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Theory and practice – While the IA consults on definitions, investors need to be pragmatic

22/04/2016

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

The Investment Association (IA) recently announced it would be launching a consultation into the basis on which funds do and do not qualify for inclusion in its UK Equity Income sector – just short of two years after The Value Perspective first discussed the perils and implications of the current definition in Hostage to fortune.

The fund management trade body is proposing three possible options, the first of which is to maintain the sector’s current requirements that its constituents 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”.

The second option would see the 110% hurdle lowered to the requirement that constituents simply better the All-Share’s yield while the third would involve greater disclosure – in other words, in addition to meeting some quantitative criteria, funds would have to declare their volatility, perhaps, or the amount of income generated for ever £1 invested. In short, more data.

One aspect of this affair that is worth considering more closely is why the IA is undertaking this consultation at all – and, with the greatest respect, we would suggest anyone now thinking “Because a number of big funds have already had to leave the UK Equity Income sector and a number of others may not be too far behind them” is being too simplistic.

The more nuanced point – as we recently discussed in Think big – is that the UK market’s yield is at present extremely concentrated among a small number of very large companies. Thus, while the UK market as whole yields 3.5%, just one-quarter of its constituents yield more than that – in other words, the market is significantly skewed, and the opportunity set for income investors is reasonably narrow.

What is more, the large companies that are doing the skewing – the likes of AstraZeneca, BP, GlaxoSmithKline, HSBC and Shell – have what might politely be described as ‘issues’. As such, one would at least have to consider the possibility the IA’s current definition might be pushing some fund managers towards buying these companies and that such a possibility might not be desirable.

It seems unlikely the IA would wish to be seen to be driving investment or for it to be thought fund managers could be changing their portfolios to fit in with its rules – hence the review. Naturally we have our own thoughts on all this but, while you might gain an idea of them from our argument income matters far more than yield in Income outcome, we will save them for the appropriate channels.

Of course, while the consultation process plays out, managers of UK equity income portfolios are still going to have to come up with practical ways to counteract the current concentration of the UK market’s yield. One answer would be to make full use of the 20% of a portfolio that can be allocated towards overseas companies.

As for the remaining 80%, UK equity income managers will be acutely aware that, in addition to the risk inherent in those ‘issues’ facing some of the big businesses currently paying big dividends, there is little prospect of dividend growth on a fundamental or underlying basis. Even if the big dividends can be maintained, there is little prospect these dividends can also grow to beat inflation – a necessary objective for all investors.

One way to offset static dividends, we believe, is to invest in UK businesses that are returning to the dividend register – as Lloyds Bank recently did and Royal Bank of Scotland will in due course. As we have argued in articles such as Green flags, Lloyds’ current dividend is unsustainably low and, as it normalises over the next year or two, it should prove a significant driver of the UK market’s income growth.

Author

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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