The prospect of some high-profile names having to quit the UK Equity Income grouping of funds for the more generalist UK All Companies sector has provoked a good deal of media comment in recent weeks. Really, though, it was only ever going to be a matter of time before this happened – and that time was three or four years.
The degree to which UK equity funds may be considered ‘growth’ or ‘income’ has exercised the Investment Management Association (IMA), the trade body that oversees such matters, for some time now. Indeed, the last couple of decades have seen halfway houses come and go – first ‘UK Growth & Income’ (merged away June 1999) and then ‘UK Equity Income & Growth’ (merged away July 2010).
The latter instance was when the IMA introduced the current rule that constituents of its UK Equity Income sector should invest at least 80% of their portfolio in UK equities and “intend to achieve a historic yield on the distributable income in excess of 110% of the FTSE All-Share yield at the fund's year end”.
Furthermore, adds the IMA, “to ensure compliance with the intended 110% yield, funds in the sector will be tested over three-year rolling periods by taking a simple average of the yield figure achieved for each fund at its year-end. Funds that fail to meet the 110% average yield for each three-year rolling period will be removed from the sector.”
So, once a year, the clock effectively stops and a fund’s yield over the previous 12 months is calculated. Clearly, since it is the average of three successive years that counts, nobody was going to fall foul of the test in 2011 or 2012 but over 2013 some funds started to be removed from the sector. It is only this year, however, that we have started to see some big-name players being affected.
The point of this article is not to focus on those big names but to point out that, the moment you set in place a fixed calculation, you become a hostage to fortune. One the face of it, a three-year rolling average looks a prudent sort of measure – certainly in comparison to using a single year or even two – but that is before real life intervenes.
The reality of this particular situation is that, in 2011, it was easy enough to beat the 110% target but, over the last two years, the performance of most UK equity income funds has been so good they have surpassed the income growth in their underlying companies by a distance. This means that, far from the target being an issue for a few funds, a significant proportion of the sector could be facing a problem.
This would leave fund managers facing two choices – the first being to go all out in the third year to meet their income requirement. If they have one year well above the income target and one year on the line, then slightly pushing to achieve sufficient income in the last year may work out OK. Regardless of the three-year rolling average, however, a single super-low year could see them dumped out of the sector.
If say, for whatever reason, a fund suddenly sees a massive spike in the share prices of companies it owns the day before the annual income ‘snapshot’ is taken, its yield is going to look unrepresentatively low. Regardless of whether or not those share-price moves were justified, that number will be locked into the fund’s three-year rolling average.
That is an extreme example but, as we said, the fact some UK equity income funds have done so well over the last couple of years means they risk missing the 110% target. But if they try and push hard to grow their income, there is a very real risk they will be taking uneconomic decisions and, furthermore, they would be allowing the tail to wag the dog.
That is because the quest for income would become the fund’s overriding aim rather than it treating both its income and capital accounts in an equal fashion. Such a situation would, in effect, lead to rules taking precedence over investment decisions.
The other choice for a fund manager in this situation involves crossing their fingers and hoping their shares do really badly, which effectively boosts the yield on the portfolio. But, again, that is hardly in anyone’s interests. So while the three-year rolling average appears to be a sensible enough measure – and, if we are honest, The Value Perspective has no better suggestion – income investors need to be aware it is by no means a perfect one.
As such, the fact that funds are being removed from the IMA’s UK Equity Income sector due to not meeting the rule may not in any way signify a weakness on their part. On the contrary, it may suggest a strength on the part of their managers, who are likely to have taken the view that pushing for extra income is potentially uneconomic and not necessarily in the best interests of their investors.