January 2011
The false hope of equity income funds
Everyone wants income these days. On top of that they want to preserve their capital at a time, where in the UK, inflation is eroding the value of cash at 3% a year. The obvious answer is to buy high yielding equities. That way you get the dividend yield of the market and the capital growth from owning equities as well as the inflation beating increases in dividends over the years. The ever popular Equity Income Sector is testament to the appeal of the concept to investors. However, the logic is deeply flawed.
Most market aphorisms are rubbish. This one though has the ring of veracity to it.
“Any share yielding 10% isn’t yielding 10%”
The market has priced the shares to yield that because, collectively, the corpus of knowledge about it indicates that the dividend is not sustainable. While that may be an extreme example it does tell us that any stock that offers a yield in excess of the current market yield of 3%, for the FTSE 350, is regarded as likely either to cut its dividend or grow it more slowly than its peers.
The logic is brutal, but equity income funds cannot offer high income and capital growth. At best they can do one or the other and, at worst, they might not deliver either.
Consider this. The current constituents of the FTSE 350, excluding investment trusts, are forecast to pay out £68 billion in dividends next year. At the current valuation of £1,850 billion that indicates the market has a prospective yield of 3.7%. If we exclude the possibility of polluting this universe of 300 stocks by including foreign shares and bonds, as many equity income funds do, how could we increase the yield from this collection of stocks? Any pure UK equity fund has to, and can only, draw from this universe. The index can therefore be viewed as one large fund.
The first thing to point out is that the income from this group cannot be increased. That figure of £68 billion is derived by aggregating all the forecasts from all the analysts covering this universe. That is not to say it will be right, but it is the best estimate from the available data.
So if the income cannot be increased the only way to increase the yield is to reduce the amount of capital needed to buy that income. Instead of paying £1,850 billion to buy £68 billion of income we can try and get the same income for less money. The obvious first step is to eliminate all shares that are not forecast to pay a dividend. In total these 75 shares are worth £74 billion. So removing these shares reduces the cost to £1,776 billion and increases the yield to 3.8%. That is hardly much of an improvement, especially when it removes shares like Cairn Energy that could potentially be significant dividend payers in the future. So the lower price comes with a risk that the smaller universe may not grow as much in the future as the untainted original.
To make a significant increase in the yield of a fund replicating the FTSE 350 it is clear that the only way to do it is to reduce the capital by more than the income. In other words reduce the size of the portfolio so that the capital is, say, 10% smaller but the income is only 5% less. Taking the argument to its logical conclusion you would end up trimming all low yielding stocks until you were eventually reduced to one super high yielding share. All very well except for the massive risk of a BP, RBS, HBOS type event and seeing the dividend cut.
It is clear from this mental exercise in taking the argument to its extreme that there is a simple trade-off between income and risk. Sure, you can increase yield, in the short term, but at the expense of potentially missing out on future dividend increases and long term capital growth. The smaller the subset of the universe you choose the higher risk of your capital underperforming the index.
While the market might not be 100% efficient it is pretty good at getting the bulk of it right; eventually. Trying to get more of that return through income and assuming high yield stocks are mispriced is a recipe for disappointment in the long term. Dividends can only be increased if the company grows at least as fast as the payout, if not more rapidly. The converse of that, to have rising dividends from an unchanged capital base, would lead to the ridiculous situation of small stocks with massive yields.
In reality the only benchmark for an equity fund is the total return of the index. The category of equity income is a nonsensical and should be relabelled as a multi-asset category, such as cautious growth, to allow it to include bonds.
The equity income label for funds is misleading. The IMA should bury it.