for those who want an income, he says, but can’t afford to have capital eroded by inflation.

Dampier points out this makes it perfect for the older investor. “There is someone turning 60 every 30 seconds,” he says. “Income investing is crucial for retirement and where else do they go?”

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